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Regulatory changes to bank liability structures: implications for deposit insurance design

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Abstract

“Tiered” depositor (or deposit insurer) preference as exists in Australia and has been recently introduced in the EU and UK calls into question the merits of ex ante fees for explicit, limited deposit insurance under such arrangements. This paper illustrates how, under such arrangements, the “fair price” of deposit insurance and risks to the deposit insurer are reduced to near zero unless virtually all bank non-equity funding is insured deposits. It is also argued that other regulatory changes affecting bank liability structures and resolution arrangements reinforce that effect, while introduction of “resolution funds” calls into question the rationale for a separate deposit insurance fund. While increased use of collateralised financing complicates resolution arrangements and raises other risks for financial stability, its impact on a “fair price” for deposit insurance under tiered preference is minimal.

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Notes

  1. EC [4] states that EU591.9 billion (4.6% of EU 2-12 GDP) of government capital support was provided between October 2008 and December 2012.

  2. Birchler [7] notes that “[m]any aspects of deposit priority rules, in particular their joint effects with deposit insurance, may need further investigation”.

  3. While some commentators suggest collateralisation reduces the quantity of bank assets available to meet depositor claims, this argument neglects the fact that deposit or other non-collateralised financing should also be correspondingly lower.

  4. They also can be interpreted as implying a form of depositor preference over any AT1 and Tier 2 forms of debt financing, even if no general depositor preference applies.

  5. Chan-Lau and Oura [9] find that in their analysis “[t]he cost of preferred deposits, declines to only a few basis points above risk-free rate even without the support from a deposit guarantee scheme …as long as the share of preferred deposits remains below 60% of total liabilities.” IADI [2] advocate that a substantial proportion by value of deposits should be uninsured. Cannas et al. [10] estimate the share of covered to total deposits for the EU in 2013 to be just under 50%.

  6. Reuters [11] report that Fitch Ratings, for example, noted that the introduction of depositor preference in Europe could increase the effective asset encumbrance ratio, from the perspective of unsecured creditors, from 28 to 72% with significant implications for recovery rates in the case of insolvency.

  7. Schich et al. [12] note from a study of European banks that “Implicit guarantees persist, however, and their value continues to be significant” despite some decline in the last few years associated with developments in bank regulation and resolution arrangements.

  8. Demirgüç-Kunt et al. [14] note that 88% of the countries in their survey with explicit deposit insurance schemes use ex ante funding.

  9. See for example IMF [18,19,20].

  10. Data provided by IADI from its 2014 survey. Very few EU countries at that time had depositor preference. The figures are also affected by multiple deposit insurance agencies reporting from some jurisdictions.

  11. One country which has explicitly eschewed this route is New Zealand, whose Open Bank Resolution approach involves bail-in, by way of haircut, applied pro rata to all unsecured bank creditors including depositors.

  12. Many commentators have expressed concerns that depositor preference will increase incentives of less preferred stakeholders to “run”.

  13. In practice, there will be other liabilities in insolvency such as unpaid employee entitlements, tax liabilities which, depending upon national legislation, may rank ahead of insured deposits or the insurer in liquidation. So also will collateralised claims.

  14. The FSB [21] identifies four categories: general depositor preference; national depositor preference; eligible depositor preference (preference to categories of deposit eligible for deposit insurance, even if above the maximum cap); insured depositor preference. This ignores “tiered” preference arrangements.

  15. This includes deposits in overseas branches which would have otherwise been eligible.

  16. The unification of member country national deposit insurance schemes into a unified EU scheme is under discussion at the time of writing.

  17. China has local depositor preference and announced in December 2014 the forthcoming introduction of a deposit insurance scheme, but details on preference status of the insurer are not readily available.

  18. The number and size of losses from bank failures impacting on the FDIC fund suggest that even though the FDIC has preference (since 1993) over other (non-depositor) creditors, an important determinant may be the proportion of insured deposits to bank liabilities. At the aggregate level, at the end of 2017, insured deposits at FDIC insured banks were 53% of total deposits and 46% of total liabilities (FDIC [26]. O’Keefe and Ufier [27], however, report that the proportion of deposits insured decreases with size and was 74% for banks with assets between $1 and $10 billion and 97% for the small sample of failed banks between 1984 and 2016 with assets under $1 billion for which data was available. Over the period 1990-2017 (excluding 2007-2010, when the figure was $4.4 billion) the average size of failed institutions was $270 million).

  19. Even though national deposit insurers may not use such explicit option pricing models in determining premiums, risk-based pricing approaches typically reflect similar considerations and, in principle, aim to (a) achieve appropriate compensation for the insurance scheme (or taxpayers) for the value of insurance provided and (b) reduce the incidence of moral hazard.

  20. While they did not explicitly consider non-depositor creditors, in the absence of depositor preference, their analysis can be interpreted to include other creditors with uninsured depositors.

  21. In this experiment, Laeven infers that uninsured debt is treated as equivalent to equity which would understate the reduction in the value of deposit insurance since the implied bankruptcy level of assets (and strike price of the put option used in calculating the insurance premium value) is lower than is actually the case.

  22. For ease of exposition, it is assumed that the deposit insurer inherits the priority status of insured depositors.

  23. It is not identical since the point of bankruptcy differs. The tiered depositor preference result is the same for cases a, b and c because the proportion of insured depositors is held constant.

  24. Alternatively, statutory bail-in powers over bank debt funding may be available to the resolution agency without any contractual provisions being included.

  25. A number of other concerns for deposit insurers if bail-in does occur are addressed in IADI [42] including use of agency funds in an inefficient resolution process and dealing with and disposing of any resulting equity stake.

  26. Merton [28] addressed a similar issue in the context of assessing the value to a bank from the introduction of explicit deposit insurance covering all non-equity (deposit) liabilities. He argued that the value of insurance to the bank is determined by the reduction in the interest rate risk premium it must pay to raise funds. Any underpricing of insurance relative to its “fair value” conditional on the existence of the insurance scheme is an additional benefit to the bank.

  27. It might be argued that recent global regulatory developments, such as increased capital requirements have reduced the value of implicit guarantees. And while they arguably have, it would appear that implicit guarantees remain of value. Schich et al. [12] estimate that significant funding cost advantages of around 132 basis points existed in Europe in 2014 as measured by the effect of credit rating uplifts for banks associated with perceived sovereign support.

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  1. Department of Finance, University of Melbourne, Melbourne, Australia

    Kevin Davis

  2. Australian Centre of Financial Studies, Monash University, Melbourne, Australia

    Kevin Davis

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Prepared for symposium in honour of Professor David Mayes at The University of Auckland on April 9, 2018. David was a good friend and valued colleague and co-author who is sadly missed. He was an important member of the Australia–New Zealand Shadow Financial Regulatory Committee, bringing an all too rare blend of practical knowledge and insights and academic rigour and curiosity to its deliberations.

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Davis, K. Regulatory changes to bank liability structures: implications for deposit insurance design. J Bank Regul 21, 95–106 (2020). https://doi.org/10.1057/s41261-019-00094-0

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