Bank guarantee “here to stay”

So says Dr Cullen, and I think his description of why is pretty spot on:

it will be difficult in two years to return to a situation where bank deposits were no longer insured by the government

When financial institution base there decision on the fact that this new framework exists, changing the framework would be problematic and painful – making it harder to remove it. Furthermore, as he says, when every other country has a scheme we sort of get stuck having to have one – or else we have to pay a higher premium on our credit (assuming of course that the private sector can’t provide insurance as efficiently – a debatable assumption).

Dr Cullen also points out a major concern that:

excessive amounts of money that could flow into finance companies to chase the guarantee for two years

In that case, why don’t they let the Reserve Bank adjust insurance premiums based on risk – the companies have to show a credit rating anyway, so the better the rating the lower the premiums. At the moment the larger organisations, which also have better credit ratings, are paying MORE for this insurance – it is ridiculous.

As Dr Cullen has identified the problem, why doesn’t he fix it?

  • When the governemnt releases a policy and then Cullen is publivly talking about the problems with it you know it was a rushed hatchet job.

    Unless the other countries drop it in two years there is no way we were going to drop it, epesicailly since the main arguemtns in favor of this policy appear to be a “me too” approach where if we don’t do it momney leaves the country. That arguemnt isn’t going to be any different in two years

    I fully agree with you, we have credit ratings for all these companies so they should pay premiums that refolect their risk. I might even go one step further and say flag the government guarantee, just legislate that these companies are required to have deposit insurance then let them obtain it at market rates. Haven’t thought this through much, interested in your thoughts.

  • “I might even go one step further and say flag the government guarantee, just legislate that these companies are required to have deposit insurance then let them obtain it at market rates”

    This depends on your view of the functioning of the insurance market. In New Zealand the insurance market is likely to be:

    1) Thin,
    2) Subject to a strong degree of asymmetric information.

    All in all this suggests that the industry will be vulnerable to long-tail shocks and will “ration” insurance in a way that is socially inefficient.

    If the government has better access to information or is able to more accurately target the “optimal” level of insurance, then a government insurance scheme makes sense – and would be relatively cheap to run.

    As a result, we would have to weigh up these factors when making a decision methinks

  • Why would the government have better information on the credit worthyness of financial instituions then companies that specialise in insurance?

    If the industry is better able to price insuarance in line with the acual risk being taken, surely this would lead to a mroe “optimal” allocation.

    On the thiness, it would probably have to be from big multinationals anyways so I don’t see this as a porblem, although I recognise in the current financial climate this might not be feasible!

    On that note it probably is best the RBNZ does it so I guess we’ve come full circle, the RBNZ just needs to hire some specialist risk analysts to price the insurance in line with market rates, there must be a few people with these skills floating round looking for jobs with all the bank failures:)

    I’m interested in your theory on long-tail shocks:)

  • “Why would the government have better information on the credit worthyness of financial instituions then companies that specialise in insurance?”

    Because the government can FORCE disclosure of information that private agents can’t get ahold of.

    “If the industry is better able to price insuarance in line with the acual risk being taken, surely this would lead to a mroe “optimal” allocation.”

    But in the case of asymmetric information we have a market failure, which leads to “under-insurance”.

    “On the thiness, it would probably have to be from big multinationals anyways so I don’t see this as a porblem”

    Agreed – but this also involves even more asymmetric information, as multinationals have less nation specific information 😛

    “I’m interested in your theory on long-tail shocks:)”

    Don’t have one – just thought I’d throw it in there 🙂 . Something to do with asymmetric payoffs between private and public industry types because of there capacity to absorb shocks.

  • sorry, I din’t clarify, in my fancifal world the governemnt would force disclosure and leave it to the market to price it. I was basicaly operating on the assumption thast with the same information the private sector would be able to better utilise it.

    Plus on the mulitnational front comapnies like AIG (bad example since they’ve jsut gone bust!) and IAG ahve big operations in NZ so I’m not sure about the local informaiton bias. Similar to why I don’t buy the home bias arguments about portfolio allocation, I don’t see it being any different for insurance.

  • “I was basicaly operating on the assumption thast with the same information the private sector would be able to better utilise it.”

    Agreed – but I am assuming that the private sector has worse information, hence why the government should provide. If information is equal than I agree – it is the key assumption.

    “Similar to why I don’t buy the home bias arguments about portfolio allocation, I don’t see it being any different for insurance.”

    Fair enough. However, empirically there is a home bias in portfolio allocation – why would that be if it wasn’t the result of information asymmetries.

  • I’ve never found the inforamtion assymetry argument for homebias convincing. I can hire US portfolio manager to amange my US ivnestments and a NZ one to maange my NZ investments, thus getting the benefit of local knowledge in both countries. While I’m loathe to rely on wikipedia, the article that is cited on the wikipedia entry says the same thing

    “Another hypothesis is that investors have superior access to information about local firms or economic conditions. But as van Nieuwerburgh and Veldkamp (2007) points out, this seems to replace the assumption of capital immobility with the equally implausible assumption of information immobility.”

    There is also empirical evidnace that home bias has been decreasing over time which could suggest it is more of a transaction cost problem and thus as the transaciton costs of shraing information and trading oversaeas have fallen, the home bias has diminshed.

  • “There is also empirical evidnace that home bias has been decreasing over time which could suggest it is more of a transaction cost problem and thus as the transaciton costs of shraing information and trading oversaeas have fallen, the home bias has diminshed.”

    Agreed – however, that is merely telling us that as the cost of sharing information falls, the information asymmetry declines. It is an important point, to be sure, but it is also completely consistent with the idea that there IS some type of home bias – it just explicitly states it is the result of transaction costs.

    Ultimately, even if we got to the point where other firms information is exactly the same – we still have a gap between private sector and public sector information. As long as this gap persists we could make an argument for publicly provided insurance. If this gap disappears, then we still know that the public sector could help (as asymmetric information will still lead to “to little” insurance) – however, the case would be FAR less compelling 🙂

  • Kimble

    Couldnt home country bias be a function of expected future consumption?

    If the goods you are wanting to purchase with your future cashflows are local, then wouldnt you want exposure to local markets? So if prices go up, the value of your investment goes up to match.

    The corollary of this is that investment in international goods is based upon the expected level of future consumption of imported goods. In which case international investing would be more of a glorified currency and inflation hedging strategy.

  • Intersting argument, bascially you use your investment portfolios to hedge consumption risk. I’m pretty sure there are academic models that take this approach. Actually, there are the consumption versions of the Capital Asset Pricing Model (CAPM, consumption models being the CCAPM) which capture this although I can’t remember if they have been generelised to an international setting.

    The one thing that jumps out at me here is that if local prices go up you could switch to imports (for tradeable goods) and thus you would still simply want to maximise the return on your portfolio. Obviously non tradeable goods changes the story, and I think that is the area where your theory would hold the msot sway.

  • Interesting stuff – go the risk aversion 😛

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