Supplementary Submission to the Financial System Inquiry 3. Protection of Depositors


113. A number of submissions to the Inquiry made reference to the current arrangements for depositor protection in Australia, as did the Financial System Inquiry Discussion Paper in Chapter 8, where it canvassed some alternative arrangements. This Chapter attempts to review these issues, and to discuss several different ways of overcoming perceived deficiencies in the present arrangements.

114. Depositor protection can take many forms, including a formal government guarantee of depositors, a general statement of intent to protect the interests of depositors, or an explicit system of insurance for deposits. All these arrangements have two basic motivations:

  • a system stability motive. By increasing confidence in the institutions offering deposits, the likelihood of destabilising ‘bank runs’ is eliminated or reduced.
  • a consumer protection motive. A ‘safe haven’ is provided for the small and financially unsophisticated saver.

115. All major developed countries have some form of depositor protection because they believe it contributes to a better financial system and hence a stronger economy. Alan Greenspan (1996) puts forward the standard view when he says ‘since the safety net makes bank creditors feel safer, the banking system is larger, more stable, and more able to take risk and extend more credit than otherwise would be the case. In the process, banks have contributed significantly to the economic growth of the nation, and continue to do so.’ But depositor protection also has some drawbacks, so the judgment in its favour is an ‘on balance’ one. The following sections discuss the drawbacks insofar as they relate to the present Australian system, then later sections discuss alternative ways of overcoming them.

The Australian System

116. In terms of the three classifications contained in paragraph 114, the Australian system of depositor protection could best be described as a general statement of intent to protect the interests of depositors. It was embodied in the Banking Act of 1945 and has therefore been in operation for 50 years. Its intellectual origin can be found in the 1937 Report of the Royal Commission into Monetary and Banking Systems in Australia, which stressed the financial system stability aspect of depositor protection rather than the consumer protection aspect. The key part of the Act says that the RBA must ‘exercise its powers and functions for the protection of depositors of the several banks’ and, in accordance with this, provides the RBA with powers to handle a bank that may not be able to meet its obligations.

117. There are two main criticisms that have been levelled at the Australian approach to depositor protection. The first is that it is unclear or, in modern parlance, lacks transparency. The greatest uncertainty is whether there is an obligation for the RBA to protect the full amount of deposits, or merely to give depositors preference over other creditors and so maximise the proportion of the original face value they receive. It is also unclear on what constitutes a deposit. Critics of the Act point out that its lack of clarity tends to give people the impression that it is a broad guarantee, although in the RBA's view it is not. We believe that the history of the Act supports our view, but others might think differently. The RBA has been one of the main critics of the imprecision of the Act, and has attempted many times to set the record straight. Former Governor R.A. Johnston spoke of the RBA as being ‘guardian not the guarantor’, and stated that: ‘the legislation is less than a guarantee to depositors of full repayment … nor does it specify how the parties would emerge in the event of winding up’ (Johnston (1985)). A similar point was made by current Deputy Governor G.J. Thompson who recently said that it is ‘important to change the common perception that RBA supervision is an absolute guarantee against institutional failure. One useful step to this end would be to recast the Banking Act, removing the widely misunderstood references to depositor protection and restating the RBA's dual responsibilities as prudential supervision (to reduce the likelihood of institutional failure) and crisis management (in the event that a failure occurred). The provision for deposits to have first claim on assets in Australia would be retained.’ (Thompson (1996)).

118. The second criticism is that depositor protection, as it is understood by most people, amounts to an implicit publicly funded insurance policy for bank depositors. This leaves the RBA, and hence the Government, exposed to significant but undefined losses should a bank (or banks) fail and not have sufficient residual assets to pay out depositors. The existence of this implicit insurance sets up a moral hazard in that in encourages depositors to ignore risk (i.e. chase the highest interest rate regardless of risk) and bank management to take excessive risks in lending (in order to be able to offer the highest interest rates). This moral hazard could, in extremis, induce the very instability that depositor protection was intended to avoid.

119. The problems associated with depositor protection, namely the possible cost to the taxpayer, and the moral hazard effects on behaviour, are ones with which every country has had to grapple over the past century. There are a number of possible responses and the rest of this paper will discuss the merits of three approaches:

  1. eliminate depositor protection entirely;
  2. clarify the existing arrangements;
  3. move to a formal system of deposit insurance.

The Elimination of Depositor Protection

120. This solution would involve removing any reference to depositor protection from the Act, and taking whatever other steps were necessary to convince the public that the Government was not guaranteeing their deposits. The other steps would include getting rid of prudential supervision, and undertaking a public education program to show that the Government did not stand behind deposits.

121. To the best of our knowledge, this approach has not been followed by any major country. There are two main reasons for this:

  • Regardless of what the Government says, it is difficult to convince the public that it will not step in and protect depositors in the event of a bank failure. While a government might be able to hold the line in the case of a small individual bank failure (and even this is not certain), failures do not tend to be isolated events – they come in waves, usually when asset prices are falling and the economy is in recession. It is hard to believe that, at such times, democratically elected governments will (or should) stand by and watch a large number of citizens (and voters) lose money they thought was relatively safe. This inability of governments to ‘credibly pre-commit’ means that they probably cannot remove the perception of depositor protection even if they want to.
  • Even if the above problem was overcome, there would be serious doubts about the nature of the resulting financial system. Not only would depositors be much more wary, banks would have to be more heavily capitalised and would be much more risk averse in their lending. Thus, the banking sector would be smaller, higher cost, more cautious and contribute less to economic growth (the opposite situation to the one Greenspan was describing in paragraph 115). In addition, there would be an anti-competitive element as depositors would move from small banks to large ones, the public assuming that the latter were ‘too big to fail’.

122. Thus, getting rid of depositor protection, even if it was possible, would probably be undesirable: it would amount to ‘throwing out the baby with the bathwater’. For this reason, it has not been seen as a realistic or desirable alternative, even by those who are critical of some aspects of existing systems of depositor protection. It should also be noted that getting rid of depositor protection, while retaining prudential supervision of banks, would achieve little, because the perception that the Government was looking after such deposits and was ‘responsible’ for them would remain.[8]

Clarifying the Existing Arrangements

123. The Australian system of depositor protection has operated essentially unchanged for over 50 years, and it would be difficult to argue that it would not benefit from a review.[9] In many ways, it has been quite successful but, on the other hand, it has not been put to a major test. The following section attempts to set out its strong points and its weak points.

(a) Arguments for the existing system

124. The biggest argument in favour of the existing system is that it has resulted in the public having a high degree of confidence in the banking system, but has not cost the taxpayer any money since the RBA or Government have not had to bail out depositors.[10] In that sense, it has been a very cheap system.

125. A good system of depositor protection should provide a high degree of confidence in the banking sector, but not absolute unquestioned faith in every bank, i.e. there should be bit of scepticism remaining. There is some evidence that the Australian system retains some scepticism in that there have been three ‘manageable’ runs on banks in the past decade. In each case, the run was stopped by an RBA Press Release pointing out that the bank was sound. It has to be conceded, however, that each bank was a relatively small one that had recently transformed from being a permanent building society. The public's faith in the larger longer-standing institutions seems to be extremely high, although there is some discipline exerted on these banks by the professional or wholesale markets. When two major banks incurred losses in 1992, their ratings were reduced and they faced higher costs of attracting ‘wholesale’ deposits and additional capital.

126. A third area where the present system stands up better than its critics would expect is in the area of moral hazard. There is little or no evidence to suggest that the institutions benefiting from depositor protection have behaved in a riskier fashion than other intermediaries. In well known overseas cases such as the US Savings & Loans (S&L) institutions, this certainly was the case, but in Australia the best known examples of irresponsibly risky lending were institutions outside the net of depositor protection.[11]

(b) Arguments against the existing system

127. Although the present system has not cost the taxpayer anything, its critics would say that it has not really been put to the test. For most of its life, the banks were so heavily regulated that they could not take much risk (the one bank that came to grief did so through an unregulated subsidiary). It has only been in the past dozen years that deregulation has allowed banks to take the sort of risks that could imperil their solvency, and in that time there have been some clear examples of excessive risk taking.

128. The other sense in which depositor protection has not been tested is that we do not know how the system would react politically or legally to a bank failure, even a small one. Would political pressures result in the Government promising to make up any shortfall in depositors' funds? Would aggrieved depositors be able to successfully sue for restitution by arguing that the Banking Act protected them? If this happened, would it mean that in future the Government would become an unlimited guarantor?

129. The problem is that although it has never been used, it is potentially open-ended. There is no scope for the system to protect depositors up to a point, and then have market discipline do the rest, or to protect one class of depositor (small retail) and let others protect themselves (large wholesale). This aspect will be discussed in more detail in the section on deposit insurance.

130. The final argument against the present system is that it bestows a benefit on banks without charging for it. Banks gain in their competition with other financial institutions because the public regards them as more secure. Normally, credit enhancement has to be paid for, but banks receive it without explicit charge because they are subject to the Banking Act. The banks might disagree with this assessment, pointing out that they also have the impost of supervision. It is a difficult task to weigh up the benefit of depositor protection and the cost of supervision. Most of the banks' competitors would regard the former as being the greater, particularly as the main cost of supervision – the minimum capital ratio – is no higher than the market now demands.[12]

(c) Clarification of the existing system

131. A simple form of clarification (as mentioned in paragraph 117) would be to spell out more clearly the fact that depositors would be given first claim on assets in the event of a winding up, rather than paid out in full in all circumstances. This would involve changing Section 14(5)(a) of the Act which currently says:

the RBA ‘shall remain in control of, and continue to carry on the business of the bank until such time as the deposits with the bank have been repaid or the Reserve Bank is satisfied that suitable provision has been made for their repayment.’

132. This change would eliminate the open-ended nature of the existing depositor protection provisions. It could, however, be resisted by those who see it as a watering down of an existing protection. On the other hand, for those who worry about the Government bailing out depositors in a future financial crisis, the change would be seen as not going far enough. The Government would still be seen as supporting bank deposits through two policies – the new narrowly defined depositor protection and the existing prudential supervision of banks.

133. An alternative that gives a narrower obligation to Government would be to specify that all deposits up to a value of x thousand dollars were to be repaid in full and, beyond that, preference would be given to deposits but no percentage of recovery assured. Another alternative would be to confine full recovery to householders and small businesses. Both of these would have the advantage of protecting the ‘vulnerable’, but allowing the discipline of the market to work through the bigger and presumably more sophisticated players. The new system would clearly resemble deposit insurance in that there would be a strict definition of the risks covered. The major difference would be that it would be unfunded, with the Government picking up all of the bill in the event of a claim. This prompts the question of whether it would be better to go the extra step to a fully articulated system of deposit insurance. This is the subject of the next section.

Deposit Insurance

134. One unexpected feature of the submissions to the Inquiry is that, although many suggested major changes to the system of financial regulation, almost none put forward a proposal for deposit insurance. This is surprising because the biggest single difference between the Australian system and those in other countries is our absence of deposit insurance. Among the 24 original OECD countries, only Australia and New Zealand do not have some form of deposit insurance.[13]

135. Deposit insurance is typically enacted by statute or other form of legally binding contract. It specifies the protection provided to deposit holders, the type of institution, the type of deposit and the level of coverage, whether the scheme is compulsory or voluntary, the nature of the funding arrangements and the mechanisms to be employed in the event of a bank failure. Different countries have developed different systems to suit their own needs, and no two are alike (although the European Union is attempting to harmonise minimum insurance coverage levels in all European systems).

136. It would be too time consuming here to go into details on all the possible combinations that are available. For present purposes, it would be sensible to have in mind a relatively conventional system that:

  • is officially sponsored but with significant private sector involvement;
  • applies to all deposits at banks or possibly all deposit-taking institutions;
  • is subject to a cap set as low as possible consistent with credible protection of small depositors;
  • is funded by banks through the payment of annual premiums, supported by irregular levies (subject to a cap) in the event of the depletion of the fund's reserves and access to Government (guaranteed) loans to cover any remaining deficiencies;
  • is jointly administered by the RBA (as the banking supervisor), the Government and the banking sector, each of which would have representatives on a governing board.

(a) Arguments for deposit insurance

137. The first argument in its favour is that it draws a line between the insured sector – or safe haven – and the rest of the financial sector. In enables savers who place a high value on security to know with certainty where to place their funds. In this sense, it is a very transparent system.

138. While it protects the small saver completely, the cap means that larger depositors, and especially wholesale depositors, would have something at risk, and hence an incentive to pay attention to the soundness of the institution. Such a system would involve less moral hazard than a general guarantee of deposits, or any form of depositor protection that was interpreted by the public as a general guarantee.

139. Since it is funded by the industry, it means banks are paying for their credit enhancement rather than receiving it without explicit charge from the Government. This should contribute to competitive equity.

140. Another argument, frequently advanced in the United States, is that it is pro-competitive in that it helps the smaller banks compete against the larger ones, who would otherwise benefit from the perception of safety that derived from their size and reputation. This is certainly true when comparing deposit insurance against systems without depositor protection at all, or where the degree of protection was very narrow or uncertain. It is not true when the comparison is made against a system that contained a general guarantee of deposits.

141. The final argument in favour of deposit insurance is that it puts the central bank or government in a stronger position to resist claims on the public purse when an institution fails (and which has no systemic implications). If properly designed, the genuinely needy will be fully protected, and the others will have the terms of their contracts fulfilled. It thus makes it easier to draw the line than in a system where depositors were given narrower assurances (such as first call on assets in case of a winding up). In this latter case, there could be intense political pressure for a complete bail-out because many people might be unhappy with the final outcome, including some who were quite needy. Once a complete bail-out had occurred, even if applied to a small institution whose failure had no systemic implications, the pattern would be set for future failures.

(b) Arguments against deposit insurance

142. Deposit insurance is not favoured by those who wish to minimise moral hazard. Although, in principle, it should lead to less moral hazard than more general systems of depositor guarantee, if badly designed it may fail to do so. The most widely cited failure of a deposit insurance scheme was the US S&L industry. This was a classic case of moral hazard where insured depositors chased the highest interest rates, which were offered by the institutions making the riskiest loans. Eventually, so many S&Ls collapsed that the losses greatly exceeded the resources of the scheme and the Government had to make up the shortfall at great cost to the taxpayer.

143. This experience illustrates the two criticisms most often made of deposit insurance, namely that it can set up an excessive moral hazard, and that the Government may still be put in a position where it feels it has to bail out the scheme (often phrased as ‘who insures the insurer?’).

144. Defenders of deposit insurance would answer the first charge by pointing out that the S&L case is not representative of deposit insurance schemes in general. Apart from being badly designed (deposits, not depositors, were insured), there was serious corruption in its administration and widespread criminal activity in many S&Ls. At the same time that it was coming to grief, the parallel deposit insurance fund for banks administered by the Federal Deposit Insurance Corporation survived. The same was true of most schemes in other countries. The general point is that it should be possible to design and administer a scheme which produces less moral hazard than that produced by a general guarantee, or a loosely defined obligation to protect depositors.

145. On the second criticism, proponents of deposit insurance would have to concede that in the case of multiple failures, it is highly unlikely that any scheme would have enough resources to meet its obligations. The Government might, therefore, still have to consider coming to the rescue if systemic issues were at stake. This is another way of saying that deposit insurance cannot be expected to handle a financial crisis of systemic proportions. Deposit insurance is designed to handle individual bank failure, and to make a contribution towards system stability. But once a systemic crisis occurs, it would be of little help and central banks and governments would have to make the decisions of how best to inject funds to restore stability to the system.


146. In Chapter 4 of the Financial System Inquiry Discussion Paper, the point is made that one of the requirements of any system of financial regulation is that it should be transparent. Clearly, the existing depositor protection provisions of the Banking Act do not meet that requirement. Since the RBA has itself made that point on a number of occasions, we can hardly argue for continuation of the existing provisions.

147. In our view, the removal of the depositor protection provisions altogether would be a major step backwards, and would almost certainly not find community support. The alternatives, therefore, are to clarify the existing provisions or to replace them with a system of deposit insurance.

148. We have argued in the past for the first alternative and continue to maintain that this would be a better system than the current ambiguous one. By clarification, we mean making it clear that depositors would have first call on assets, but that they would not necessarily be repaid in full if the assets were insufficient. For many people, this would be regarded as a move to a much tougher stance than what they interpret the current provisions to be, but it would certainly pass the test of transparency.

149. The other alternative of limited deposit insurance would be a less tough stance for the majority of depositors and may, therefore, correspond more closely to what the community currently expects. It should be possible to design a scheme which retains (or increases) the present degree of discipline exerted by the professional or wholesale markets.

150. In a financial crisis which threatened system stability, it would not matter which system was in operation. The threat to the real economy would be severe and the Government would probably be prepared to use the public purse to restore and maintain stability. No system can handle a crisis of that size, so the test is really how they handle isolated bank failures without systemic implications.

151. If there is no systemic risk, it is important that the Government not resort to the public purse to provide depositors with any more than they are entitled to under the scheme that is in force. There are some reasons to believe that a well designed deposit insurance scheme may make it easier to handle the pressures that would arise on such an occasion.


In New Zealand, there are no depositor protection arrangements in place but, under its Act, the Reserve Bank of New Zealand (RBNZ) carries responsibility for prudential supervision of the banking sector. This could make it difficult for the RBNZ or the New Zealand Government to deny involvement, and hence expose the Government to pressure to compensate depositors, notwithstanding the absence of formal protection arrangements. This is largely academic, however, since all but one bank operating in New Zealand is foreign owned. Foreign banks account for 99 per cent of bank deposits in New Zealand. [8]

The Campbell Committee devoted only two pages to this subject. [9]

The only occasion where a bank subject to the Banking Act (and hence its depositor protection provisions) was considered likely to become unable to meet its obligations was in 1979 when the Bank of Adelaide was absorbed into the ANZ Bank. In the early 1990s, two State banks – the State Bank of Victoria and the State Bank of South Australia – got into difficulties and had to be recapitalised at great cost by the State Governments that owned them. This, however, was a consequence of the State Governments owning the banks, not a result of them being the supervisor. [10]

Although this should be qualified by admitting that the excesses of the two State banks were partly due to the fact that they were subject to a higher order of moral hazard – they were wholly owned by State Governments which unconditionally guaranteed all their liabilities (not just deposits). [11]

The Non-Callable Deposit (NCD) arrangements involve the imposition of a tax on banks, currently amounting to around $200 million annually. These arrangements have never had any prudential purpose and do not represent a charge or a payment for Reserve Bank prudential supervision. [12]

See Garcia (1996) and Kyei (1995) for summaries of international experience with deposit insurance. [13]