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September 13, 2010 | by  | in Opinion | [ssba]

The incentive to fail

Many of the huge bank bailouts in the United States stem from the repeal of the Glass-Steagall Act in 1999. The Act, originally instituted in 1933 as part of Roosevelt’s New Deal policies, was designed to pull the US out of the Great Depression. Alongside the creation of Federal Deposit Insurance, the Act separated commercial and investment banking in order to control speculation.

Commercial banks, where ordinary folk deposited money, were covered by the insurance scheme. These banks weren’t given the opportunity to invest in high-risk ventures, ensuring that money deposited was largely safe. The insurance was simply to avoid bank-runs, a phenomenon whereby panic spreads among depositors if a bank is rumoured to be on the verge of collapse.

Investment banks, on the other hand, were institutions where people and firms could invest with the chance of higher returns, but with much greater risk. As a result of this increased risk, the Federal Deposit Insurance did not cover these deposits.

The repeal of the Glass-Steagall Act in 1999 removed this restriction, but did not remove the Federal Deposit Insurance. Commercial and investment banks merged, and deposits became tied up in high-risk investments. Due to the widened scope of the Federal Deposit Insurance and the hugely inflated size of these merged banks, these deposits had to be covered.

In New Zealand, the Retail Deposit Guarantee Scheme (RDGS) was set up for a similar purpose. In 2008, in response to the recession, the Clark Government extended the scheme to include finance companies. This saw New Zealand follow Australia’s lead in order to deter a massive run of funds from New Zealand into Australia. The Key government has not amended the scheme and, as such, the collapse of South Canterbury Finance was protected and taxpayers have footed the $1.7 billion bill.

The key problem around the Glass-Steagall Act and the RDGS lies with incentives. The protection of ordinary peoples’ money while it is invested in the bank is a pragmatic solution to ensure banks don’t face any irrational runs—and consequently all depositors are protected. However, if individuals and firms are going to invest their money in an attempt to try to gain higher rates of interest, they must face the consequences of the higher risk associated with those investments.

By extending the RDGS to include finance companies, the New Zealand government is incentivising firms such as South Canterbury Finance to take bigger and bigger risks in the knowledge that their investors will be covered if the investments fail. Furthermore, it removes the incentive from investors themselves to ensure the company is using their money in a way appropriate to the associated returns.

It is also important to note, as Scoop columnist Gordon Campbell points out that “by some estimates, fully one third of the 35,000 investors being bailed out under the rescue package may fall into the class of speculators betting against South Canterbury Finance”. These speculators invested on the very gamble that the company would fail, which would allow them to be compensated with premium returns under the RDGS.

So while taxpayers foot the bill, investors in South Canterbury Finance get their investment back plus the interest promised to them when they signed up. Furthermore, when one takes into account that the government has extended the RDGS to cover South Canterbury Finance’s foreign investors who weren’t specifically covered by the RDGS, the government’s actions become even more of a joke.

Also, remember that this scheme has not been widely applied. So, while South Canterbury Finance’s investors get generously bailed out, investors in finance houses such as Hanover Finance are not covered by the RDGS and receive no compensation from the government.

$1.7 billion is a veritable shit-load of money. It has been reported this equates to $340 for every single New Zealander. Man, woman and child. One can only imagine what this figure is when limited to the actual New Zealanders who are taxpayers. When one takes into account that the Government have pledged only $5 million to the mayoral fund set up to rebuild quake-ravaged Christchurch, their priorities seem to be clear.

Sure, it was the Clark Government who widened the umbrella of the RDGS, but the Key government has failed to amend the scheme and protect the taxpayer. If you’re going to roll back the ‘nanny state’, it seems inherently unfair to me to simply attack those on welfare while simultaneously ‘nannying’ the wealthy. It is crucial that significant changes are made to the regulation of the financial sector in New Zealand, and around the world. If an individual or firm wants to risk their money, they should be welcome to do so. But this should come at their expense, and not at the expense of ordinary, prudent citizens.


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