How would Europe, Australia and New Zealand cope with a Big Bank Collapse?

How would Europe cope if a big bank collapsed in its midst? How effective is deposit insurance in Europe? Those are questions asked in a recent Economist article, entitled When the Safety Net Fails.
The article raises some interesting points, comparing the fragmented European system to America’s FDIC and to the uninsured systems in Australia and New Zealand. It also draws attention to the ridiculous bureaucracy involved in pan-European banks which have to participate in numerous deposit insurance schemes.
The Economist article concludes however that:
It is a popular fallacy, however, that a deposit-insurance scheme can stem every banking crisis. The presence of a safety net is meant to give people enough confidence not to start a run in the first place. If they do, even the best-funded scheme may be insufficient to stop it. In that case, it is up to the government to decide whether the bank is worth saving. If it is, the more back-up it provides, the better.
Then, a reader at the Economist website, David Hillary, went on to comment on experiences in New Zealand, which has a very lightly regulated - but some would say more healthy - banking system:
Government deposit insurance, like government bank regulation, is unnecessary and counter-productive.
Here in New Zealand, as the article mentions, we don’t have deposit insurance, and we don’t have much bank regulation either. No licence is necessary to operate a bank, banks instead are registered, if they feel the need to be supervised by the government. Unregistered banks operate as issuers of securities to the public in New Zealand, in the same way as, for example corporates that issue bonds, with a requirement of disclosure under a registered prospectus, and the appointment of a supervisory trustee to hold the security, and in the event of default, to appoint a receiver.
In the last year or two, about 18 New Zealand deposit accepting financial institutions have failed, putting about Euro1b in deposits in jeopardy, giving a reasonably good example of distress in a largely unregulated banking market. What lessons can be drawn from the experience?
1. Deposit accepting financial institutions fail for a wide variety of reasons. These include:
a) running out of liquidity due to lack of renewals and not being able to take in enough new deposit funds
b) making too many bad loans, typically as a result of a combination of higher risk loans and most of the loans being in the same industry or sector (consumer finance car loans and property development loans, typically)
c) Lack of diversification, i.e. some individual loans making up 10-20% of a loan book
d) Related party lending
e) Fraud and operational problems (e.g. car dealers falsifying credit history reports when acting as agents for lenders)
2. Losses resulting to depositors vary greatly. In some cases depositors have or are expected to fully recover their principal, albeit with a delay of many months, while in others depositors are projected to recover as low as 19c in the dollar.
3. In most cases receivership has been used to recover what is recoverable, while in a couple of cases re-organisation has been possible (via proposals made and accepted by 75%+ of creditors).
4. Contagion is limited to financial institutions with similar characteristics. Overall, a flight to quality occurs, leaving the weakest and most exposed financial institutions in trouble, while others continue to raise funding and earn reasonable profits. Depositors appear to be rational in this regard.
5. Most deposits made with failed financial institutions were understood to be fairly risky investments, and were for substantial sums invested for term deposits of 1-3 years. Although some failed deposit accepting financial institutions did offer call deposits, few, if any, were offering transactional deposit products, thus the failures have not resulted in any difficulty in transacting business or personal affairs.
6. Looking at the registered prospectuses of failed deposit accepting financial institutions show the risk factors quite accurately. The following signs indicate higher risk:
a) Lack of diversification. This is disclosed in the financial statements and is hard to miss.
b) Lack of industry or loan type diversification. This is disclosed in the financial statements and elsewhere in the prospectus.
c) Higher risk loans. This can be seen in several places, including the financial statements show the asset quality and bad loans expenses incurred in the past, the proportion of the loan book that is second of subsequent mortgages, and the higher risk loan types such as used car loans and property development finance. You can also see the finance rate on the loan book: the higher the rate they charge, probably the more risk they are taking.
d) the financial covenants in place and how close the financial institution is to them, and the commercial credit facilities they have, and how much of them are used. For example a recently failed financial institution was required to have a 5% capital ratio and is was just slightly better than this, and it had a credit facility that was something like 90%+ used at the time the last prospectus was issued. Given that its loan book consisted almost entirely of second mortgage secured property construction loans, 5% capital ratio is hardly adequate.
7. Subordinated deposits/notes etc. are very unlikely to see any repayment should the financial institution get into trouble: normally the losses are much bigger than the firm’s capital and subordinated deposits, leaving senior depositors still exposed to some losses and more junior creditors with nothing. Typically subordinated deposits paid only slightly more interest than senior deposits, and were only about 5% of total deposits.
My conclusion: all I can say is diversify, diversify and diversify! Follow your Know-Your-Banker policy, check out banks’ annual reports, but most of all open lots of different accounts in different banks, different countries and in different currencies. Never leave all your eggs in one basket!