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RBNZ Says Deposit Insurance May Increase Risk of Bank Failure

New Zealand’s central bank says deposit insurance may make banks more susceptible to failure because it reduces the incentives to properly manage risk.

“We believe it is better to keep the risk of failure very low including through a strong regulatory framework, than to build structures that can distort incentives and behavior,” Toby Fiennes, head of prudential supervision at the Reserve Bank of New Zealand, said in a speech in Wellington.

Deposit insurance is not always effective in preventing bank runs by depositors, and is hard to price fairly with a chance that least risky banks subsidize more risky ones, Fiennes said. When bank losses are large it may overwhelm the resources of the deposit insurance fund, he said.

A recent World Bank report concluded that deposit insurance led to more risky behavior by banks in the 2004 - 2009 period, he said.

New Zealand doesn’t have deposit insurance, and the central bank is proposing a system of open bank resolution as a better tool to manage a bank in the event that it fails. That system uses a form of statutory management to freeze a bank’s accounts, then release a proportion of those accounts the next day with a government guarantee to prevent further runs on the bank.

The two systems could work alongside each other, and it may make it easier to manage a crisis by having insurance to deal with the “political noise” from depositors, he said.

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