Towards Putting a Price on the Risk of Bank Failure (WP 15/03)

Abstract

This paper develops a new approach for conceptualizing and measuring the risk associated with bank failure. The price of this risk in risk-adjusted present-value terms is estimated at $170-340 million per annum (0.07-0.15% of GDP), representing the price of the financial risk that exists ex-ante (ie, before a bank fails). This can be interpreted as the cost that is either passed onto the banks via higher funding costs, or borne as an implicit risk on the government's balance sheet. Alternatively, one could think of this as a one-off cost, in the event that all major banks failed in a single crisis. If that were to happen, and if net losses were to be 5-10 per cent of bank liabilities the total cost could be $16-31 billion (7-13% of GDP). This can be interpreted as either the net cost of a government bail-out, or the total value of haircuts on wholesale and retail creditors that would be applied under an Open Bank Resolution (OBR) or a liquidation.

Bank bail-outs are not necessarily required or recommended in New Zealand given the existence of OBR. However, the major banks currently receive a one-notch uplift in their credit ratings specifically because of the expectation of government support. These ratings' uplifts are used to estimate the market-implied likelihood that the banks would be bailed out in the event of their failure, and therefore the size of the implicit guarantee banks that are seen to receive. This perceived implicit guarantee is estimated to be worth around $80-$230million per annum (0.04%-0.11% of GDP), equivalent to a 3-8 basis points subsidy on banks' total borrowing costs. This estimate is low by international standards, consistent with the current soundness of the major domestic banks and the relatively low perceived likelihood of government support.

Acknowledgements

I am grateful to Craig Fookes, Anna Everton, Jennie Kerr, Stephen Revill, Mario DiMaio, Brian McCulloch, Michael Reddell, and Kevin Hoskin for their comments on earlier versions of this paper. I am especially grateful to Sebastian Schich at the OECD for his valuable comments and support of this work.

Disclaimer

The views, opinions, findings, and conclusions or recommendations expressed in this Working Paper are strictly those of the author(s). They do not necessarily reflect the views of the New Zealand Treasury or the New Zealand Government. The New Zealand Treasury and the New Zealand Government take no responsibility for any errors or omissions in, or for the correctness of, the information contained in these working papers. The paper is presented not as policy, but with a view to inform and stimulate wider debate.