Early redemption options
- Why we would want to provide early redemption options
- The rules governing early redemption
- Improving stability in the banking system
- In summary
One feature of Investment Accounts will be the 'Early Redemption Option', which will give a customer the option to withdraw a part of their investment before the agreed Maturity Date or or Minimum Notice Period
The following section explains why we would want to provide this option. The second section explains the rules that would apply to banks that wished to give customers this option. These rules are critical to ensure that giving Investment Account holders the option to withdraw some of their investment early does not re-introduce instability to the banking system.
Why we would want to provide early redemption options
The modernised system gives customers two options - keep the money safe and receive no interest (Transaction Accounts), or invest the money and receive a return (Investment Accounts).
It would take a certain leap of faith to tie up your money in an Investment Account for the next 6 months (for example), knowing that you will lose all access to the money for that period of time.
What if the car breaks down and the repairs are expensive, or the house needs some repairs that aren't covered by the insurance? With an instant-access savings account, you would just withdraw some of your savings to cover these expenses. But if your money is tied up for 6 months or longer and you don't have access to other funds, what can you do?
You would probably take the decision to put 80% of your 'savings' into the Investment Account, and hold back 20% as an emergency fund.
The similar decision would be taken by thousands of other potential investors. The end result that a significant percentage of the funds that customers wish to invest will be held back because the potential investor may need to use the money in the case of emergencies.
Consequently the total amount of funds available for investment may only be 80% of what it could be, with the other 20% held back in the 'car repairs and emergencies' account.
It is a little inefficient to hold back 20% of the funds that would have been available for investment just because the investor's car may break down while their money is tied up in the Investment Account!
The solution to this problem is simple.
Firstly, it's unlikely that 100% of potential investors will all suffer an 'Emergency' in the same period of time. It's more likely that just 20% of the Investment Account holders would need emergency funds while their money was tied up in an Investment Account.
It is also likely that, of the 20% of people who need to withdraw some of their savings before the agreed date, most of these would only need to withdraw a proportion of their total savings - not the full amount.
Consequently, we have 20% of Investment Account holders who may, on average, need to withdraw, say, 10% each of their investment before the maturity date.
It is likely that those who need to draw on their savings before the maturity date are those with a lower income or wealth, who don't have the spare funds to cover emergencies such as a major car repair.
Someone with just $1,000 in savings is far more likely to need to call on those savings than someone with $50,000 in their Investment Account. As a result, the 20% who need to withdraw part of their savings before the Maturity Date are likely to hold far less than 20% of the total funds invested with the bank.
Let's say that:
- 20% of Investment Account holders need to draw on their funds before the maturity date in any one period
- This 20% of Investment Account holders in total provided just 5% of the total funds that have been invested.
- Of this 20%, on average, each customer needs to withdraw just 20% of their total Investment Account.
We now find that just 20% of 5% of the total funds will be withdrawn before the agreed maturity date. In other words, in a normal period of time, just 1% of the total funds placed into Investment Accounts across an entire bank will be called upon before the Maturity Date.
We now know that:
- Of all the funds ever placed into Investment Accounts, a tiny proportion, possibly just 1%, will be needed before the Investment Account matures.
- Giving investment account holders the option to withdraw part of their Investment before the agreed Maturity Date could increase the total amount invested by a significant percentage. For this example, we'll say that allowing customers to have instant access to at least a portion of their Investment will increase the total amount invested by at least 20%. This is good for the economy (more investment funds for small businesses, for example), good for the bank (more funds available for loan-making) and good for the customer (they don't lose interest on 20% of the funds by keeping them in Transaction Accounts for 'emergencies').
However, we do need to set the 'rules of the game' to prevent this facility creating instability in the banking sector. The rules outlined below do this.
The rules governing early redemption
Every authorised deposit taking institution may offer the customer an Early Redemption Option for the Customer Investment Account, which shall specify conditions for early redemption of a portion of the Customer Investment Account.
The Early Redemption Option would say, in plain English, something along the lines of "You may withdraw up to 20% of the funds invested before the agreed Maturity Date".
The penalty for doing so would vary, depending on the bank and the particular type of Investment Account, but may include:
- Waiving a portion or all of the interest, or taking a very low interest rate on the funds that remain invested, or
- Paying a fixed fee, or
- A combination of both.
For the best result for the economy, these penalties need to be high enough to discourage the customer from exercising the Early Redemption Option unless essential, but not so high that it would encourage them to hold their spare funds in Transaction Accounts or 'under the mattress' instead.
Note also that it is likely that an account with an Early Redemption Option would offer a lower interest rate than an account with no Early Redemption Option. Consequently, some customers would choose to waive the Early Redemption Option completely.
The sum of all Investment Account funds subject to Early Redemption Options will be known as the Maximum Early Redemption Liability.
We are now looking at how these Early Redemption Options are managed internally within the bank.
The bank will be able to work out what percentage of its total funds placed into Investment Accounts could be withdrawn on demand at any one time:
This would give a monetary amount of say $500m, that could be withdrawn on demand. This monetary figure will be known as the Maximum Early Redemption Liability, and represents the maximum 'payout' that the bank would need to make in a disaster scenario where all customers exercised their Early Redemption Options on the same day. (This scenario is the nearest thing to a 'run on the bank' in the modernised system).
The Reserve Bank will set a Ceiling Rate on the Maximum Early Redemption Liability, as a percentage of the Bank’s Investment Pool. The Reserve Bank may set different Ceiling Rates for each individual bank.
Let's say that for BigBank Ltd the total amount that has been invested in Investment Accounts (i.e. the amount that bank will have to repay to their investing customers) is $5bn.
The Reserve Bank looks at BigBank's investment portfolio and considers it to be relatively low-risk. It sets the Ceiling Rate on the Maximum Early Redemption Liability at a high 20%, meaning that the bank can offer Early Redemption Options on $10bn of the funds in its Investment Accounts.
Why would the bank set such a high Ceiling Rate on the Maximum Early Redemption Liability? After reviewing the loan portfolio and finding the bulk of loans to consist of conservative investments in low risk markets, it takes the view that there is a very low risk of the bank suddenly announcing significant losses or write-downs on bad debt.
As long as this doesn't happen, there should be no reason for customers to start exercising their Early Redemption Options in great numbers. Consequently, even though the total Maximum Early Redemption Liability is $10bn, it is highly unlikely that more than $500m of this will ever be called upon in any period of time.
They may also look at ToxicBank, with a riskier investment portfolio of $50bn, or which has a track record of making bad investment decisions, or which appears to have a lot of bad debt on its books. It would receive a much lower Ceiling Rate on its Maximum Early Redemption Liability, say 2%, meaning that it could offer Early Redemption Options on no more than $1bn of the funds in its Investment Accounts at any one time.
The Reserve Bank would make the decision to limit ToxicBank's ceiling rate (and potentially reduce it even further over time) in anticipation that the bank will suffer significant losses and write-downs which would encourage the bulk of customers to exercise their Early Redemption Options at once.
Each commercial bank must retain a minimum percentage of its Maximum Early Redemption Liability in its Operational Account at all times. The Reserve Bank or the regulatory body will set this minimum percentage.
In the example of BigBank, the Reserve Bank considers the risk of a 'run' on Investment Accounts to be very low. After setting the Ceiling Rate on the Maximum Early Redemption Liability at 20% ($10bn), it then states that the bank must keep 5% of this 'on hand' at all times.
5% of $10bn is $500m. The bank now has enough funds on hand to meet the amount of Early Redemption Options that are likely to be claimed.
In contrast, the Reserve Bank may look at ToxicBank and decide that it should retain 50% of its current Maximum Early Redemption Liability, significantly reducing the risk that ToxicBank will need to appeal to the Reserve Bank for emergency funding.
Improving stability in the banking system
The discretion that we hand the Reserve Bank (or the banking regulator at the time) allows them to reduce the risk that 'bad banks' pose to the financial system as a whole. In the case of ToxicBank, the Reserve Bank understands that if the bank starts to realise (and publicly announce) its bad debts and losses, Investment Account holders will start to exercise their Early Redemption Options as quickly as possible.
ToxicBank will not be able to meet all these demands at the same time, so will have to seek emergency funding from the Reserve Bank.
By reducing the Ceiling Rate on the Maximum Early Redemption Liability for ToxicBank, and by raising the minimum percentage of the Maximum Early Redemption Liability that they need to keep on hand, the Reserve Bank starts to reduce the risk of future problems with ToxicBank.
The Early Redemption Options enable us to get the best deal for bank customers (increased flexibility), without introducing any serious risk into the system.
Doing so should increase the amount of funds that people are willing to invest (because they know they can access a portion in case of an emergency) and therefore increase the amount of funds available to lending and investment, but without allowing money to be created by the banking system.