Government sometimes cannot stop itself from providing bailouts when risk-taking goes wrong.  

This kind of ‘free’ insurance policy leads to no end of bad outcomes. 

If central government cannot credibly promise to let depositors bear even minor losses when a bank fails, then deposits effectively come with free insurance.  

If that free insurance did not exist, banks wanting to reassure depositors would need to hold enough capital to demonstrate their safety. But depositors expecting bailouts will not exercise diligence. That encourages prudential regulators to require banks to be very strongly capitalised.  

At best, regulated capital requirements replicate those that unregulated banks would choose if their capitalisation was their depositors’ only insurance, and when their shareholders and creditors assets would be the first to be liquidated. But ‘free’ insurance comes at high cost when capitalisation requirements err on the side of caution.  

The problem extends well beyond banking.  

In 2019, BNZ filed a claim against Wellington Council for the BNZ building that failed in the 2016 earthquake for “no less than $101,243,345”.  

Council had issued resource consents and code compliance certificates for the building. That certification comes with a form of ‘free’ insurance enabling building owners to sue council if the building fails. This week, the Supreme Court said that engineering and design consultancy Beca might share some liability with Wellington Council. Council’s liability could yet be large. 

The BNZ building is not an outlier. In 2019, MBIE-commissioned work showed that in about half of the cases in which claims of building defects lead to compensation, councils wind up bearing the entire burden.  

Without that free insurance policy, people commissioning new buildings would demand warranties or explicit building insurance against defects and failures. The strength of those warranties and insurance would be a point of competition in the building market. Construction companies would weigh the costs of different building methods against the expected costs of warranties.  

When a building consent comes with a free insurance policy, every consented building is a potential liability for council. Councils then become highly risk averse in consenting, pushing up costs across the sector.  

The government may yet legislate to remove this burden from councils, but the broader underlying problem remains.  

When people expect government bailouts if anything goes wrong, from increased flood risk to unexpectedly high power prices, that insurance comes at very high cost.  

Ending bailouts may be the best insurance.