Credit Crisis Averted by Bank Deposit Guarantee

Wednesday October 22, 2008

The recent announcement by the Government to guarantee all Australian Bank deposits was unprecedented in Australia and many first world economies. This extraordinary action was extremely effective in producing the desired result. It was as they say a massive dose of "Bex and a good lie down".

It produced a calming effect on those who were in danger of falling prey to the so called animal spirits portrayed by the noted economist John Maynard Keynes. When people are in fear of losing their life's savings nothing can make them act rationally.

If everybody had tried to withdraw their money from their bank then the banks would have failed and most people would have lost their savings above the guarantee provided by the Government.

Now that was last week, this week we have a new problem. The guarantee was not extended to all types of deposit takers in Australia. There are a few foreign owned deposit takers who are not covered by APRA because they deal in the wholesale area. The wholesale area is for people who deposit funds greater than $250,000 and because they have this level of money they are assumed to be smarter than ordinary folk and therefore need less protection.

Some of these "wholesale" investors who had funds deposited with these foreign bank representatives woke up to the fact their funds were not guaranteed by the Government and maybe just maybe it would be a good idea to move them to one that was.

This has lead to large amounts of funds be transferred away from these foreign institutions and they are not happy about it. We should care because those foreign companies are part of the bigger worldwide credit market and are an important source of funds for Australian Banks who then provide them as loans to ordinary Australians. Having access to offshore credit sources is extremely important for the Australian economy and needs to be considered.

Another unintended consequence was raised by a professor of banking and finance at the University of Canberra, Milind Sathye, who said that "With the blanket guarantee in place, financial institutions would be encouraged to do exactly what led to the crisis: lend to sub-prime borrowers." One of the prime reasons capitalism works is that good business practices over the long term are rewarded and bad ones are punished. The Government intervention needs to take this into account.

In the big scale of things the crisis was averted, the tsunami of fear was sledge hammered into submission but now there is time to tinker at the edges of the guarantee to negate the unintended consequences.

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