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Defining the boundaries

October 21st, 2008

I did a radio interview this morning, in response to a couple of stories about the second-round impacts of the government’s decision to guarantee bank deposits. Both at retail and wholesale levels, the decision has produced a rush to move funds where they can benefit from the guarantee. Those at the losing end, including foreign investment banks and mortgage funds are, unsurprisingly, upset.

This process was in fact underway before the announcement of an explicit guarantee, though the main trend was from smaller banks to the “too big to fail” Big Four. The guarantee benefitted the small banks, but put the pressure onto nonbanks and foreign banks. This was more or less inevitable and raises the question of the next steps.

Two responses are necessary. First, the government has to define the boundaries of its guarantee, making it clear that any investment outside the guarantee will not be bailed out under any circumstances. Second, it has to make it clear that there is a significant price to be paid for the guarantee. The price will include both an insurance premium and restrictions on risk-taking.

In the long run, this should lead to the kind of narrow banking model I’ve long advocated, in which publicly guaranteed banks stick to a tightly regulated range of well understood activities. This allows for a completely separate set of financial institutions, of which stock markets are the exemplar, where government guarantees are ruled out in advance*. These would offer higher returns but no possibility of transferring risk to the public.

The ultimate losers from the process are likely to be the Big Four, which previously got the benefit of “too big to fail” status at zero costs.

* It’s probably impossible to preclude emergency rescues of firms seen as vital, like Chrysler in the US or Rolls-Royce in the UK. But, where such rescues are unavoidable, they should be done on terms that wipe out the great bulk of shareholder equity and require a substantial haircut for bondholders as well.

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  1. Uncle Milton
    October 21st, 2008 at 14:38 | #1

    “This allows for a completely separate set of financial institutions, of which stock markets are the exemplar, where government guarantees are ruled out in advance”

    The problem with this the failure of financial institutions outside the net can cause the failure of financial institutions inside the net, as the Lehman example has spectacularly shown. In hindsight, letting Lehman fail might have been a big mistake.

    For your proposal to work, the exposures of the guaranteed institutions to the non-guaranteed sector (not just individual institutions) will have to be strictly limited.

  2. Joseph Clark
    October 21st, 2008 at 14:41 | #2

    You stole my idea! ;)

  3. kymbos
    October 21st, 2008 at 15:12 | #3

    John,

    Have you commented on the view of Steven Keen and Nouriel Roubini and the like that mainstream economics somewhat fundamentally misjudged this crisis by focusing on interest rates and ignoring personal debt?

    I would be very interested in your views.

    http://www.debtdeflation.com/blogs/2008/10/21/play-the-ball-and-not-the-man/

  4. Don Robinson
    October 21st, 2008 at 15:34 | #4

    Well said!

  5. Steve Hamilton
    October 21st, 2008 at 15:38 | #5

    Really, really well said.

    Cheers

  6. October 21st, 2008 at 16:09 | #6

    John, I suggest you have a word to Malcolm Turnbull, Julie Bishop and Joe Hockey, but wait until their ears have stopped ringing after the blast they got from Kevin Rudd in Question Time.

    They were not eager to wait for the outcome of ongoing discussions on details, or for Glenn Stevens’ assurance of his support for the Government, before trying to make hay from the article in this morning’s Oz. I bet they wish they had.

  7. jquiggin
    October 21st, 2008 at 16:46 | #7

    Uncle M, your point is exactly what I intended when I referred to a completely separate set of unregulated institutions. No debt, equity or lending should cross the boundary.

  8. Damocles
    October 21st, 2008 at 16:57 | #8

    Regardless of the long term shape of any narrow banking model, there’s the short term question of what, if anything, the government should do in the short term if any major non-banking institutions get into serious liquidity problems in the next few weeks.

    If the objective of the guarantee is to prevent a loss of confidence in the entire banking system or major difficulties for counter-parties you have to ask why it makes sense to guarantee small ADI’s like credit unions and building societies and not to guarantee Mac Bank.

  9. Uncle Milton
    October 21st, 2008 at 17:17 | #9

    “No debt, equity or lending should cross the boundary.”

    This would mean the end of Nick Gruen’s Peach Home Loans. I would think he relies on banks would be inside the net to raise the money which he then lends to people for housing.

    It would also mean the end of CommSec, and a whole lot more.

  10. jquiggin
    October 21st, 2008 at 17:47 | #10

    Uncle M, I doubt that any financial institutions will emerge from the current crisis with their business models intact. We’ve already seen the disappearance of the entire investment banking sector in the US for example.

    I’m not sure about how Peach Home Loans works (or might work in my proposed system), but I would be happy to see the end of CommSec. There’s no reason why a bank should be a stockbroker. It’s only a few steps from there to ANZ’s dealings with Opes Prime, for which the public are now, ultimately, on the hook. The central idea of narrow banking is to stop this kind of thing at the first step, rather than to let the institutions push the boundaries all the time.

  11. jquiggin
    October 21st, 2008 at 17:49 | #11

    Damocles, I trust that Mac Bank will be allowed to sink or swim. There’s no obvious “too big to fail” case and anyone who dealt with them had plenty of warning.

  12. October 21st, 2008 at 19:33 | #12

    PrQ,
    I would see the problem here as being strong pro-cyclicality, even worse than the current system. During upswings, funds would move out of the guaranteed institutions as the risk of default of the unsecured institutions approached zero. Funds would then flow back to the regulated ones as times went bad. A stampede out of an unregulated institution would then be likely to cause a cascade failure, particularly as the banks that would be the recipients of the funds would not be able to step in to help due to the firewall.
    Politically driven fund allocations (like into infrastructure or housing) would also then be more likely, as the asset classes that the regulated banks would be able to end against would (presumably) be defined.

  13. jquiggin
    October 21st, 2008 at 19:48 | #13

    AR, my expectation is that the unregulated sector would wax and wane as you describe, but would never get large enough or interconnected enough to pose a systemic risk. The stock market provides a pretty good paradigm. It’s obvious that money flows into the stock market in booms, and runs out again in downturns, but provided the banking system is kept safe (as it wasn’t in 1929), this doesn’t seem to pose any big macro concerns.

  14. observa
    October 22nd, 2008 at 03:39 | #14

    Well finally and emphatically, Rudd’s grand gesture has bitten if you take my bank Westpac as an example. Right through the crisis in stock markets and Glenn Stevens cutting interest rates to 6%, when Westpac like the other banks didn’t pass on the full 1% cut to borrowers, they continued to offer depositors 6.8% on daily balance, at call, payable monthly. Yesterday they dropped that rate to 5.85% and joined the other banks in cutting their variable home loan rate by 0.2%. Nice work if you can get it and thanks for the guarantee Kevin. Now the rest of the financial marketplace is beginning to squawk that they’re being frozen out, while on the face of it the banks are building their reserves on the backs of that grand gesture by Rudd. A gesture which we note Stevens naturally supports but there are still some ‘details’ to be worked out, although how you need to work out any details of a categorical and blanket depositor guarantee, is anyone’s guess eh Glenn and Kev?

    Now contrast Kev’s grand gesture with-

    ‘PHILIPPINE President Gloria Arroyo is to ask Congress to pass a law quadrupling bank deposit insurance to boost confidence in the banking system amid the global credit crisis.
    The maximum insured deposit guaranteed by the state-run Philippine Deposit Insurance Corp. will be increased from 250,000 pesos to one million pesos ($29,500).

    Arroyo sees the increase as a “proportionate response to the global uncertainties,” Executive Secretary Eduardo Ermita told a news conference.

    He stressed that while the country’s banking system is stable, the increase was felt necessary to help underline confidence.

    “There are no bank runs now,” Arroyo spokesman Jesus Dureza stressed.

    “The 1997 (Asian) crisis prepared us for this eventuality,” he said.

    “Our fundamentals are strong but we are ready for possible problems in the future.”

    Hmmm…perhaps Kev doesn’t need to charge because our banks were much safer to start with and perhaps we should all be buying bank shares with our deposits, particularly if they’re going to catch the Japanese disease a la falling interest returns vis a vis any alternative safe investment returns, although methinks there might be a wee fallacy of composition in there somewhere.

  15. Labor Outsider
    October 22nd, 2008 at 20:33 | #15

    Interesting post but highly unlikely that it will occur.

    Some questions:

    - can you provide more detail about why you think that the unregulated sector won’t become large enough or interconnected enough to become systemic? Some of the conditions you impose on the regulated sector are likely to mean that the unregulated sector is considerably more profitable than the regulated sector, especially during good times (which we know can last for over a decade). Presumably you think that your warning that the shadow sector will not be bailed out under any circumstances will be enough to limit its size – but how do you make that threat credible?

    Also, perhaps you can comment on why you think such a drastic step is necessary. As far as the RBA and APRA are concerned, Australian financial institutions are in good shape. As far as I am aware, the RBA has not mentioned the lack of ring fencing as a concern in any of its financial stability reviews.

    Also, what do you think it will do to competition in the mortgage and business lending market? You seem to assume that the big-4 will be most strongly affected, but relative to other financial institutions it might be easier for them in the short-term to absorb the cost into their margins.

    And what about the transitional effects? Presumably your policy would reduce profitability in the financial sector. That would strongly affect share prices and hence the wealth of anyone with a share portfolio or superannuation. And what about the effect on portfolio flows that fund the current account deficit? Would there be any risk of a sudden depreciation of the exchange rate as foreign investors pulled money out?

  16. Joseph Clark
    October 22nd, 2008 at 20:42 | #16

    Labour Outsider,
    Why do you have to come in and spoil everything by asking sensible questions?

  17. jquiggin
    October 23rd, 2008 at 05:40 | #17

    Labor outsider, your first para is a matter of judgement. I think that, even in a relatively prosperous period there will be regular failures (consider LTCM in 1998). As long as the regulated sector is kept separate, from the unregulated (as was not the case for LTCM or more recently) the commitment not to bail out can be maintained in these cases, and that will increase its credibility more generally. As I noted, the stock market provides an example where investors have frequently suffered large losses while direct bailouts have been rare (HK in the 90s, and I guess you might say the Greenspan put in recent years in the US).

    As to the process questions, I’m not proposing an abstract plan for reform, I’m suggesting a possible outcome of the radical changes that are now under way globally. No doubt there will be plenty of transitional effects and falling share prices, but it’s a bit late to worry about that now isn’t it?

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