bank guarantee

Rudd should dip his cap to undo damage Milind Sathye From: The Australian October 27, 2008

MUCH water has flowed under the bridge since I questioned on this page on October 15 the Rudd Government's decision to introduce a blanket financial guarantee.
The Opposition has walked away from its initial support and instead turned up the heat on the Government. A senate estimates committee tried to investigate what advice the Government received before the decision was made. Most importantly, unintended consequences of the decision - the distortion of financial flows in the money market - have come to the fore.

Why have we arrived at this situation less than a fortnight after the Government announced its decision, which initially was hailed by almost everyone? Could the run on non-bank financial institutions have been avoided? Did policy makers carefully scan what measures other countries took and why? Was there really a need to take an extreme measure such as a blanket financial guarantee in a hurry? Was a three-year guarantee ab initio necessary? And what do we do to get out of this mess?

Ireland was the first country to announce a financial guarantee, on September 29, as the global credit crisis deepened. However, it initiated the measure in stages. On September 20 it merely raised the ceiling on deposit guarantees from E20,000 ($40,664) to E100,000 and applied it selectively, only to individual deposits and to Irish credit institutions.

Nine days later the guarantee was extended to "all deposits" - retail, commercial, institutional and interbank - of selected banks. Significantly, the Government specifically announced it acted on the advice of its central bank.

It is important to realise that the Government took these decisions because Ireland was facing a property market meltdown, a credit crunch, its first recession in 25 years and the effects of the global credit crisis. Yet even in such an extreme situation the country approached the problem in stages.

Australian actions were in stark contrast to those of the Irish Government. The Rudd Government made an unprecedented change from no guarantee whatsoever (the $20,000 deposit guarantee was not approved by parliament) to a blanket guarantee.

And while the Irish guarantee was applicable to select financial institutions (domestic banks and other institutions), the Australian guarantee was applicable to all banks - whether domestic or foreign - credit unions and building societies.

Implementation in stages would have helped the Australian Government know the impact of the measures and then take further corrective action. This could have avoided the present distortion in the market.

Crucially, the Irish decision was made after advice from the central bank; in Australia we still don't know what the RBA advised.

Interestingly, the US and Britain, the worst-affected countries, didn't introduce blanket deposit guarantees.

In Britain the deposit guarantee was raised from pound stg. 37,000 ($94,631) to pound stg. 50,000. Again, Britain was severely affected by the crisis, unlike Australia, and yet still decided to move in stages. Of course, it introduced the emergency measure of recapitalisation of banks simultaneously. But these were extraordinary circumstances in the British financial system, not even a semblance of which was experienced in Australia, and still the British Government did not introduce a blanket guarantee.

The case of the US, the country most hit by the crisis, was no different. The Fed raised the deposit guarantee from $US100,000 ($161,342) to $US250,000 in the midst of the crisis but yet again no blanket guarantee was proposed.

Blanket financial guarantees are an emergency measure. Turkey, for example, underwent in upheaval in its financial system in the mid-1990s. Overnight interest rates had peaked at 1000 per cent, resulting in panic in the financial system. Banks faced a severe liquidity crunch due to substantial deposit withdrawals. The International Monetary Fund was called in, three banks were taken over and a full guarantee to all savings deposits was introduced until May 2000.

That is the kind of situation that calls for emergency measures such as blanket guarantee or bank nationalisation. Was Australia facing such a situation?

It seems that with the stock market tumble on October 11, panic buttons got pushed. Granted the markets needed a boost, but the Government could have moved in stages rather than taking hasty action with resultant adverse effects.

The Government's announcement on Friday of a free guarantee for deposits below $1 million and a paid guarantee for those above $1 million still doesn't address the distortion.

What it does is create four market segments: those below $1 million (99.5 per cent of the market) with either free cover or no cover, and those above $1 million with either paid cover or no cover.

Financial flows will continue in the sub-$1 million segment from the no cover zone to the free cover zone, and even in the above-$1 million segment from the no cover zone to the paid cover zone if there is an advantage after factoring in the cost of cover.

Also, if one has a deposit of $1million, one needs withdraw only $1 to get free cover, and if you have $10 million you just need to spread it over 10 institutions evenly to avoid paid cover. Such games will now begin in the market place.

To get out of this mess of its own making, the Government should unwind its blanket guarantee and instead cap it at $60,000. If required, it could be progressively scaled up. This would normalise financial flows in the market.

The unlimited deposit guarantee also puts the commercial paper market at a severe disadvantage in relation to the deposit market. As commercial papers are generally in denominations of $100,000 or more, a cap of $60,000 would permit normal functioning of the CP market.

Last, Australians need to know exactly what advice was given by the RBA. The Government says its actions have been supported by the RBA, but there is a difference between a recommendation and support. A recommendation is given prior to the decision while support is offered afterwards.

What we need to know is whether the RBA recommended a blanket deposit guarantee as the central bank in Ireland did. Given the problems in the financial flows that surfaced following the decision to offer a blanket guarantee, it seems unlikely the RBA would have recommended it.

If it had, it would mean that it was unable to foresee the problems that would arise in the market. That would suggest incompetence on the part of the RBA. This is highly unlikely and leads us to the conclusion that probably a decision was taken by the Government and the RBA was then asked to support it. If this is what has happened, then it is the Government that is undermining our economic institutions.

Milind Sathye is a professor of banking and finance at the University of Canberra and a former central banker in India.