Avoiding moral hazard when banks are on the brink

Banks, companies and investors are preparing for a collapse of the euro. Cross-border bank lending is falling and asset managers are shunning the eurozone. Amid ongoing talk that Greece may leave the zone, Prime Minister Antonis Samaras has been playing for time to improve his country’s worsening economy. There are also concerns about Italy’s high borrowing costs, Spain’s banking crisis and Germany’s vulnerability as a key provider of funds to the bloc. A break up of the single currency looks increasingly likely.

People are pulling money out of Greek and Spanish banks, fearful that they are on the verge of collapse and that the governments cannot guarantee their deposits. What is the potential fallout of all this turmoil for Australia?

According to Ross Buckley, a professor of finance law at the University of New South Wales, a collapse of the euro would cause world financial markets to freeze. “Everyone will panic because no-one really knows what things will look like,” he says.

While Australia undoubtedly would do it tough, it is in better shape than it was in 2008 when its banks borrowed heavily in offshore wholesale markets. “They have since learned that lesson, so the disruption won’t be as bad,” says Buckley. “Plus, Australian banks do not typically hold substantial amounts of European sovereign debt, so again the consequences should not be as dire as before.”

Aussie bank depositors have no reason to worry. In February this year, the federal government promised it would continue to guarantee customer deposits under its Financial Claims Scheme, thus reassuring Australian people that their money was safe. Government will guarantee up to A$250,000 per retail account.

At the height of the global financial crisis in 2008, Australians were spooked by the runs on UK’s Northern Rock bank where frightened people queued for days to get hold of their cash. But the federal government jumped quickly to prevent similar panic runs in Australia by guaranteeing bank deposits. Local incidents also spurred the rapid reaction. Fears that their cash was at risk had caused a small, silent bank run in Australia’s major cities just after the giant US investment bank, Lehman Brothers, collapsed in 2008. While not classed as a “panic run”, there were reports of people suddenly withdrawing much bigger licks of cash than usual.

A blanket guarantee on customer deposits of up to A$1 million per account was introduced in Australia at the time, and in 2010 the federal government decided this emergency measure would continue indefinitely, although it’s now at a reduced level. However, the banking guarantee remains highly controversial.

A windfall for banks

Current events in Europe make the guarantee on retail deposits in Australian banks more essential than ever, according to Buckley, who has long contended that the banking guarantee should not be free. “I don’t see any justification for taxpayers to be giving a big gift to the banks,” he says.

The Australian banking system is now much more concentrated as a result of the global financial crisis, with the Big Four banks – the Commonwealth Bank of Australia, ANZ, Westpac and NAB – controlling about 92% of the market. Buckley points out that under the terms of the banking guarantee, the government effectively is underwriting the solvency of the banks.

“Why should government freely guarantee the liabilities of the banks when it doesn’t guarantee liabilities for everyone else?” he asks. “Most governments of rich nations guarantee bank deposits up to a certain level, but they all charge very substantial premiums for doing so. Introducing a non-fee guarantee during the crisis is one thing – it doesn’t really change the risk of moral hazard – but making it permanent does.”