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Since the last poll came out (marginally) in favour of deposit insurance, I thought I would take it a little further. This one looks at how far that insurance should go in the event of a full bailout – should we be covering only private individuals (the “Mums and Dads” group) or go wider?

Should bank bailouts cover more than ordinary depositors? (Poll Closed)
 
 
 
 
 
 
 
 
 
Total Votes: 19

During the current turmoil there seems to have been some suggesting that Islamic finance models may provide an answer. The next poll will look at this option.

While I have been (fairly) consistent in my criticism of the regulators, it should also be noted that there have been some serious failures at some banks, as well. In this sort of context, it is fairly obvious that the failures have either been in the risk management departments, with senior management or both.

Leaving aside the sorts of groupthink that Steve Edney identified in an earlier comment, the fact remains that banks have not had enough liquidity in reserve. Note that I have not said capital – most of the banks had enough1. Once the rumours started (and Lehman’s is a good example) the banks’ reactions seem to have been first to disbelieve that anyone could believe the rumours and then go into panic mode, seeking bailouts.

This is where liquidity risk has not been managed well – risk management have not been running scenarios that included this situation, management have not been demanding that this situation be tested and there have been insufficient contingency plans drawn up. “Run” scenarios have not been tested.

None of this is exactly rocket science – and it is certainly less difficult to run a few of these scenarios through your plans than it is to deal with this sort of outcome – seeing your entire life’s work suddenly shunted into another bank because rumours started. The rumour does not have to be factually based, either. Risk management should not be only about making sure the truth is covered.

From management’s point of view there should be plans already in place.

  1. Staff should already know exactly what to do – and should be reassured regularly that the bank has enough to see it through. This should already be happening now – the weekly staff meetings should have accurate and timely information about the bank’s position.
  2. If you are using outside people to deliver cash to the branches, make sure they are included in your contingency planning. Ensure they have enough trucks to deliver to all your branches quickly. Nothing will spread faster than the news that one of your branches has run out of cash.
  3. The media must be on side. Journalists that can contact you – and you have already contacted – will be the most ready to help in a crisis of confidence. Make sure you know the local news journalists well. They may print the rumour, but if they can get hold of you and they have believed you in the past they are more likely to discount it in the articles they write.
  4. Make sure you have contingency lines. Big ones at the moment.
  5. Dry run the tests – do simulations. They may not be exactly match any actual scenarios but if everyone knows their part panic is less likely to set in.
  6. Now is not the time to hunker in your bunker. Disclose more. Let your customers know on a fairly continuous basis what your reserves are. Fear is what causes panic. Do not let it even begin.

If you have good liquidity models in place, use them. Unlike a year ago, there are now plenty of examples of runs developing – check which ones you could deal with and which you could not. It is the arrogant banks that think “this could not happen to me” that get caught in the headlights.

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1. I am not aware of any banks that have failed recently because they had a negative net worth as a going concern – or even below the Basel (I or II) limits. Please fell free to correct in comments. Even if there have been one or two, most of the failures have been liquidity based.

Given we now have the ability to add in polls, I thought I would look to do a poll a week for a while. The first one will be on deposit insurance.

Do you think deposit insurance in Australia is a good thing? (Poll Closed)
 
 
 
 
 
 
 
 
 
 

If you want to suggest topics for further polls, please go ahead. I think the next one will be on bank bailouts – but I am happy to be persuaded.

I was writing up a long piece on deposit insurance in Australia when I read the news that the Federal Government had just moved to guarantee all bank deposits in Australia – meaning the bulk of the text was pointless. I will rescue some of it in this piece – but not much.

With my long opposition to the implementation of such a thing I can only hope that this is a temporary measure. I believe, however, that there is virtually no chance of this being reversed any time soon.

On a personal level, over the next few weeks my reaction is going to be fairly simple. Any surplus cash I may have I am now going to move into the highest possible paying bank account totally regardless of the riskiness of the institution – for the simple reason that risk is no longer any different across any of the ADIs in Australia. This is a totaly ludicrous outcome, but one that has been set up by this change. Provided the institution is APRA regulated I just have to look for the highest rate. This is bad micro-economics.

In short, this move gives an advantage to the ADIs with high risk portfolios and penalises the safe ones. This measure will effectively guarantee a funding stream for any banks that want to play fast and loose with the markets. APRA’s supervision will have to be stepped up to levels reminiscent of the USA. Great. Is this really the outcome that the Government wants?

The other, again rhetorical, question I would ask is whether this will actually make the system any safer. Just have a quick guess as to the stability of those countries with “strong” deposit insurance schemes against those without them. Good examples of “strong” schemes are the USA and Britain – and (drum roll) which countries have had the most problems? The USA, Britain and Iceland. Oh, just in case you were wondering, Iceland had a strong scheme too. Check out this World Bank paper. It simply does not do what it is meant to do.

I do not believe this is going to prove temporary for the simple reason that it would be very difficult to remove any time soon – if ever. Having made the announcement that deposit insurance is in place its removal would cause strong political stresses. Policians, being a spineless lot, will just use any subsequent problems as an excuse to intervene more. That said, many of the more advanced nations that once had full deposit insurance (like Sweden) subsequently reduced the protection – so there may be hope.

I should add that we have now joined those paragons of banking excellence who have full deposit insurance:

  • The Dominican Republic
  • Ecuador
  • Indonesia
  • Kuwait
  • Malaysia
  • Thailand
  • Turkey
  • Turkmenistan

Tragic.

Time after time after time while attending seminars on the current problems I see “the Market” copping the blame for causing all this. It is also all over blogs everywhere. Supposedly, if only the regulators had been doing their jobs well, or current “fads” in deregulation had not existed then there would have been no problems.

As regular readers of this blog would know, I would class myself as very much of a sceptic on this type of analysis. There are several suppositions in there that I find at best unconvincing and at worst straight out wrong.

Firstly – apart from a few loans given out by fraudsters most of the loans were made in the expectation of returns. Banks are not charities and so they were expecting to get prinicipal and interest back. Where the loans were made to people with NINJA conditions (no income, no job or assets) it would have been through capital increase – i.e. appreciation in the value of the home.

A second problem here was those banks using brokers to sell the loans and then giving them incentives for getting the loans in through the door, rather than (as happens here – and not by regulation) for continuing performance through trail commissions. This mean that some brokers were just handing them out and using high-pressure techniques and breaking both the law and their contracts with the banks.

At a regulatory level, however, the problem gets more interesting. Firstly, Fannie and Freddie, as GSEs (government sponsored enterprises) were using their implicit government support to lower the lending rates to the prime loans they were (largely) restricted to. This also heavily skewed the markets – home lending through Fannie and Freddie became the same as lending to governments, so there was no risk sensitivity. They were also able to (and increasingly did) use these borrowing rates to issue many complex derivatives based on home loans. They were also, as GSEs, not subject to the same regulations as everyone else. Nobody really cared about this because there was an understanding that Uncle Sam would ride to the rescue if needed – as they did.

Worse, since 2004 Fannie and Freddie were not restricted to prime loans – they had about USD 500 billion in the sub prime market. The entry of Fannie and Freddie into this market acted to further squeeze the private money into the riskier end.

A further, major, regulatory problem is the way that housing loans were (and in the US still are) treated under Basel II. For capital purposes all home loans were treated exactly the same – whether a ninja loan to someone in the projects or a 10% LVR loan on a $10,000,000 stately home on Long Island.

Everyone knew this was silly, so there grew up a large market in derivatives based on home loans that was designed to arbitrage the difference between the loans the GSEs could touch and those they could not.
The net result of this interplay between the GSEs, the capital regulations and lax lending standards due to high monetary growth was that the banks were stuffed with cash they had to get out the door. They were unable to use the cash to make loans to the good risks that Fannie and Freddie had cornered and the capital regulations said that all home loans were as safe as each other. The brokers were often being paid to make loans (not necessarily good ones) and the banks did not care as much as they should have as, for the last 10 or more years, home prices had risen as much as, if not more, than their prime lending rates. Many of the banks were also, by their charters, prohibited from lending outside the US or for other than homes.

If Fannie and Freddie had not been there and the capital regulations (if they existed) had actually been risk sensitive then lending would have been (IMHO) better – but, as always, not perfect. This would have reduced (but perhaps not eliminated) the ninja loans, meaning the house prices would not have gone up as much, meaning returns from other than capital would have been examined.

I am not trying to assign sole blame for this to the regulators. All I am saying is that they did not help – so expecting more regulation to fix the problem would be the triumph of hope over experience. In the US at least, the problem was in large part caused by the multiple overlapping systems of regulation, the effects of the GSEs and the frankly stupid incentives it gave many of the market participants. My strong suggestion would be to look at sorting these out first before running off and trying to put in place more straitjackets for an industry that is already tightly bound.

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