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I have been away from the purely banking risk area for a little while, so I had dropped my regular visits to the BIS website. Having headed over there for some stats recently I noticed how much they had beefed up their coverage.

A few interesting things have also appeared.

Deposit Insurance

The CP on deposit insurance that they issued in March has been updated into a full set of recommendations – the paper is here. Regular readers would know my opinion on deposit insurance, but in general the principles in this paper are sound. A worthwhile note is on page one:

The introduction or the reform of a deposit insurance system can be more successful when a country’s banking system is healthy and its institutional environment is sound. In order to be credible, and to avoid distortions that may result in moral hazard, a deposit insurance system needs to be part of a well-constructed financial system safety net, properly designed and well implemented. A financial safety net usually includes prudential regulation and supervision, a lender of last resort and deposit insurance. The distribution of powers and responsibilities between the financial safety-net participants is a matter of public policy choice and individual country circumstances.

Advice to our PM and Treasurer – do not do this in a hurry and in a poorly thought out manner. Nuff said.

Basel II Changes

Pillar I

The latest tweaks to the main Basel framework seem to be trying to do a little stable-door shutting on securitisation – with a fair bit of language added around understanding the risks and a few risk weights being increased.

Pillar II

The language of the amendments to Pillar II is also interesting – this places a large amount of emphasis on improved risk management at the banks, including reporting structures, concentration management and, in particular, the off-balance sheet stuff.

One recommendation in particular is interesting – the separation of the CRO’s office out of the business lines to report directly to the CEO and Board (pillar II amendments – 19).


This one is also good (pillar II, para 40):

A bank should conduct analyses of the underlying risks when investing in the structured products and must not solely rely on the external credit ratings assigned to securitisation exposures by the CRAs [credit ratings agencies]. A bank should be aware that external ratings are a useful starting point for credit analysis, but are no substitute for full and proper understanding of the underlying risk, especially where ratings for certain asset classes have a short history or have been shown to be volatile. Moreover, a bank also should conduct credit analysis of the securitisation exposure at acquisition and on an ongoing basis. It should also have in place the necessary quantitative tools, valuation models and stress tests of sufficient sophistication to reliably assess all relevant risks.

I would agree – but it should not take a regulator to tell a bank this. I wonder who is going to pay for all the extra analysts – or will banks just walk away from this market?
The whole document is worth a close read and I should get around to it soon. From my scan, though, I cannot see it having a significant impact in Australia. APRA was already doing most of this – but the changes to securitisation may cause some heartache amongst those institutions that rely on them, such as many credit unions and other smaller ADIs. I would be looking to the specialist mortgage providers and the bigger banks to benefit from these.


As expected, as well, the BCBS has boosted its look at liquidity – with almost as many mentions in the 41 pages of this as in the 400 of the Accord itself. Given much of the problems (like those at Northern Rock) at least started as liquidity issues this is not surprising. The language looks mostly drawn from the relevant Sound Practices document, but this incorporates it into the Accord itself. Again – not much to see here, as much of this is already in the relevant Australian liquidity regulation, and APRA is well across this.

Stress Testing

Brand new is a whole two pages on stress testing. As I highlighted nearly three years ago in one of the perennial favourite blog posts here – the original accord had little to say on the subject beyond telling you that it had to be done. The two pages here go some of the way to addressing that gap, but not nearly all the way. They are obviously leaving the wording fairly general here and leaving it up to national regulators still.

Pillar III

Much of this is focussed (as can be expected) on improving disclosure around the areas that have caused problems recently. Almost all of the changes to Pillar III are about increasing disclosure of securitisation exposures – with some consequential changes to the CRM stuff. None of this should cause any banks to sweat too much – these sorts of numbers have been demanded of the banks by the regulators for a while. It is just publishing the disclosures rather than sending them to the regulators.

Wrap Up

All of these comments, though, are fairly preliminary. I will need to go through this in a bit more detail and give it some thought. If I have missed anything, feel free to point it out in comments.

This so-called “new” regulatory “system” for the US – at least on the first draft – looks like it is simply going to add a few more regulators into an already over-governed financial system. Adding in more regulators to a system in which, even at the lowest count, there are more than 54 I cannot see as an improvement. From prior experience all I can see it doing is increasing the amount of buck-passing, adding yet another reporting layer and making it even less clear than it already is as to who it is a given financial institution has to listen to.

If you are going to have a regulated system at least make it bloody clear who is responsible and then give them the powers to deal with most, if not all, problems. Then trust them to do their jobs – i.e. get out of the way.

The Australian example is a good one – the government delegated regulatory powers to APRA. There is little doubt over who regulates what – in Australia APRA deals with systemic and individual financial institutional risk – banks, insurers, the lot. The ASX deals with listed companies where it has anything to do with information to shareholders. ASIC deals with companies and any non-APRA regulated small financial entities. The individual States have some responsibilities with respect to consumer protection. AUSTRAC deals with money laundering and some elements of criminal behaviour. The Federal Police deal with other alleged criminal activity.

Even that takes a while to say – and does leave some overlaps, but it is nothing compared to the situation in the USA. At least I can get most ofthe Australian system into one paragraph.

I have always thought the correct way to deal with a mess was to tidy it up. The suggested system seems to amount to clean up a mess by throwing more rubbish on it. It is an innovative solution to the problems – but I cannot see it as brave, useful or intelligent. The US has only just sorted out how to go to Basel II – it has not yet been implemented.

If I can put in my suggestion – other than a free banking system (unlikely to be politically possible) the best solution would be fairly simple. Make the Fed responsible as the sole regulator of all non-State chartered financial institutions, insurance and banking alike. Close the FDIC and allow private sector insurers into the market. Close the OCC and all of the other parts of the alphabet soup that are currently failing to do their jobs.

Close down Fannie, Freddie, Sallie, Maggie (or whatever the rest are called) and the rest – if they need a federal guarantee (implicit or explicit) to do their jobs then they probably should not be doing it. Sell off all of their assets and then the US government makes good on all outstanding liabilities – and the shareholders lose their holdings unless by some miracle they are actually worth something.

Replace US accounting standards with proper ones – IFRS will do. The Fed then implements Basel II the way they wanted to do it (which is also the should be done) – not the half-arsed way they have had to do to get it past the FDIC.

Get all that done and you would have a “New Regulatory System” – and one you could be proud of. As it is you are just going to make a bad situation worse.

I have been interested to see the changes in advertising by the Australian banks over the last few weeks – the changes seem to be directed (for the first time ever in my memory) towards reassuring customers and potential customers that the banks are strong and safe. All of the previous campaigns I have seen have emphasised value for money or high service levels, with the non-price associated advertising predominating.

Trying to understand this using pure logic – this makes no sense. The banks at the moment are the safest they have ever been as they now have a full government guarantee (for deposits under $1m), something they have never had before. In fact, with all ADIs being guaranteed in this way they are just as safe as each other.

To me, this illustrates one thing clearly – the banks believe that the knowledge of the government guarantee has not penetrated to all of their deposit customers and, for those that do know it, the banks are trying to create the belief that they will be just as safe once it is withdrawn.

I can’t see this as being a long term trend, but it may be a pre-emptive strike. Once the guarantee is withdrawn (hopefully on schedule) then I think we can expect to see much more of this.

I can’t see the smaller institutions being happy about it.

Just a quick vent from me. I was thinking about how I could show how important Pillar III of the Accord is when I thought again and realised there is no point to it in Australia at the moment. If you look at the reason for it, which is, according to the BCBS:

809. The purpose of Pillar 3 ─ market discipline is to complement the minimum capital requirements (Pillar 1) and the supervisory review process (Pillar 2). The Committee aims to encourage market discipline by developing a set of disclosure requirements which will allow market participants to assess key pieces of information on the scope of application, capital, risk exposures, risk assessment processes, and hence the capital adequacy of the institution. The Committee believes that such disclosures have particular relevance under the Framework, where reliance on internal methodologies gives banks more discretion in assessing capital requirements.

Think about it – a government guarantee, particularly one that guarantees wholesale funds as well, renders all this work pointless as there is no “market discipline” on any of the ADIs in Australia. They all have exactly the same risk on borrowed funds as any other as they are all government guaranteed.
Sad really – all this for nothing.

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.

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


Report in the BBC today saying the British government is about to nationalise Northern Rock. This was probably inevitable after the search for new owners failed. The loss of confidence in the name of the business meant that getting new depositors to replace the old, without a complete change in ownership, was always going to be impossible.

What will happen now looks fairly clear – the government will pass a bill, the doors will shut to new business and current depositors will walk away. Mortgage holders will be encouraged to refinance elsewhere. This will both increase the exposure to the government and reduce what value is left to pay out to shareholders, if any.

Really, it should have been allowed to fail. As my several posts on this situation have made clear, this would have resulted in the business closing, the depositors paid out a reasonable amount at first and then all of it (including interest) over time. Shareholders would then have got a return out of the residual funds – which there would have been. The FSA’s deposit insurance scheme would have been up for some payouts, but they would have recovered it all. The only (minor) losses would have been to shareholders.

Admittedly, this may have caused worries about other institutions – but none was in a position like the Rock and this could have been made clear.

The real panic here was from the regulators and the government, who were blind-sided by something they probably believe they should have spotted.

Following on from the discussion in the previous post on whether bank1 deposits are money the question arises as to what happens when bank depositors try to convert their bank deposits into money – make a withdrawal, write out a cheque, pay a bill or uses any of the other methods to get at the funds. Will the bank be able to meet the demand for cold, hard, cash?

In short, how do banks manage liquidity?

The Problem

For banks, the problem is actually a fairly simple one to state. Long term, banks typically make money by borrowing short and lending long. As yield curves are typically upward sloping this works well – borrowing borrowing from people who want to deposit short and are prepared to receive between 0 and 4 or 5% to do so and then lending this to people who want to borrow to build homes and pay from 6 to 10%, run credit card balances at around 12% (or more) is a good business. With modern banking practice this even is profitable at a net interest margin of less than 2%.

Given that bank makes the most money by transforming short-dated liabilities into long dated loans the way to make the most money in the long term is to lend it all out and for as long as possible. Great strategy – with only one flaw. Some depositors are inconsiderate enough to want to be able to actually ask the bank to do what the bank has promised to do – pay their deposit at call.

The trick to making the most money, then, is to make sure that you only have enough liquid assets on hand to meet all your depositors calls on the funds and as little as possible more. This is because liquid assets pay little interest, with the most liquid, cash, paying none at all.

Getting this right is the responsibility of the ALM (Asset / Liability Management) function, usually headed by the (gloriously named) ALCO (Asset Liability Committee).

Get it wrong and, no matter how solvent your bank, if it cannot pay depositors calls you will very shortly not be a functioning institution. Read the rest of this entry »

This is intended to summarise the several posts over the last few weeks on the current market issues. Let me start by making a few issues perfectly clear:

  1. No major Australian ADI (authorised deposit-taking institution – i.e. those you can deposit money into) is going to be unable to pay all their depositors their deposits on demand as a result of these issues. None. You are not at more risk than you would otherwise have been.
  2. I am not aware of any minor Australian ADI that is not going to be able to similarly meet withdrawal requests as and when they are made. There may be a micro institution out there in trouble, but I would be surprised.
  3. The only ones that may have some problems are the ones that do not take deposits, but rely on wholesale funds. Crucially, these will not the the ones you have deposited any money into. Again, I doubt any will collapse, but even if they did the worst consequence for their retail customers would be that they would have to re-finance their loans, or, if you are a shareholder, you may lose that money. It is unlikely, though.

The reason for this is very simple – the Australian regulator of ADIs, APRA, is very conservative (too conservative in my opinion – but beside the point here). If an Australian ADI was writing a lot of loans similar to the US sub-prime loan they would be stopped from doing so and essentially forced to unwind the loans in some way. I would be shocked if APRA had not noticed an Australian ADI running up these positions as they are normally very close to the regulated entities. The reason I am hedging a bit on some of the smaller ADIs is that there is always the potential for fraud somewhere, but I think it unlikely.

For clarity, the situation at Northern Rock in the UK:

  1. is illogical;
  2. will not result in the loss of any depositor funds; and
  3. is probably terminal for Northern Rock as in independent institution

for fairly simple reasons – and I would refer you to my previous post on this. It is unlikely to be copied in Australia for the simple reason that most Australian ADIs have good deposit bases and are not overly reliant on wholesale funds. In any case, as commenter Asa Mark linked to ( the second link) this market is starting to open up again in Australia as the markets work out that the fundamentals of the Australian economy have not changed and that lending is still as safe as it normally is.

If you are really worried and with one of the smaller ADIs, move to one of the big 4 banks or the major regionals. I would think you will move back fairly smartly though, once you get annoyed by the difference in service levels.

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