by Rodney Maddock and Stephen King, The Conversation
Banks borrow short and lend long. So if all of a bank’s depositors suddenly want their money, the bank would be unable to pay them. A bank may have made great loans but it can only unwind these loans slowly over time.
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In most situations this doesn’t matter. Banks know their cash flows and play the probabilities, making sure they have a buffer of liquid assets to meet normal withdrawals.
However, a crisis can trigger a run on banks. Every depositor wants to get his or her money out of the bank before everyone else. The bank runs out of cash and closes its doors. It fails.
Bank regulation is at the heart of the current Financial System Inquiry chaired by David Murray. It will consider which regulations are important, which need to be strengthened and how international banking rules should apply in Australia.
Our recent research compares some of the different rules that may be used to limit bank risk. We find that increased bank capital requirements are the most effective policy but must be applied across all institutions to stabilise the banking system.
The global financial crisis
The 2008 crisis resulted in plenty of traditional bank runs. In the United Kingdom, retail depositors lined the streets to take their money out of the failing Northern Rock.
We also saw a different type of bank run during this period. For example, a bank run led to the collapse of Lehman Brothers. Yet this didn’t involve retail depositors. It was institutions that stopped lending to Lehman Brothers on the wholesale market.
Australia’s banking system in 2008 was fundamentally sound. Our banks didn’t have abnormal levels of bad loans. Legal differences meant the default issues plaguing bank mortgages in California, Florida and elsewhere in the United States couldn’t occur in Australia.
Yet our banks were still exposed to the crisis through their reliance on imported wholesale funds. The Australian government responded to this risk of an “imported crisisâ€. In October 2008, it introduced explicit deposit insurance and guaranteed bank wholesale borrowing.
But why did Australia’s sound banking system come under pressure in 2008? Is there potential for Australia to import a banking crisis in the future? And what sort of banking regulations do we need to deal with this possibility?
