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Overburdening the bank guarantee

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31 October 2011 13:20

The European sovereign debt mess is a reminder of how foreign capital flows can get countries into trouble. It's not just the southern Europeans who are feeling the pinch. The heavy investment of French and German banks in Greek government bonds (and the debt of other troubled countries) has left these banks weakened, probably in need of government support.

Nor is it just spendthrift governments that cause the problems. In the case of Ireland, it was the readiness of foreigners to fund the bank-promoted property boom that has left the country in a parlous state.

The credit rating agencies might have us believe that Australian banks are subject to the same vulnerability of foreign funding. It is true that the Australian banks get more than a quarter of their funding from the foreign wholesale money market, and it was the drying up of this market in September 2008 that left them scrambling for dependable funding.

There was, however, a straightforward answer to that problem. The Australian Government's AAA guarantee allowed the banks to tap medium-term funds even when the market was closed to most borrowers. There can be no doubt that such backing would be provided again if it were to be needed.

In any case, the Australian banks have moved to make their funding position less dependent on overseas lenders. They have raised more domestic deposits. This week confirmed another move which will strengthen bank balance sheets further: the introduction of covered bonds.

Banks are now allowed to issue bonds which, unlike mortgage-backed securities, remain liabilities of the issuing bank. The bonds have the backing of an explicit set of assets on the bank balance sheets, plus the ability to draw on further backing if needed. Thus these covered bonds effectively rank ahead of bank depositors in the unlikely event of bank failure.

As usual there is no free lunch. The effect of introducing covered bonds is to widen the extent of the government guarantee that stands behind banks. The issue of such covered bonds was resisted over the years by the bank regulators for this very reason: bond-holders would rank ahead of depositors.

The banks have now won this extra advantage, at the expense of the taxpayers who are the ultimate guarantors. Whatever you think about the banks getting more government help, there is no doubt they are a bit safer now than they were before.

The banks might be safer, but this creates, at least at the margin, an increased macro-vulnerability for the country as a whole. Someone has to fund Australia's substantial current account deficit. At the moment this is largely done by the Australian banks' overseas borrowing. If the banks issue covered bonds up to the limit envisaged by the regulators, the banks will be able to obtain most of their funding requirements from domestic depositors and from investors such as the Australian superannuation funds.

Who, then, will do the overseas borrowing, funding the current account deficit? In normal times foreign capital flows can come through a wide variety of channels: foreign purchase of equities or bonds, direct borrowing from foreigners, and foreign investment. Any slack from the banks' smaller foreign borrowing will be made up by other borrowers.

But should there be a repeat of September 2008, which dried up many of these channels, the easy option used at that time — ensuring the continuation of bank funding through the government guarantee — will no longer do the job.

Photo courtesy of Flickr user antwerpenR.

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