Why did our banks survive the Global Financial Crisis?

By Stephen King • July 22nd, 2013

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The 2008 global financial crisis (GFC) developed over a long period of time. It included a housing bubble in the United States and then a slow squeeze in liquidity that brought down banks around the world. Europe and the USA, in particular, are still suffering from the crisis.

So why did Australian banks survive?

Robert Marks has a ‘timeline’ of the GFC published by the Royal Society of NSW. It is like reading about a slow motion train wreck. In 2007, some familiar names start to pop up in the timeline, such as UBS, Northern Rock and Citi. By mid 2008, it is clear that panic has set in. Banks are bailed out and, in some cases, nationalised. Whole countries, such as Iceland and Ireland, face a credit squeeze. Economies move from growth to recession.

Yes, occasionally the regulator, the Australian Prudential Regulation Authority (APRA) steps in. Sometimes the Australian Government has to act, such as on October 12 2008 when it announced a guarantee on all bank deposits up to $1 million and also guaranteed banks’ wholesale funding…. But the overall message is clear. Australia’s banks survived the GFC remarkably well.

Why?

Australia’s ‘exceptionalism’ was noted early on. In March 2009, former Reserve Bank of Australia governor, Ian MacFarlane, suggested that it reflected our ‘four pillars’ banking policy.

The ‘four pillars’ policy, which dates back to the Hawke-Keating government in 1990, prevents mergers between Australia’s four largest banks – Commonwealth Bank, Westpac, ANZ and NAB. It has been criticised as anti-competitive, for example, by the 1997 Wallis inquiry into Australia’s financial system. And the claim that Australia’s banking system ‘needs’ more competition appears to be a regular catch cry by politicians seeking a popular cause. So did a lack (or at least a limit) on competition save Australia’s banks from the GFC?

The idea that there can be ‘too much’ competition in an industry like banking reflects problems of corporate governance. Shareholders face asymmetric returns. If a company takes a gamble and this pays off, then shareholders get all the upside. If the gamble fails, the shareholders are protected by limited liability. The company may be bankrupt but the shareholders don’t have their personal wealth at risk. Other creditors, such as bondholders or, for banks, depositors, should have an incentive to stop excessive risk taking. But if these creditors are dispersed then each might have only a small incentive to monitor the business. And if the business is a bank, and creditors are either explicitly or implicitly protected by government guarantee, then creditors’ incentives to keep a check on management are further weakened.

The nature of banking exacerbates the corporate governance issues. Banks ‘borrow short and lend long’. So if there is any fear that a bank may have financial problems, creditors can either try to change the bank’s behaviour or just take their funds and leave. When the latter occurs, a ‘bank run’ can result. No bank carries enough short-term funds to pay out all short-term creditors, and no creditor wants to be left behind if other creditors withdraw the existing short-term funds. The resulting panic can bankrupt even a healthy bank.

If increased competition leads to increased risk taking by banks, this can raise the vulnerability of the banking system to a ‘run’. Limited competition and strong regulation, which limits banking activities and requires banks to have more equity (i.e. shareholder funds) and more secure investments, can lead to a more secure banking system.

Of course, this could go too far. If there is too little bank competition then customers are likely to get a poor deal. And if a bank is so big that government cannot let it fail, for political and macroeconomic reasons, then the incentives for creditors to keep the bank from taking excessive risks disappear. Further, regulation has costs and can potentially prevent desirable and profitable banking activities. Banking, by its very nature, involves risk.

What role did bank competition and regulation play in the GFC?

A recent International Monetary Fund paper argues that there is a “U-shaped relationship between bank competition and stability” and that “an intermediate degree of bank competition is optimal”. While the data is messy, Australia, along with Canada, appears to have had a ‘middle’ level of bank competition in 2008. And both country’s’ banking systems did well in the GFC.

…So it appears that Australia’s banks did well during the GFC for three reasons: Goldilocks competition – neither too hot nor too cold; strong regulation; and decisive government intervention when needed.

It is worth remembering these factors, because the 2008 GFC was not the first financial crisis to hit the Australian financial system, and it will not be the last.

http://economicstudents.com/2013/07/why-did-our-banks-survive-the-gfc/

1. What type of market (market form) do Australian Banks operate in? Give some reasons why. (8 marks)

2. If there was another financial crisis and a lot of Australian banks failed, which components of aggregate demand would this affect? How would this affect real GDP? (No diagram required- but you may discuss a diagram if you wish) (12 marks)

Case Study based on

• Pricing and Output Strategy 1

• Pricing and Output Strategy 2

• Modelling the Macroeconomic Environment

Requirements & Structure:

• Each case study will have 1-2 questions which students need to answer using no more than 200 words (- /+ 10%) for each question.

• The answer needs to directly address the question(s) with reference to theory and at least two external sources. The answer does not have to be in essay or report form.

• Ideas and information adapted from sources other than the lectures or tutorials need to be referenced using Harvard referencing