What if Australia?s banking system needs a Government bailout?

August 17th, 2010

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As most of us are aware, Australia has the ?four pillars? ? four large banks that provide the majority of Australia?s local banking credit. Over the last few decades, these four banks have increased their exposure to residential mortgages, even in the face of what appears to be a large housing bubble.

Mark Joiner, NAB?s finance director is confirms in this article:

[CBA and Westpac] ?with mortgages accounting for more than 60 per cent of the Sydney banks’ balance sheets?

“Australia should have a balanced economy; not a big skew to mortgage or business lending”

Each of these four banks lends money to each other and has enough influence on the economy to be considered ?too big to fail? by most – the failure of one bank potentially triggering the collapse of another and so on.

Popular opinion suggests that if such a scenario were to occur, the Australian Government would step in to bail out the banks and prevent them from collapsing. This would require the Government to acquire money, either by borrowing it, selling bonds or ?printing? it.

If we make the assumption that the Government would be forced to act in this way, the repercussions of such action could be that borrowing or bond sales increase the Government?s financial liability. This increases the risk of lending to the Government, possibly even our AAA debt rating. Such increased risk will:

  • increase the cost of borrowing for the Government and local companies including banks
  • decrease the amount of credit easily available
  • increase the Government deficit and annual interest payable
  • increase local interest rates, making it more expensive for the public to service debt or take on new debt, possibly reducing the ability of the public to purchase property

If the Government resorted to money printing (or equivalent), it is likely that the value of the Australian dollar would depreciate, causing credit problems similar to the ones mentioned above. And if such problems persist, they would form part of a feedback loop that amplified them over time (see Serious vulnerability in the Australian banking system).

However, this does not mean that the problems would be inescapable. Strong fiscal policy, increased taxes, reduced spending ? all of these could contribute to bringing Australia back into healthy financial territory.

But what are we missing? Even now, people are crying out for spending on infrastructure in NSW, VIC and QLD by the state and federal governments. How will the Australian Government have the funding to pay for any of this if it is trying to pay down debt, or if the cost of debt is increasing? Every dollar of government spending sourced through taxes, services, bond sales or borrowing has been labelled to be spent on something. If the Government allocates money to bail out banks, it is taking it away from spending on other items. From this we get a mis-allocation of spending, which will create market distortion and potentially hamper the economy at a time when Australia can least afford it.

From this we can deduce that there must be a limit to how much money the Government would realistically allocate to a bank bailout. At some point the risk of bank failure to the economy will become less than the risk of removing Government spending from the economy. Whether from this point the banks will actually fail or not cannot be known at this point.

And a final point to consider is that after bank bailouts, will the banks be very cautious lenders who have learned valuable lessons about asset risk and reserve requirements, or will they have an increased risk appetite due to a feeling of assurance that the Government will always step in and save them from ruin?

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