Brian Easton casts an eye over the 'inherently unstable' financial sector, noting it can result in very high performance

This is a re-post of an article originally published on pundit.co.nz. It is here with permission.

Evaluating the recent crashes of Silicon Valley Bank in the US and Credit Suisse in Switzerland plus two other banks (perhaps more by the time you read this) needs to begin with a review of the inevitable instability in the financial sector.

The financial sector is inherently unstable, like military jets which are deliberately designed to be unstable with controls to override any potential breakdown; it results in very high performance.

Thus it is with financial institutions, especially those which take short-term deposits and invest them long term. That is an advantage to depositors because they get a higher return and implicitly diversify their investment portfolio which reduces risk; moreover, it reduces the costs of investment management to the depositor. All of which is good. But when a lot of depositors choose to withdraw their funds, the bank or other financial institution may not be able to redeem its investments quickly enough and it gets into financial difficulties. Sometimes, but not always, the withdrawals are caused by the financial institution making bad investment decisions and they cannot recover their lending. (Effectively it is their depositors’ lending.)

Such financial crises happen more often than are remembered. A New Zealand example is that in 1882 a Christchurch law company, Harper and Co., had been taking in deposits and reinvesting them unwisely. Those who had entrusted savings received a ‘farthing in the pound’. About the same time, the Bank of New Zealand, the Colonial Bank and the National Bank of New Zealand all had to be rescued when their investments turned sour.

That happened during the Long Depression when everyone was struggling. The standard account starts the  international depression off with the failure of the City Bank of Glasgow in 1878 (again unsound investments); it would not be the last time that an overseas financial failure impacted on the New Zealand economic and financial stability. We were brutally confronted with this truth in 2008 during the Global Financial Crisis.

(Australia took it harder. In 1891-93, 54 non-bank financial institutions failed while in 1893, 13 of the 23 trading banks suspended withdrawals for some months.)

The list of subsequent domestic failures is too long to report. Not all failures were public. For instance, during the 1984 devaluation crisis one of the trustee savings banks (they no longer exist) had to ask the Reserve Bank for help when withdrawals by depositors exceeded the cash available. Its investments were in house mortgages; it could hardly ask for its money back all at once. The RBNZ, judging it was fundamentally sound, provided the cash to fund the fleeing depositors.

It was following ‘Bagehot's Dictum’ that in times of financial crisis, central banks should lend freely to solvent depository institutions (but only against sound collateral and at interest rates high enough to dissuade borrowers not genuinely in need). It was practised again during the 2008 Global Financial Crisis, and for all we know has been since.

More difficult is when the financial institution’s problem is not the mismatch between maturity lengths of its deposits and investment – the instability of a high-performance jet – but failed investments. (I put aside fraud. It happens, but more rarely than is claimed. Sometimes fraud occurs in an attempt to hide investment failures but occasionally it happens from the beginning. Some crytpo schemes are recent examples.)

Someone has to cover any financial losses. In the first instance, it is the shareholders. Then there may be bond holders who get higher interest returns in exchange for the possibility of losing their cash if the institution fails. Next in line are the ordinary depositors; that is the risk they take when they hand the cash over.

Some argue that the deposits should be guaranteed by the state. It is a complicated policy issue, but most affluent countries provide such guarantees, levying on the deposits to fund the scheme amounting to  a form of insurance.

There is a concern that this insulation of the depositors from the state of the institution in which they are investing removes the need to judge whether it is sound and a discipline on the financiers. This issue of ‘moral hazard’ was well illustrated when the government offered a (temporary) deposit guarantee in 2008 to prevent depositors taking their funds out. South Canterbury Finance offered higher interest rates to obtain more cash. It needed it; when it crashed, it cost the taxpayer slightly under $1b. (There was a cock-up, because the central authorities could have limited the guarantee to existing deposits only.)

Curiously, little attention was given in the GFC to the moral hazard of those working in the banks which crashed, who were still paid their bonuses (often at the expense of taxpayers) despite having been reckless.

There is a proposal before Parliament to introduce deposit insurance for the first $100,000 (which is low by international standards). The scheme will be pre-funded by levies on deposit takers and supported by a Crown backstop. It is currently sitting in the select committee. If implemented, a depositor with more than $100,000 would have to take a ‘haircut’ on the excess, that is, they would have to make a proportional contribution from their excess deposit to cover any loss not covered by shareholders and those with the more at-risk deposits.

The recent financial crashes of Silicon Valley Bank, Credit Suisse and all may increase the urgency for passing the legislation even though each failure occurred for different reasons although rising world interest rates are a part of each’s story. In the early 1970s, rising interest rates brought down at least four New Zealand financial institutions.

Will there be another global financial crash? The answer is probably one day, but it may not be soon. On the other hand, I would be remiss not to wonder whether the recent failures are harbingers of something bigger perhaps precipitated by the rise in interest rates. I remember thinking about – and writing about – this possibility in 2007, as the odd financial institution fell over, although I never dreamed about how complicated the GFC would be.

So what should you do, if you think the possibility is significant? Currently your best choice is to be cautious about your return – the higher return, the greater the risk – and to choose financial institutions which are well supervised and regulated by the Reserve Bank of New Zealand.

One option would be to draw all your savings out. A banknote is, in effect, a deposit in the Reserve Bank which is as safe as the government of New Zealand is safe. The catch is that you will get no interest on the note and there is the risk of theft (or fire); buy a safe.

So depositing in sound financial institutions has its attractions, despite the inherent instability in the financial system.

*Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.