It seems that each week brings a new piece of bad news about some financial institution in serious trouble. This shouldn’t be surprising as we are witnessing the end of easy money and rising asset prices, and the ensuing credit crunch. But how much worse can it get?

In contrast with the US, Australia has not experienced the excesses of financial engineering and serious failures of bank regulation, such as the disregard of off-balance sheet transactions through so-called Special Purpose Vehicles.

As far back as 2000, APRA had warned about the “residual risk” for banks from the securitisation of mortgages. Thanks to their oligopoly situation, the profitability of commercial banks has been strong and has not required relaxing lending standards to boost their loan books. This does not mean that they are not affected by the spread of uncertainty about the prospects for financial markets, and the related higher risk premia required by investors to buy bank bills or notes. They have also incurred losses from lending to failed non-bank financial institutions, such as brokerages, mortgage originators, or hedge funds, but they are all “too big to fail”, even the smaller ones.

What has been demonstrated in the US with Bear Stearns and the UK with Northern Rock is that the national authorities will not allow the markets to sort out problems in one financial institution if those problems may have “systemic” consequences for the whole financial system, even if this entails a serious moral hazard and a potential cost to taxpayers. That is why the dire warnings about a repeat of the Great Depression are excessively pessimistic. It is true that the RBA’s sole mandate is to keep inflation under control, but it is also the lender of last resort and like the European Central Bank, which has a similar mandate, it can be expected to act to prevent a financial meltdown.

This does not mean that the financial sector will have easy sailing in the period ahead. The most heavily indebted businesses feel the pains of the credit crunch and higher interest rates, and investors remain risk averse. The greatest uncertainty is the prospect for the property market. If it were to turn down sharply, as it has in the US and may be about to in the UK, more bad loans in the banks would aggravate the credit crunch.

Australia’s policy-makers face difficult challenges, a resurgence of inflationary pressures, a sizable current account deficit, the legacy of an exceedingly voter-friendly fiscal policy, the uncertainty of the prospects for its commodity exports, but the collapse of its financial system is unlikely to be one of them.

At the same time, the regulators will be called upon to avoid a situation that would require a costly intervention by the authorities. This is the counterpart of the implicit guarantee they have received. The old model that allowed Australia to do without deposit insurance on the grounds that the discipline of the market is sufficient has become out of date.

Get Crikey for $1 a week.

Lockdowns are over and BBQs are back! At last, we get to talk to people in real life. But conversation topics outside COVID are so thin on the ground.

Join Crikey and we’ll give you something to talk about. Get your first 12 weeks for $12 to get stories, analysis and BBQ stoppers you won’t see anywhere else.

Peter Fray
Peter Fray
Editor-in-chief of Crikey
12 weeks for just $12.