The study also explores the impact of various policy outcomes. This will be of relevance for the development of government policy for dealing with financial firms facing potential insolvency. Significantly, the policy measures of the last six years have been found to have varying success. A debt guarantee, such as that introduced in 2008, may temporarily allay fears of bank failure. However, an excess reliance on an artificially low price of debt may subsequently distort the banks’ funding mix and magnify potential future losses.
The CIFR-funded study was authored by Professors Stephen King and Rodney Maddock from Monash University. Professor King said their analysis showed how a rise in the costs of wholesale funding could trigger a crisis in an otherwise healthy banking sector.
"In the short term, a significant price rise will lead banks to switch towards other sources of funding, such as domestic deposits, and to reduce lending. This, in turn, may lead to bank insolvency as banks are unable to meet existing obligations," he said. "In the longer term, the potential for a funding shock will be taken into account by banks when establishing their operations. For example, variability in the international price of wholesale funds will change the expected pool of profits for competing banks. This will determine the number of banks that are viable and the degree of competition in the domestic banking sector."
The study analyses a range of policies that can be implemented by the government to help avoid an imported banking crisis, focusing on the implications of such policies for the structure and level of competition in banking and the rates paid by borrowers and received by depositors, in ‘normal times’.
Professor King said, "We were able to show that some policies, such as minimum equity requirements, can stabilise the banking sector, while ad hoc policies, such as debt guarantees or bailouts, can destabilise the banking sector."
