Banking: one big Ponzi scheme?

by: James Adonis , The Sydney Morning Herald

Among the stories coming out of Cyprus these past few weeks, one of the saddest has been the Australian business owner who spent 35 years running a stand at a Sydney market. Once he’d saved up $1 million he retired and moved back to the country of his birth. But all of that money was kept in just one Cypriot bank account. At the bank that went bust. Most of his funds are now gone.

That event could be brushed off as a European problem that would never happen in Australia, where four of our banks are among the world’s safest. Global Finance Magazine, which formulates the annual list based on data from the major ratings agencies, even has three of the big four in the top 15.

Just because a bank is safe by global standards doesn’t make it safe in practice. It could be that they’re all operating on an unstable platform, ready to drive us back into another financial crisis.  

Take, for example, the controls that have been placed on Cyprus’s banks, limiting the amount depositors can withdraw. The authorities have implemented those measures to prevent a bank run, essentially because banks don’t have enough in cash.

Neither do the banks in Australia. Banks don’t need to hold in cash the amount of money they have recorded as deposits. They just need to have enough in reserve to cover the day-to-day demands of their customers.

But what if, all of a sudden, an unexpected event caused the sort of panic that compelled a mass of Australians to rush to their banks seeking to withdraw what was rightfully theirs? The banks here, just like in Cyprus, would not be able to pay out what they owe. Not in the short term, anyway.

That’s why the Federal government guaranteed bank deposits here just as the recent financial crisis was kicking in. (Then again, Cypriot deposits were also ‘guaranteed’.)

This diminished faith in the stability of our banking system was what prompted a colleague to remark recently: “Banking? Pfft. The biggest Ponzi scheme on the planet, ready to collapse at any minute.”

A little dramatic, sure. And, granted, Ponzi schemes are run with the malicious intent of defrauding people, which is not the case with banks. But maybe he has a point, albeit a minor one. So I sought clarity from a bona fide expert.

Dr Tro Kortian is an economics lecturer at the University of Sydney and a former research economist with the Reserve Bank. Unsurprisingly, he disagreed with the proposition banking is a legal Ponzi scheme.

He explained banks play an important role in facilitating the transfer of funds from savers to borrowers – an essential service for the functioning of a strong economy. As intermediaries, they accept deposits from savers and then provide those as loans to borrowers, thereby stimulating economic activity.

A consequence of this intermediation is that a mismatch arises between a bank’s assets and liabilities. He says this is one of the main reasons for the fragility of the banking sector and justification for banking supervision and prudential regulation.

Normally, this mismatch isn’t a concern. In Australia, at least, there are plenty of deposits being made. At the same time, banks are good at managing their loans. This combination means a bank’s capital and liquidity are sufficient to meet any demand for withdrawals.

(But, there’s a but…)

“If, however, something happens to disturb confidence, this situation can be quickly destabilised,” adds Dr Kortian. “No bank would have enough capital and liquid assets on hand to cope with all of the deposits being taken out at once.”

So that’s what’s holding much of it together. Confidence. Heaven forbid that screws up.