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Monday, October 13, 2008

Kevin Rudd has dodged a bullet

Had he gone ahead with his plan to legislate this week to guarantee only the first $20,000 of each bank deposit he could have sparked a run on the banks.

It's easy to see how.

When he said Friday the guarantee would protect up to 85% of depositors he was implicitly telling the other 15% they would be unprotected.

In order to get that protection a depositor with, say, $120,000 in an account would have to withdraw $100,000 and split it up into five separate accounts.

The resulting withdrawals could have caused chaos.

Professor John Quiggin from the University of Queensland says while the money withdrawn would have been quickly redeposited, “the churn process might not be symmetrical, and would in any case be likely to generate considerable alarm”.

He says the possibility of it turning into a run was “far from remote”.

No bank can cope with a sustained run of withdrawals. The little-acknowledged truth is that they lend out more money than they have.

That Kevin Rudd saw sense over the weekend is a tribute to him and to his advisors, and also to Malcolm Turnbull who pointed out early that the scheme was unworkable...

Just as important is the guarantee the government will be extending to the foreign funders of Australian banks that their money is safe.

Lending to an Australian bank has always been extremely safe, but foreign funders have become so scared by their experiences with US banks that they are now unlikely to lend at a reasonable price unless they know their money is absolutely safe.

The Australian government will give them that assurance and charge a fee for it. It will act like a commercial insurer – charging an insurance premium in order to make good their loans in the extremely unlikely event that they defaulted.

The extra $4 billion to be spent buying mortgage-backed securities from non-bank lenders will extend the same sort of benefit to them. If foreign lenders are too frightened to finance Australian mortgages (which are among the safest investment propositions in the world) the Australian Treasury, with much better access to information can do it, and make money along the way as well.

The G7 Finance Ministers meeting in Washington on the weekend agreed on a 5-point plan of action to keep their financial systems afloat. On Sunday Kevin Rudd ticked every one of those 5 boxes.