Story: Banking and finance

Page 4. Risk in banking and finance

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Balance of risk

Banks and other financial institutions are an important source of liquidity (spending power) for an economy, since deposits held for transaction purposes must be available for transfer on demand. A substantial proportion of bank deposits are held in on-demand or readily accessible accounts. On the other hand, borrowers generally need longer-term funding. Banks reconcile these competing needs by assuming that not all customers holding demand deposits will withdraw or spend them at the same time.

However, this balance can be upset if customers lose confidence in the bank or financial institution. In this event, little will be deposited with it and substantial amounts will be withdrawn, possibly leading to the ultimate failure of the bank.

In the early 2000s banks experienced strong profitability and low loan default. Much of that profitability was sustained by household debt, while a high proportion of the funds available for lending were from overseas investors. Of the $373 billion of total bank assets as at 31 March 2009, households supplied 23.7% of funds and accounted for 45.2% of total bank lending – mostly housing-related. Reflecting New Zealand’s poor savings record and the difficulty banks have had in attracting retail deposits, 31.1% of total funding comes from offshore.

Finance companies and other non-bank lenders

Other parts of the financial system lack depth and liquidity compared to banks. The second biggest lenders to firms, after banks, are the existing owners of those firms plus other informal sources such as family and friends. Equity, venture capital and debt markets are comparatively underdeveloped in New Zealand compared with other OECD countries. In Australia in 2007 the banking sector accounted for about 50% of the assets of the financial system compared with 74% in New Zealand.

The vulnerability of the non-bank financial sector was highlighted from mid-2006 to mid-2008, when 24 finance companies failed to varying degrees. An assessment in June 2008 suggested that of more than $2.3 billion of investor funds in these companies, nearly $600 million (around 25%) had vanished.

On the investor side, the most vulnerable companies were those that had relied on small-scale individual investors – who were more likely to panic – or those that did not have the backing of a major bank. Institutions that had such backing, or were primarily vehicles for savings rather than speculation (such as building societies and credit unions), were less vulnerable.

Bridge to nowhere 

One of the finance-company collapses involving a large number of small investors was Bridgecorp, which specialised in property. It defaulted on repayments of some term investments in July 2007. It owed around $500 million to 18,000 investors; receivers estimated investors would get a payout of between 18c and 51c for every dollar they were owed. 

Reserve Bank interventions

In response to these developments, and also to the world-wide liquidity crisis and economic downturn that gathered pace from September 2008, in the second half of 2008 Treasury and the Reserve Bank announced a retail deposit guarantee scheme to assure the customers of banks and eligible finance companies that their deposits were secure. They also announced a wholesale guarantee scheme to make it easier for financial institutions to raise money overseas.

The health of the banking system was assisted by the fact that the none of the principal banks trading in New Zealand – all Australian – had engaged in some of the riskier financial dealings that had got many northern-hemisphere banks into difficulties in 2008.

The wholesale deposit guarantee scheme expired on 30 April 2010, with no claims having been made under it by that date.

The retail deposit guarantee scheme lasted until 12 October 2010 and covered total deposits of approximately $133 billion with 73 financial institutions. By July 2010 just under $80 million had been paid out. Payments in respect of South Canterbury Finance, which went into receivership at the end of August 2010, were by far the most substantial; the crown paid out all 35,000 depositors (but no shareholders) in full at a cost of $1.6 billion, and also paid out other creditors at a cost of $175 million (to simplify the receiver’s task).

An extended guarantee scheme for retail deposits in approved companies was to operate from 12 October 2010 to 31 December 2011; it covered seven institutions at its commencement date.

How to cite this page:

David Tripe, 'Banking and finance - Risk in banking and finance', Te Ara - the Encyclopedia of New Zealand, (accessed 19 May 2024)

Story by David Tripe, published 11 Mar 2010