When Prime Minister Kevin Rudd and Treasurer Wayne Swan popped in yesterday, supposedly for a chat about fighting inflation, perhaps the fellows at the Reserve Bank found a little time to brief them about the conference the Bank held without much publicity just before the calling of last year’s election.

“The Structure and Resilience of the Financial System” was the theme of the two days of talking at the end of August by a collection of economic and financial luminaries from around the world whose papers were published by the Bank when the election was safely our of the way.

It is hardly light reading when a man like Claudio Bario, head of Research and Policy Analysis at the Bank for International Settlements puts his views in measured tones such as “financial distress is more likely to involve, as a manifestation and as a key transmission channel, the evaporation of market liquidity.” The message for politicians is nevertheless clear from the very fact that the Reserve thought it was an appropriate time to have such a conference.

The prospect of “financial distress” is real and, as Mr Bario put it, “we have witnessed the globalisation of finance”, which means that Australia will not escape the impact of things like the overnight bailout in the United States of Citibank and Merrill Lynch. As The Financial Times of London describes, it is “unprecedented” that the two major US financial institutions have to raise “$21.1bn in fresh capital, mainly from outside the US, to shore up balance sheets devastated by the subprime mortgage crisis.”

Australian banks and other lending institutions are increasingly dependant on money borrowed from overseas to meet their lending commitments at home. As the accompanying graph shows, household deposits which made up 40% of money banks had to lend back in the early 1990s is now down to 20% with foreigners replacing them. Yet when even the world’s biggest bank can get into trouble, uncertainty about the creditworthiness of other participants is bound to happen. The Australian Government discovered what that can mean when rates on home mortgages were increased last week without any change in official interest rates because those foreigners have started charging Australian institutions more.

 

Or, as Mr Borio puts it:

Indeed, just like banks, markets are subject to runs. The mechanisms at work are exactly the same – concerns about credit risks, uncertainty about the creditworthiness of other participants and the drying-up of funding liquidity. In other words, the current financial system is particularly “funding liquidity hungry”.

Perhaps among those talking with Messrs Rudd and Swan at the Reserve Bank yesterday were Chris Ryan, head of the Bank’s Financial Stability Department, and Chris Thompson, the department’s Senior Manager. Their contribution to last year’s conference touched on what is potentially the most serious political problem that will confront the new Labor team as this “financial distress” works it way through the world.

That is the way the significant increase in the size and changes in the composition of the household balance sheet over the past couple of decades has left many households wealthier, but also more directly exposed to financial risks than they were in the past. In their paper they said:

While individuals have always been the ultimate bearers of risk in the economy, in the past the true incidence of risk was more opaque and typically thought of as being borne by institutions rather than households.

In a defined benefit superannuation fund, for example, the market risks associated with the investment of the fund’s assets are not borne by the fund’s members, but are indirectly borne by those households that own shares in the fund’s sponsor. By contrast, market risks are borne directly by the members of a defined contribution fund.

The increased transparency and, arguably, increased concentration of risk-bearing by households therefore poses the challenge of ensuring that households have the knowledge and tools necessary to understand and manage this risk.

That is the economists’ way of saying that ordinary people will know what a market collapse means when they get their half yearly report from the super fund showing that their wealth has gone down. Add in the impact of realising that the value of your house is going down rather than up and politicians do begin to have a problem and it has nothing to do with inflation.