RDP 2013-01: Currency Demand during the Global Financial Crisis: Evidence from Australia 2. Financial Crises and Currency Demand

2.1 A Historical View

Financial crises can result in depositors losing confidence in financial institutions and withdrawing their money, which can then appear as increased currency in circulation. Banks and other deposit-taking institutions are vulnerable to such withdrawals because they typically retain only a fraction of their customers' deposits in liquid form, investing the remainder in loans whose terms are often longer than those of deposits. In extreme circumstances, this can result in a bank run. Expectations of a bank run can become self-fulfilling because depositors have an incentive to withdraw their deposits if they believe that other depositors will withdraw their funds (see Diamond and Dybvig (1983) for a theoretical discussion). History has shown that bank runs can quickly turn a liquidity problem into a solvency crisis (see Reinhart and Rogoff (2009) for a review).

Australia, like many countries, has had some experience with financial crises and bank runs. An early crisis occurred in the 1890s, following a property boom associated with lowered lending standards at many financial institutions. As property prices collapsed, depositors became concerned about the solvency of some exposed banks and building societies. Some depositors transferred deposits to more conservative and well-established financial institutions and others withdrew their deposits from the banking system. As a result, the value of currency in circulation increased in ‘leaps and bounds’ in a short period of time (Holder 1970). Even solvent banks not exposed to the property market faced liquidity problems and became increasingly unable to redeem depositors' claims. At the height of this crisis, half of all deposits in Australia were suspended (Rohling and Tapley 1998). Most deposits were paid back between 1893 and 1901 and did not suffer direct financial losses, although there were ‘considerable indirect losses via frozen deposits’ (Kent 2011).

In contrast to the 1890s financial crisis, only three Australian financial institutions suspended withdrawals after runs on deposits during the Great Depression. This was because in the years leading up to the Great Depression, there was less speculation in the property market, less rapid credit growth and many financial institutions had become more conservative in their risk-taking due to less competition (Kent 2011).

In more recent history, there was a significant financial crisis in the mid 1970s. Again, the crisis followed a property boom and was precipitated by a liquidity squeeze that led to ‘the failure of almost half of the largest 20 finance companies’ (Bloxham, Kent and Robson 2010). The crisis was concentrated in building societies and did not involve a noticeable increase in currency on issue.

Another crisis began in 1989, after a combination of high interest rates and a softening commercial property market brought credit quality problems to light. The crisis involved a number of runs on building societies and small regional banks (Fitz-Gibbon and Gizycki 2001). Two larger banks also suffered large losses, but had, or were able to raise, sufficient capital to cover them. The crisis resulted in a steep increase in currency demand in 1990/91. From then until late 2008, Australian financial institutions largely avoided difficulties. There were no out-of-the-ordinary increases in currency demand until the intensification of the global financial crisis in late 2008.

This historical view, as well as international experience, demonstrates that periods of financial instability and losses of confidence in financial institutions can be marked by increases in the public's demand for currency. This suggests that during financial crises, changes in currency demand may provide useful information about the degree of public confidence in the financial system.

2.2 The Global Financial Crisis

The global financial crisis was associated with a substantial increase in currency demand in Australia. While it is difficult to date the beginning of the crisis precisely, money market spreads first began to widen in August 2007 following a series of announcements of losses by financial institutions and the suspension of some bank-sponsored investment funds (Ellis 2009). In Australia, corporate bond spreads also began widening around that time (Figure 2).

In September 2007, there was a depositor run on Northern Rock, a mortgage bank in the United Kingdom (Dodd 2007). This was the first bank run in the United Kingdom since 1866. However, it did not follow the traditional model of bank runs. Rather than occurring prior to official support for the bank, it occurred after Northern Rock sought, and received, emergency liquidity from the Bank of England (Shin 2009).

The next major disruption occurred in March 2008 when Bear Stearns suffered a sharp withdrawal of funds. This prompted an injection of liquidity by the US Federal Reserve through JPMorgan Chase, which subsequently announced its acquisition of Bear Stearns (RBA 2008).

The greatest period of disruption followed the announcement of Lehman Brothers' bankruptcy on 15 September 2008 (Edey 2009). Soon after, AIG required emergency support from the US Federal Reserve, and several large banks (e.g. Washington Mutual, Wachovia and Iceland's Landsbanki) were placed into receivership or forced sales. During this period, confidence collapsed, equity prices fell sharply and wholesale credit markets went into a state of serious dysfunction.

The Australian policy response to the unfolding crisis was prompt. In October 2008, the RBA lowered the cash rate from 7.0 to 6.0 per cent. The easing continued until April 2009 when the cash rate was lowered to 3.0 per cent (Figure 3). As well as lowering the policy rate, the RBA undertook a range of market operations designed to provide liquidity in the Australian market (RBA 2009a). The Federal Government also announced a series of measures to bolster confidence in Australian financial institutions, including an Australian deposit guarantee scheme, which took effect on 12 October 2008 following the announcement of similar measures in other countries. A wholesale funding guarantee was announced at the same time. Soon after this, the Federal Government announced stimulus payments to be made to households in December 2008. More stimulus payments were announced early the following year (to be paid from 11 March 2009), as well as tax bonus payments that would begin on 6 April 2009. The value of payments to households totalled approximately $21 billion, or almost $1,000 per capita (RBA 2009c).

2.3 Currency Demand in Australia during the Global Financial Crisis

As the global financial crisis unfolded, the stock of banknotes on issue increased dramatically. Figure 4 shows the cumulative increase in banknotes on issue on a daily basis alongside relevant events that occurred at the time. The surge in banknote demand was not an immediate response to the intensification of the crisis around the collapse of Lehman Brothers, suggesting that the Australian public was not immediately concerned. However, the stock of banknotes on issue began rising sharply around the same time as the RBA's 100 basis point cut in the cash rate (on 8 October) and accelerated further upon the Federal Government's 14 October announcement of the upcoming cash payments to households.^[3]

Standard explanations of currency demand posit that lower interest rates should cause increases in currency demand but the speed and magnitude of this rise suggests that this explanation is not the full story.^[4] The further increases in banknote demand following the announcement of the stimulus payments could be the result of banks stocking up on currency in anticipation of increased cash withdrawals. This might seem overly preemptive given the payments were not to be made until December, but liaison with banks at the time suggests that it was a factor.

The magnitude of the growth in banknotes on issue suggests a role for precautionary demand that was not immediately apparent in September 2008. Given that this demand appears to have coincided with the policy responses of the RBA and Federal Government, it is possible that there was some adverse signalling effect of these policies.^[5] However, it is also possible that the public and policymakers were both responding to the ongoing deterioration in financial conditions over that period; indeed, the deposit guarantee is likely to have limited the extent of the rise in currency demand by providing added confidence in deposits.

Another factor that contributed to the rise in currency demand was a rise in demand from offshore as a result of the sharp depreciation of the Australian dollar seen in this period. Information collected at the time suggests that expatriates, tourists and families of international students studying in Australia took the opportunity to obtain Australian currency at what appeared to be a good exchange rate (RBA 2009a). Indeed, foreign banks engaged in currency exchange reported that they were barely able to keep up with the demand for Australian currency. We are unable to quantify this offshore demand, but it may have been a significant contributor to the overall rise in banknotes on issue.^[6]

The daily banknotes-on-issue series shows demand in real time, which reflects changes in both household and bank behaviour. These daily data may be useful to monitor in order to inform judgements about whether financial market turmoil is spilling over to the broader economy. The close working relationship between the RBA's Note Issue Department and the commercial banks also yields information on the motivation for banknote demand.

Footnotes

Single and multi-day changes in this period were 2–5 standard deviations larger than average for that time of year. [3]

This is borne out in the modelling results in Section 4. [4]

A similar line of argument can be found in Taylor (2008). [5]

Previous sharp depreciations do not appear to have been associated with rises in currency on issue, and we find the exchange rate is not significant in a currency demand model (see Section 4.4.2). [6]