Quiggin endorses explicit guarantee - with reservations

Noted Australian economist John Quiggin has endorsed the federal government's move to an explicit guarantee of retail deposits, while arguing for a system of "narrow banking".

In his submission to the Senate's banking competition inquiry, Quiggin argues that banking competition may undermine financial stability where lending to banks is guaranteed.

But he says an implicit and undefined guarantee, such as that which prevailed in Australia prior to the global financial crisis, was proven worthless by the global financial crisis.

Treasurer Wayne Swan said in Sunday's banking statement that the explicit retail guarantee created in 2008 would remain, but that the cap would be reviewed.

Quiggin's submission also notes that the wholesale guarantee has created a precedent which will lead banks to expect that they will be protected in a system-wide crisis.

He argues for "sharp boundaries" between protected and unprotected institutions, and for caution in allowing protected institutions to adopt financial innovations before their potential risks to the system are understood. "In the resulting system of 'narrow banking', the financial sector would become, in effect, an infrastructure service, like electricity or telecommunications," he says.

Quiggin also argues that serious potential problems remain in the Australian financial system. He repeats the call he made as one of the six signatories to the 2009 "six economists' letter" calling for a new inquiry into the financial system.