Ask Colin

I have a lot of cash with bank. How do you manage this risk?

The detailed question was:

I now have a large portion of my equity fund in cash with one institution. I am therefore highly exposed to the credit quality of this single institution. How do you manage this risk? Do you diversify your holdings among a number of institutions or are you comfortable with the credit quality of say the four big Australian banks? What other steps do you take to reduce this risk?

 

There are two types of risk we are exposed to here. One is general risk of a complete collapse of the banking system. The other is the specific risk of failure of one bank.

 

General risk to the banking system is the harder one to deal with, but also the less likely. One approach would be to hold cash in interest bearing securities rather than cash, as such. However, this may only be a partial solution, because in a banking system failure, the issuers of such securities may themselves be at risk. There will also be a liquidity risk, no matter what we do in this kind of situation. Another approach might be to invest part of the cash holding in banks in another country. However, again in a general failure, the problems may not be confined to one country. There is also an added currency risk in moving off shore. A partial solution there would be foreign banks operating in our own country.

 

Specific risk is much easier to deal with. The classical answer is diversification. We should spread significant cash holdings across several banks. I have dealt with this one by having my current cash holdings in four different banks – two of them based in two overseas countries, but operating in Australia.

 

There is a third risk in holding large cash holdings, which is not strictly a banking security issue. This is potentially the biggest risk of all, which is inflation. If we see an increase in inflation, interest rates on cash holdings may stay at levels greater than inflation, but this is no certainty. The other issue is taxation on interest. The after tax return from interest is rarely greater than the rate of inflation. In a high inflation environment, we should be in real assets, if at all possible.

 

As an interesting aside, I once worked for a white Russian who was in Shanghai during the 1930s hyper inflation. I recall him telling me that they were paid at lunch time. They then went out and bought almost anything with the cash because by the end of the day the cash was worth only half what it was at lunch time. Just hope we never get to live in such interesting times.

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