Imagine the scenario.
You live in a country in which interest rates are amongst the highest in the world.
With interest rates in some of the largest countries like Japan and the United States effectively around zero, an interest rate of 4% looks very attractive. That makes your banking system vulnerable to significant inflows of money. In order to pay those lovely 4% deposit rates, bank chiefs need to invest the incoming funds at higher rates, either within the country or outside it.
As you might have guessed, this isn't Australia but Cyprus. It couldn't happen here, right?
That's probably what the Cypriots thought.
Now we know that Cyprus and the EU have struck a deal which will see the country's second largest bank fold, and deposits over €100,000 frozen and used to pay down debts. Deposits under that amount will be transferred to a 'good bank', and no levy will be imposed on any deposit funds in any Cyprus bank with less than €100,000 in them.
With echoes of a similar situation that occurred in Iceland, Cyprus's banking system became too big for the country. Iceland's banks are estimated to have held in excess of €50 billion, compared to gross domestic product (GDP) of €8.5 billion, while Cyprus's banking system is estimated to have held €68 billion in deposits compared to GDP of around €19 billion.
The situation in Cyprus almost certainly couldn't be replicated here – our government has a solid fiscal position and our major banks including ANZ Bank (ASX: ANZ), Commonwealth Bank (ASX: CBA), National Australia Bank (ASX: NAB) and Westpac Banking Corporation (ASX: WBC) haven't taken the same sort of risks (that we know of).
The problem is that no-one predicted the Iceland debacle, the Greek problems or the Cypriot collapse. The questions, however, remain: what risks are our banks taking? How exposed are they to certain countries? Industries? Events? These are real risks – and there will be others, unknown to investors and consumers alike.
Foolish takeaway
As Warren Buffett said of the US banks: "When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is running."
Along with the sky-high valuations, that's likely just another reason to be wary of the banks. While the Australian government guarantees deposits up to $250,000, shareholders get no such guarantee.
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The Motley Fool's purpose is to help the world invest, better. Click here now for your free subscription to Take Stock, The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned.
