Pearls and Irritations

“When you combine ignorance and leverage, you get some pretty interesting results.” Warren Buffett

“There is no evidence that the growth in the scale and complexity of the financial system in the rich developed world over the last twenty to thirty years has driven increased growth or stability, and it is possible for financial activity to extract rents from the real economy rather than to deliver economic value. We need to challenge radically some of the assumptions of the last thirty years and we need to be willing to consider radical policy responses.” (Adair Turner, UK Financial Services Authority 2010). 

We are more than a decade on from the Global Financial Crisis (GFC) that no risk modelling or prudential supervision forecast and that forced the Government into guaranteeing billions of dollars of bank debt. Since then Australia has failed to address a key underlying driver of that crisis (excess leverage – too much debt, too little equity/cash), let alone the more fundamental questions posed by Adair Turner.

Instead, the myriad inquiries into Australia’s banking system focus on second-order symptoms – customer deception, interest rate manipulation, inflated executive salaries; and, the same superficial causes cited post the GFC – conflicts of interest, incompetent governance and risk analysis, executive greed and inadequate regulation.

Some of the suggested solutions may be useful in encouraging greater transparency, competition and alignment of incentives. But they do not address excessive leverage head on. And they are certainly nowhere near overcoming the related “too big to fail” (TBTF) problem that will continue to deliver our big four largest banks a government guarantee when, inevitably, the next financial crisis hits. A substantial reining in of leverage may not be a sufficient condition for avoiding major financial crises in the future. But it is an “almost” sufficient condition, and certainly a necessary one in respect of the pivotal role the big four play in macroeconomic risk, accounting as they do for some 75 percent of bank deposits and effectively monopolising money creation via their lending.

Against this standard, APRA’s proposals on leverage, based on the Murray Financial System Inquiry findings, just don’t pass muster: a leverage ratio of 4 percent, buttressed by risk evaluation models untested by essentially unknowable external future disruptions. This is at a time when the ratio of household debt to income in Australia is some 200 percent – a historic high and 25% above the pre GFC level.

What should be done? Two, interrelated major changes: first, increase the capital adequacy ratios of the big four to 20-30 percent, by incremental increases over an adjustment period (perhaps 2-4 years); second, wind back the implicit TBTF subsidy to the banks.  This should be supported by consistent changes for other deposit-taking institutions.

These measures would: mitigate the huge systemic risks that crystallised during the GFC, reduce the need for micro-regulation and problematic risk evaluation of bank portfolios; and, begin a process of rebalancing the structure of the real economy and share market that has been distorted by excess leverage and the protected status of our largest banks.

So why have the role of leverage, and related issue of the implicit guarantee that preferentially benefits the big four banks, been underplayed? Simply because these arrangements drive their business model and its associated record of performance and conduct. While it creates huge systemic risk, maintenance of the current system reflects the vested interest of not only the big four banks but also government and agencies, shareholders, depositors and superannuation funds.

Not surprisingly, therefore, the current thrust of policy and regulatory development in response to the banks’ serial misbehaviour (reflected in Murray Inquiry, Government ad hoc interventions, Productivity Commission and APRA inquiries etc) is for more detailed regulatory supervision and information sharing. More regulators will be employed to peer into the banks, based on asymmetric information and using risk assessment models that they understand less than the banks and which break down under extreme events.

None of this goes directly to the underlying business drivers for banks – excess leverage and government guarantees – that spawn questionable lending and risk management practices, excessive executive pay etc.  This clearly suits the banks. More regulation (or even the odd public pillorying of CEOs) may be tiresome but doesn’t significantly undermine their business model, market dominance or threaten their implicit government guarantee.

Granted the major challenges in addressing the twin pathologies of excess leverage and TBTF, are there other ways of reducing the big four’s dominance in ways that promote the public interest? Yes. One important approach has been suggested by Nicholas Gruen (see Some real banking competition – central banking for all, P&I 3 April 2018).  It addresses the big four’s market dominance and control of credit/money creation by the RBA becoming a low-cost lender in the retail mortgage market, with a resulting major gain to government revenue as RBA becomes a major player in credit/money creation.

Arguably, the impact of this proposal would be broadly similar to increasing the banks’ capital ratio requirement and constraining the implicit bank guarantees, or the measures might work in tandem. To date, however, this idea has been dismissed out of hand by the RBA and Productivity Commission.

In summary, major structural reforms that would address the manifest problems created by banking policy in Australia are not under serious consideration anywhere in government. As with so much of what now passes for public policy debate in Australia, vested interests and administrative convenience trump the public good. As amply demonstrated at the AFR Banking and Wealth Summit, insiders demonstrate their political savvy by their shared assumption that anything radical – that is, to echo Lord Adair’s comments above, anything that will address the central problem – is dismissed with a wave of the hand as self-evidently politically out-of-bounds. Yet tariff and tax reform were once regarded as politically out-of-bounds.

The central problems are too profound to be allowed to remain unaddressed.   As Nicholas Taleb has said “Banking is a very treacherous business because you don’t realize it is risky until it is too late. It is like calm waters that deliver huge storms.” A dozen years on from the GFC, we don’t appear to have learnt that lesson.

Mike Waller has served in senior economic roles in the UK Treasury and with federal and state governments in Australia. He was Chief Economist for BHP Ltd and a founding partner in a consultancy firm providing strategic advice to global resource and energy companies.  He has also served variously as board member or chair of a number of not for profit and commercial bodies.

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