MIKE WALLER. The real problem with our banks- “it’s leverage, stupid”

“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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6 Responses to MIKE WALLER. The real problem with our banks- “it’s leverage, stupid”

  1. Peter Small says:

    I made my last post whilst droving a mob of sheep down the road and there are a number of typos for which are obvious, but I need to add, it was my father who when I was a small boy always reminded me of the banks in Birchip that failed in the 1890s.

  2. michael lacey says:

    “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.”
    Very true we have done little to nothing!

    Since the financial crisis they’ve been sweeping changes to bank regulation Globally but critics argue that big bonuses big risks and big losses seem as common as ever.

    Nicholas Taleb professor a risk engineering and author of the Black Swan. He talks about primarily incompetence, with little to understanding of risk, their risk metrics do not work and they use tax payers money as protection. Banks like JP Morgan should be more regulated and go bust when they go wrong.

    Banks are utilities and we have been bailing them out since 1983 globally as soon as you bail them out they become civil servants!

    • Peter Small says:

      As a small boy when I drove down the main street of Birchip, a Mallee town in Victoria, he would point out to me all the bank buildings were banks closed there doors in the 1890 ‘s bank crash never to reopen.
      That experience left an indelible impression on the minds of lenders, depositors and of course bankers behind the counter.
      This was relatively fresh in the minds of Bankers in 1929, and I suspect saved 1929 from being even more devastating than it was!
      The longer it is until the next financial crisis the more the more devastating it will be.
      There is no corporate memory, no experience of the last
      Greed and ignorance of risk will destroy the West and another Empire will surely collapse.

  3. Michael Hart says:

    Glad to see some have spotted the ‘elephant’ in the room – bank leverage, aka private debt, which apparently matters not in the world of current economic thinking and advice. Lord Adair has succinctly phrased the problem, extractive rents (profits) via money creation add nothing to real economic activity but are merely a drag on that activity but they do a lot for increasing wealth for some.

    Giving the Banks a guarantee merely kicked the can down the road as did QE in the US and Europe and did nothing to disturb the mindset of bankers and their shareholders about the risk, they just do not understand the risk. The banks are seriously exposed to the asset bubble they have created here, real estate valuations, and still fail to see the risk, not a correction in the asset price but the incapacity and inability of their customers to continue to carry the costs they have acquired with those assets in the face of the never ending erosion of their income and the continue plundering of their dwindling discretionary income by businesses who need profit margins to demonstrate either growth or solvency.

    At current levels of private debt to GDP ratios the games up, one major tremor that begins to take out peoples employment (income) and then business income streams (profits) will bring the house down, no amount of bank guarantees will fix that. Lord Keynes worked that out a long time ago. Given the level of stagnation already evident in low wage/income growth, expanding credit can no longer substitute for proper employment, income and profitable economic activity.

  4. John Murray says:

    Leverage and TBTF are indeed major problems, but there is a more fundamental barrier to reform: the revolving door between regulators and the banks.
    At the decision making level, the three main regulators (ASIC, the RBA and APRA) and indeed the Treasury itself are infested by former or prospective bankers. How can we expect meaningful reform proposals to get a run if this is the case? Senior decision makers in both regulators and the firms they regulate are the same people, with the same mindsets, only at different stages in their career. At the decision making level, regulators and the firms they regulate should be strictly separated just as police integrity commissioners typically cannot be former police officers. Not only should they not share the bankers’ appetites for risk and profit, they should be positively apprehensive of these appetites, because their job is to reign bankers in, to protect us from bankers instincts and to protect the bankers from their own instincts. Given too free a free hand, banks will always take on too much risk even to the extent of their own demise, which is why banking crises and bailouts are so frequent all around the world. Regulators will be more likely to ask for more powers when they need them and enforce what powers that they have. They would be more likely to insist that governments take action before it is too late. Unfortunately in Australia it probably is already too late, and when the era of “light touch” regulation is proven a failure we must demand appropriate banking regulation and appropriate distance between regulators and banks.

  5. Peter Small says:

    Our thanks to Mike Waller for taking us back to look more seriously at the fundamentals of our banking system. His quote of Nicholas Taleb “Banking is very treacherous because you don’t realise it is risky until it is too late”, is one we all should ponder.

    It is often said “that the seeds of the next financial crisis are sown in the last”. Two “seeds” that could bare fruit next time could be the myth created by Western Governments that they have the ability to save the banks. And a new financial instrument that the Abbot government legislated for and was waived through parliament at the request of the banks, by all parties. Covered Bonds. Could Mike explains how these bonds work? from my understanding it gives the holder of these bonds ( money lent to the banks) first and immediate access to all bank deposits in the event of a financial crisis. In addition could Mike or any one else who may know, advise us if information sourced from the minutes of the Federal Reserve (FRB) in the US is correct. — That in the last financial crisis the Reserve Bank of Australia (RBA) had to seek help from FRB to the tune of $55billion to save the big four.

    If that is correct, and I understand it is, then next time our Banks will certainly fail and we will learn the extent our Banks understand risk and the damage to both domestic borrowers and lenders!!

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