Inquiry Needed but not for Bank 'Victims'
Updated: May 2, 2018
The following post was published on AB+F (Australian Banking and Finance)
This debate has generally focused on the 'victims' of the banks, and their need for redress. I
do not support a Royal Commission for that reason. However, a Royal Commission is needed to consider the following macro-economic issues:
Special role of financial institution in a capitalistic society
It is well understood that banks as mobilisers of capital have a unique, special and therefore privileged role in a capitalistic economy. There are significant benefits that accrue from being a bank which are not available to other organisations. It is critical that there is a strong and robust banking system; however: Does financially stable have the same meaning as profitable?
A Royal Commission should examine this special role and the risks that are inherent in banking. These key risks are liquidity, interest rate, credit, market and operational risk. However, a closer examination of these risks reveals that liquidity and solvency risk are carried by the taxpayer, because of the Federal Government guarantee of deposits. Interest rate risk is primarily worn by the borrower. Banks generally do not engage in proprietary trading, and therefore their market risks are not significant. The major risks banks face are credit, and to a lesser extent, operational risk.
If this is so, does the bank charge for credit risk correctly reflect the economic cost? By comparison, in the US mortgage market interest rate risk is carried by the secondary market investor, while credit risk is carried by the US taxpayers through the Government Sponsored Enterprises (GSEs), e.g. Fannie Mae and Freddie Mac.
'Too big to fail'
There is an economic cost of having institutions that are so called 'too big to fail'. This opportunity cost is neither understood, nor has there been a rigorous debate about it. Is 'too big to fail' in the long-term interests of Australia? Why is there passive acceptance of 'too big to fail'? Should the opportunity cost be analysed and quantified? Is the 'too big to fail' model one that Australia wants to adopt for the next 25, 30, 50 years?
This refers to a conscious change in behaviour before or after an event occurs. In the context of the banking industry it refers to the fact that banks know that the Federal Government will not allow them to fail, so they are able to indulge in unnecessary risk taking. Prior to the Global Financial Crisis (GFC) there was an implicit Government guarantee which became explicit during the GFC with the introduction of the wholesale and retail depositors guarantee.
Some banks did not use this guarantee as it was intended. There has been no discussion of this. The question to be answered is: Should banks obtain the benefit of moral hazard? This question is intertwined with the special role that banks play in our economy and the 'too big to fail' question.
Role of banks in the new de-regulated financial services world
It is now 30 plus years since the Hawke Government de-regulated the financial services industry, floated the dollar and opened Australia up to the world. Given the importance of these decisions, there is now a need for a formal public review to assess the benefits. Undoubtedly, there are lessons that can be learned, which can help Australia respond to the changing global environment. Australia needs to position itself to the new world order that is evolving.
Shadow banking and disintermediation
The growth in shadow banking and disintermediation from the internet is a cause for concern for regulators globally. The macro-economic risk and cost need to be examined, as the trend is increasing which is diminishing the ability of central banks to effectively implement monetary policy.
RBA use of banks to implement monetary policy
Historically, banks have played a key role in implementing monetary policy by passing on cash rate changes to depositors and borrowers. More recently, the Reserve Bank of Australia (RBA) through Australian Prudential Regulation Authority (APRA) has been applying monetary policy. Specifically, APRA has required banks to change its loan serviceability rules to align them with the RBA’s monetary objectives.
With approximately 20 per cent of the developed world now with negative interest rates, a new global phenomena, the possible impacts need to be examined. A critical question not being publicly discussed is: Should monetary policy be used to transfer wealth from savers to borrowers?
In the past savers were rewarded which is consistent with sound economic policies. Will and should banks be allowed to pass on negative interest rates? In Denmark, after a number of years of negative rates, some mortgage holders are now being paid by the banks.
The size of the financial services sector
In July 2012, BIS examined Organisation for Economic Co-operation and Development (OECD) countries and determined that if a financial services sector is too small then an economy was not achieving optimum growth. Conversely, if the financial services industry is too large then it is a drag on economic growth.
BIS concluded that Australia’s financial services sector is too large, and since the report was published its size as a proportion of our economy has increased further. The trend is in the wrong direction and it will take years for other sectors of the economy to increase their share; thereby reduce the financial services component. Iceland found out the hard way when an economy is grossly overbanked.
Circulatory and Inter-dependence
The major banks are the four largest companies by market capitalisation on the Australian Securities Exchange (ASX). Consequently, superannuation and institutional funds must invest in them either directly or indirectly through index funds. Given moral hazard and 'too big to fail' this circularity and independence is a risk to the Australian economy that is not being debated.
Regulators are applying band aid policy decisions to address this risk. Unfortunately, these decisions continue to shore up the status quo, which is just 'kicking the can down the road'. Simply, a Royal Commission is needed to examine the macro-level issues outlined above as they are structural matters that impact on our future prosperity.
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