Answer: very little. On the day that the biggest banking oligarch of them all, the once-wholly-owned Commonwealth Bank of Australia, reported an incredible $2.94 billion cash profit for the first half of 2009, which was up 54% on the previous period, the government issues a weak denial that it is preparing the groundwork for Australia Post to exert some competitive pressure on the banking cartel. Now if this was, in fact, a key element of the government's 2010 election strategy, they would be understandably keen to ensure that folks like me do not pull the rug from underneath them. I guess we will never know, until we really know!
This is, however, uncannily similar to what the government did in response to my idea for them to invest directly in Australia's residential mortgage-backed securities market at the start of 2008. After a flurry of denials, and attempts by the RBA and Treasury to pour cold water over the proposal, Wayne Swan ended up committing $16 billion to the idea. And it proved to be an exceptionally successful policy strategy, saving the bacon of many second- and third-tier lenders.
But let's cut to the chase. I ask you this simple question: would the Commonwealth Government allow, say, CBA or Westpac to fail? That is, the two institutions that collectively control around 50% of Australia's multi-trillion dollar deposit-taking and loan market? Of course not. This is a new reality that commentators, politicians, and regulators need to front up to. So what does it mean? In short, the major banks are government-guaranteed institutions.
Okay, so what do the too-big-to-fail lenders like CBA and Westpac instinctively remind us of? C'mon, you can do it. Why Fannie Mae and Freddie Mac. You see, the problem with Fannie and Freddie was exactly that they had this amorphous public-private status. They benefited from a so-called "implicit" government guarantee. While the US Government explicitly denied that they would ever bail Fannie and Freddie out, no one believed them. Just like no one would now believe any denials of the Commonwealth's willingness to save the oligarchs' backsides.
In the US, this had a few nasty consequences. First, investors, quite rationally given the information available to them, treated Fannie and Freddie as taxpayer-backed enterprises and allowed them to raise capital at very cheap rates. Sound familiar?
Second, these businesses were arguably corrupted by moral hazard with a series a fraud-related scandals in the noughties--that is, heads the CEO wins, tails the taxpayer loses. And that is, we now know, precisely what happened. At the first sight of crisis, the US Government bailed Fannie and Freddie out, taking them into the euphemistically-described "conservatorship".
As I have argued before at length (see this article published by RGE Economics in the US), the problem with Fannie and Freddie was that they should never have been privatised in the first place. Fannie was established in 1938 and IPO'd in 1968 in response to financial stresses induced by the Vietnam War. But because it was a monopolist, the US Government literally went off and created Freddie just to compete with Fannie as a similarly semi-private entity in 1970. (There were other issues with these institutions, which I have argued effectively resulted in the disintermediation of the traditional deposit-taking system, but I don't have time to retread through them now.)
The key message here is simply that the US experience surely has important learnings for how we think about our four oligarchs. In particular, I have put that now the oligarchs' "protected species status" has been made explicit (via the guarantees), we need to reappraise the risk exposures they can take. So just like Fannie and Freddie should never have been allowed to dance down the credit curve and acquire much riskier "Alt-A" loans, the major banks should be subject to analogous constraints. One especially significant metric here is their "return on equity (RoE)". Most of us have return O.C.D. That is, we are fixated with raw returns and typically ignore risk. Even many sophisticated investors fall foul of this tendency. But it is critical to remember that the unavoidable flip-side of soaring returns is...Yes, much higher risk.
Yesterday, CBA reported that its RoE had jumped back up to 18.5%. This is an exceptionally strong payoff for investors. Now some argue that the major banks' need to deliver searing growth rates in order to keep shareholders happy. They point out that the major banks have enormous leverage, which in turn warrants robust equity returns. But there is a fundamental flaw with this logic.
As regular readers would know, I have relentlessly reminded folks that the banks' business models are precariously predicated on an extraordinary asset-liability mismatch, which gives rise to their inherent vulnerability: in sum, they borrow short from at-call depositors and wholesale creditors (with maximum terms of around 5 years), and then lend that money long for 25 years via home loans. Of course, if depositors withdraw their money, or wholesale lenders do not allow the banks to "roll-over" their debt, they are cactus. This is why we have the taxpayer-owned RBA: to provide banks with "liquidity facilities" during emergencies.
If you take the government's willingness to explicitly guarantee bank deposits and liabilities, combined with the lender of last resort services taxpayers supply the banks care of the RBA, you can start to see that the "leverage" these institutions take is not of the "garden variety".
In simple language, what I am saying is that the very high levels of debt the banks assume is not the same as the leverage borne by, say, Allco, Babcock & Brown, or MFS. Indeed, it is fundamentally different. One way of understanding this difference is by simply observing that all the companies I referred to no longer exist because of their garden variety debts. There was no hope of any taxpayer-funded bailouts. Yet if the banks ever look like they are going to be unable to service their liabilities, taxpayers are inevitably obliged to step in and provide them all manner of support. And the larger of this genus, the four oligarchs, which control around 80% of all lending in Australia, are just too important to Australia's economy to be allowed to collapse.
In the crudest possible terms, banks are an absolutely essential economic utility that act as the piping that connects savings with investment. They take our money, which we feel is safe to deposit with them because of the abovementioned assurances, and then they redistribute these savings as loans to households and businesses. Loans that are used to produce goods and services that we need in order to survive and carry out productive lives.
And so, if all the banks fail, the "system" (read our economy) fails. And if any of the majors imploded, the system would be exposed to immmense risk. Now one of the reasons why the system would fail is because there are no public lending institutions. All the banks are notionally private. And hence we confront this awkward stalemate, whereby we allow banks to privatise socially-subsidised profits because they are a necessary condition to a functioning economy.
Okay, so what does this tell us. First, the major banks actually have extremely low risks, but only because of their implicit and explicit taxpayer guarantees. In the absence of this backstop, their business models are very risky indeed. Ergo, the returns that they need to offer in exchange for their utility-like risk profile are considerably lower than the returns they will report. Third, since the public wears a lot of the downside risk on behalf of the banks if the sh-t hits the fan, it is not unreasonable for us to ask them to refrain from assuming "non-core" savings and loan activities (I would definitely put AXA in this category).
Finally, there is a fundamental conflict between the interests of shareholders (eg, fund managers), the management of the banks, who just like the executives and Fannie and Freddie will always be straining at the leash to capitalise on their protected-species status and maximise medium-term returns in the knowledge that the catastrophic downside risk has been insured away, and taxpayers who need to be constantly vigilant to restrict and regulate these risk-taking behaviours, which are a pure manifestation of moral hazard.
Returning to where I started, the government issued the following denial (as reported by Business Spectator) in response to my post yesterday on "AussieBank":
Govt denies Australia Post law changes
By a staff reporter
The federal government has denied speculation that it has drafted legislation to facilitate Australia Post's entry into the banking sector.
The comments were made in response to a report from Business Spectator's blogger Christopher Joye, who said he was told by "very reliable Canberra sources" that Communications Minister Stephen Conroy had drafted new legislation to amend the Australian Postal Corporation Act 1989 to pave the way for Australia Post's move...
There has been speculation that Australia Post is looking to enter the banking sector to rival the current big four – ANZ Banking Group Ltd, Commonwealth Bank of Australia Ltd, National Australia Bank Ltd, and Westpac Banking Group Ltd.
The postal monopoly only recently appointed former NAB banker Ahmed Fahour as its new managing director and chief executive officer following a four month international search.
So maybe my source, who had over 20 years of service at the highest levels of government, was wrong. But then one of the most knowledgeable Canberra-watchers in the country--who was notably not the originator of this intelligence--confided that the denial:
"Doesn’t begin to cover the possibilities...they [could have] requested the Department or the Office of Parliamentary Counsel to draft a bill, because OPC do the actual drafting). Conroy could well have sought advice on what impediments there were to a banking activity and how they could be addressed (including whether there were non-Parliamentary ways of doing it)...[There are specialist people who] give advice on how things could be achieved without having to go through Parliament)."
My take: some kind of policy action is utterly ineluctable. We are going to see rolling waves of incomprehensibly large bank profits and CEO bonuses over the next few years. Unconfirmed stories, like those reported by one of my readers yesterday of ANZ's consultants flying to Milan to purchase a $500,000 boardroom table for the new headquarters (that's a table that is about $100,000 more expensive than the median Australian home price!), and the CEO designing himself a 100 square metre office, which is the size of a typical apartment, merely provide further 'perkquisite' grist to the mill. It is starting to sound like the 1980s all over again.
Interestingly, Adele Ferguson reports today that there is enormous latent support amongst "investors" (ie, not even lay consumers) for the government to use Australia Post to take on the majors:
"In good news for Australia Post, 78 per cent of investors support the notion that the government-owned entity enter the banking market with basic services. Of these, 64 per cent agreed “absolutely” with the idea. The remaining 36 per cent agreed on the condition that it would not destabilise the big banks. Put simply, there is a ready pool of customers waiting to support the move if it happens."
So I say, tongue-planted-in-cheek, let the proletarian revolution begin (at least in financial services!). The bottom line is that we need more honest and frank dialogue around these issues. Most commentators and policymakers are sweeping them under the carpet.
(As an aside, it would be great if ANZ's people could confirm or deny the veracity of the claims regarding the half million dollar plank of wood that has been built for the Board. One of ANZ's Directors, Gregory Clark, is actually a good friend of the family. Maybe I will ask him myself.)
