Sometimes I wish I could just read, write and think. Sit me on a desert island with my wife, two poodles, Missy and Puffy, access to the Internet, and a gym, and I’d be a pretty happy camper. Dealing with the practical imperfections of the world in which we live is frustrating. Too often one sees mediocrity prevail over merit.
Today I am going to touch on two policy issues. First, the belated arrival of some honesty amongst Australian bankers as to the state of their industry. If judged only by the frankness of these communications, our bankers are now streets ahead of regulators like APRA and the RBA, which is truly bizarre. And then I am going to turn to a fascinating speech by a senior Bank of England executive that forcefully backs some ideas that we have been pushing for years now.
Last week the Australian Financial Review called me for a background briefing on the consequences of the withdrawal of the bank guarantees. And the journalist in question, Matt Drummond, has reciprocated in kind delivering arguably the best article of his career.
My key message to Matt was simply that the real question is not whether the guarantees should have been used or withdrawn—they were, after all, undeniably necessary and sound policy steps at the time. The main preoccupation should now be the longer-term consequences of these unprecedented measures.
And I summarised these as follows: first, it is now well known that we have inadvertently created an exceedingly concentrated industry structure; second, bankers and the financial markets will forever assume that these guarantees will be available to bail them out in future crises. Amazingly, Ralph Norris says exactly this today, commenting, “Obviously in the future, if there was ever a situation that was similar, you would expect to see a similar sort of approach”; third, the guarantees themselves directly contradict the central policy tenet of Australia’s prudential system, as articulated by the 1997 Wallis Inquiry, which was that irrespective of the gravity of the situation you never bailout private institutions; fourth, the moral hazard risks today in a post-guarantee world are, ironically, much higher than those that prevailed prior to the GFC, which, one can persuasively argue, was at least partly caused by moral hazard (the government sponsored enterprises in the US, Fannie and Freddie, while notionally private were assumed (correctly) by the markets to be backed by the US Government); and, finally, if this is the unavoidable outcome of the policy response function during the GFC, policymakers need to put their thinking caps on ASAP as to the new regulatory architecture that is required to address these risks (hence my call for a Son of Wallis). As most know, I am personally inclined towards the view that the major banks should be treated like utilities.
It was interesting that throughout the crisis most bank CEOs relentlessly railed against anyone suggesting they were benefiting from taxpayer subsidies. Yet it appears as if we have now turned the corner. Even the bankers are beginning to slowly appreciate the obsolete nature of this argument. This was most vividly reflected in remarks by the CFO of NAB, Mark Joiner, which I never frankly expected to read:
“The guarantee has underlined the privileged position that banks have in the economy and that at the end of the day the state will step into to support them. It has shined the light on the obligations on banks not only to act in their own self-interest but to keep in the front of their mind they have obligations to all stakeholders.”
Joiner’s words have to rank among the smartest spoken by an Australian banker in some time (no great feat given the paucity of thoughtful commentary). Much better to front up to the realities of the world in which you operate, and then just deal with them (I presume this also informs NAB’s latest marketing byline, More give, less take). But wait, there was more. The former CEO of the CBA, David Murray, was also quoted today offering up some equally sobering opinions:
“Governments and taxpayers are better off from a safety viewpoint if they are not exposed to highly concentrated banking industries. Ideally, there should be a large number of smaller banks who are still sizeable enough to perform sophisticated intermediation of credit through the economy."
And the always-to-the-point Bendigo & Adelaide Bank Chairman, Robert Johanson, who already runs a ‘narrow bank’, capped off this wave of introspection with these criticisms:
“We went into the crisis with no bank too big to fail in Australia. Coming out of it, I don’t think that still the case...We have ended up with an industry structure that’s far more rigid and in a way more vulnerable to the next shock.”
One personal source of disappointment is that after the best part of two years making, alongside some other economists, similar statements, Australians have heard next to nothing along these lines from their bank regulators, APRA and the RBA. Instead, we have been greeted with pretty meaningless defences of the state of competition throughout the crisis, a practice which I have been consistently critical of. The regulators start looking a bit silly when even the companies they oversee begin owning up to the problems.
All of this brings me back to the apparently more courageous Bank of England, which has, of course, had a near-death financial system experience with which to fortify its views. I was brought to the Bank of England in a round-about way via President Obama’s new housing policy, which he announced a few days ago. While Obama had many innovative alternatives available to him, including one potentially bullet-proof plan that I had crafted, and which Administration officials had informed me they were seriously contemplating taking up in December last year, it would seem that once again the mediocre has triumphed over the meritorious. As I have learnt through my own experience, when you face consensus-based decision-making processes you inevitably arrive at lowest-common-denominator solutions.
I was not going to bother writing about Obama’s new housing plan were not it not for a speech forwarded to me by Dr Nicholas Gruen. The speech in question, entitled, The Debt Hangover, was recently delivered by a senior Bank of England official, Andy Haldane, and is well worth reading. Combined with another outstanding lecture given by the Governor of the Bank of England, which, as I reviewed here, bravely took on the question of how we need to evolve banking business models in a post-GFC world (I return to this later), it does tend to make the RBA’s outpourings look comparatively anodyne. Anyways, The Debt Hangover offers up some creative analysis of the economic consequences of a long ‘deleveraging’ cycle.
What was most interesting for me personally is that the Bank of England has ended up advocating precisely the same policy solution that I formulated for the US housing crisis: ‘debt-for-equity swaps’. You can read a short summary of my proposal published by the Financial Times in March 2009 here. The Bank of England makes similar points (emphasis added to final sentence):
“If a borrower has a large debt overhang, there is a case for restructuring the claim from debt into equity – a debt-for-equity swap. In some cases, such swaps are no more than recognition that an impaired debt is, in substance, an equity claim. But more than that, debt-for-equity swaps can potentially benefit both lender and borrowers by airlifting a debtor to the safer side of the debt Laffer curve [CJ: essentially ensuring that borrowers have an incentive to continue paying down their debt rather than giving up and resorting to ‘jingle mail’].
A number of global banks have begun putting such a strategy into practice. Around a hundred debt exchanges were carried out by global banks during 2009, typically converting debt instruments into equity or retiring debt below face value, so reducing leverage in the financial sector...
Debt-for-equity swaps could be used to tackle the debt overhang in other sectors. There are already some examples of voluntary debt-for-equity exchanges among companies...In principle, mortgage contracts could also be adapted to lessen the burden on over-indebted households by allowing lenders to convert their loan into an equity stake…”
One thought-provoking idea that Haldane proposes is imposing pro-cyclical dividend payout ratios on banks. His analysis demonstrates that even when profits are low, banks continue blindly distributing large dividends to shareholders based on nothing more than market convention. What they should be doing is retaining these profits and building up their capital base:
“This would allow banks’ balance sheets to be repaired while supporting lending to the real economy… So far during this crisis, there has been little evidence of such prudential opportunism. Among global banks, net income fell by over 20% between 2006 and 2007. Over the same period, dividends grew by 20%. In 2008, global banks made losses totalling $60 billion, but on average still made dividend payouts of over $60 billion…
If UK banks had reduced dividend payouts ratios by a third between 2000 to 2007, £20 billion of extra capital would have been generated. Had payouts to staff been trimmed by 10%, a further £50 billion in capital would have been saved. And if banks had been restricted from paying dividends in the event of an annual loss, £15 billion would have been added to the pot. In other words, three modest changes in payout behaviour would have generated more capital than was supplied by the UK government during the crisis.”
In searching for other policy solutions, the Bank of England arrives at the same position I did in 2002-03: ‘state-dependent’ mortgage contracts. These are hybrid debt, or synthetic equity, instruments that offer a much stronger alignment of interests between borrower and lender: the repayment burden, or debt obligation, increases only when the state (or value) of the borrower’s financial assets also rise. On the other hand, when the value of their assets falls, their debt repayment burden also declines thereby reducing the risk of default. I wrote a 380 page report for the Prime Minister in 2003 on exactly this subject. And the company I work for, Rismark, has pioneered the development of these instruments in Australia and overseas. Of course, it took a global financial crisis for many mainstream economists to start to appreciate the social benefits of such innovations. I will leave you with the Bank of England’s characterisation of why these contracts are a good idea (emphasis added):
“A better-designed debt contract would automatically adjust repayment terms when the borrower found the going getting tough. Debt would become, in the language of economics, state-contingent – contingent on the borrower’s state of financial health…
By cushioning fluctuations, these instruments have the potential to stabilise automatically debt dynamics. And by averting costly default, they potentially benefit both creditors and debtors.
There has been recent interest among banks in issuing state-contingent instruments – so-called contingent capital. These instruments convert into equity in the event of a pre-defined stress trigger being breached. So these instruments offer repayment insurance to banks at the point it is most valued. They are, in effect, a contractually pre-committed form of debt-equity swap.
As several academics have argued, the same basic principles could be applied to the debt contracts issued by households, companies and even sovereigns. Take a typical mortgage contract. A rise in the value of a property relative to the loan gives the borrower equity against which they can borrow. This provides an incentive to tradeup, raising house prices and generating further equity. This amplifier operates symmetrically, as falling collateral values reduce refinancing options and drive down prices. Economists call this effect the financial accelerator. It adds to cyclicality in credit provision and asset prices...
[I]t might be possible to devise mortgage contracts that slow, or even reverse, this financial accelerator19. Instead of being fixed in money terms, imagine a mortgage whose value rose with house prices. So the repayment burden would rise automatically with asset prices to slow a credit boom and fall in a recession to reduce the chances of mortgage default. Mortgages would operate like a contractually pre-committed debt-equity swap between households and banks. They would automatically stabilise household loan-to-value ratios. By reducing the amplitude of the credit cycle, they ought to benefit both borrower and lender.”
