While presenting to the Obama Administration alongside Robert Shiller last year I started reflecting on the notion of bank ‘diversification’. The idea I was toying was whether diversification, which is an accepted aspiration by most analysts, executives, consultants, and commentators, could be a contradiction in terms over the longer-run.
That is to say, could it be the case that although bank diversification can undeniably help to reduce short-run risk, it can concurrently contribute to heightened probabilities of cataclysmic loss? And do the financial incentives bank CEOs face, which are calibrated by the typically myopic interests of investors, further boost the likelihood that they will make decisions that opportunistically capitalise on current gains at the long-term expense of taxpayers?
This touches on the argument I have canvassed before that policymakers need to better address the fundamental conflict that exists between the management of large banks and their shareholders, and the more enduring desires of taxpayers that ultimately act as the insurer of last resort when things go awry. This remains one of the signal policy questions of our day.
These issues are especially germane to our current conditions given NAB’s bid for AXA’s assets, which would extend its reach further beyond core banking into the ostensibly unrelated areas of wealth management and insurance, and recent speculation that ANZ is looking to acquire additional Asian assets in order to fulfill its pan-Asian ‘super regional’ strategy.
On this note, I’ve repeatedly queried why nobody is focusing on the fact that the greatest strength of Australia’s major banks lauded by so many during the GFC—the absence of material exposures to foreign markets with significant economic, political, and rule of law risks—is being undermined by those same institutions in the aftermath of the crisis via their attempts to ‘bulk up’ with acquisitions overseas.
Glenn Stevens himself claimed this week that a key explanation of Australia’s ability to avoid the worst of the calamity was that our banks “did not have to go and do exotic things in foreign markets the way maybe some European banks felt more pressure to do because natural growth in Europe is less—here, there is more natural growth at home doing plain vanilla things. So that environment was helpful.”
Interestingly, the normally very bank-friendly RBA revealed a decidedly more hard-lined tone during ASIC’s Summer School. Stevens pointedly summarised the policymaker’s challenge with the observation that, “A world in which losses are socialized and the profits privatized is not sustainable.”
And contrary to claims that the RBA is going to resist more radical policy proposals emanating from the G7, Stevens lent cautious support to the idea of ‘systemic capital charges’ and ‘living wills’ for too-big-to-fail institutions:
“It would be foolish to think that everything is just ‘peachy’…I think there are things for us to learn, and adjustments we can make…The more controversial things that are talked about are ‘systematic risk charges’ if you are big…perhaps that’s a good idea, and there there’s the ‘living will’ stuff…Maybe these are good ideas.”
My thought underlying all of this is that perhaps banking crises teach us that so-called ‘diversification’ actually elevates the risk of catastrophic loss. Using this inverted view of the world, one can argue that comparatively pellucid organisations, such as Bendigo & Adelaide Bank or Members Equity Bank, are actually safer over-the-horizon concerns for taxpayers to insure than the inherently more obtuse majors.
So while establishing foreign businesses and/or jumping into wealth management might help reduce the volatility of outcomes around a bank’s ‘expected’ growth rate during the ‘good times’ (ie, lessen the probability of loss when everything is fine and dandy), the tails of that earnings distribution become much thicker by virtue of what might be termed ‘happy days diversification’. That is, diversification itself gives rise to higher probabilities of extreme loss.
Framed differently, diversification could contribute to what might be called a ‘leptokurtic’ return distribution: a higher ‘peak’ around the ‘expected’ growth rate than a ‘normal’ distribution (ie, reduced variability surrounding the earnings the market ordinarily anticipates), but with the critical trade-off of far ‘fatter’ positive and negative ‘tails’. That is, a much larger probability of suffering three, four, or five standard deviation events (aka ‘Black Swans’).
Most now accept that policymakers dropped the ball on banking competition and industry concentration during the GFC. Today this begs the question as to whether they should allow Australia’s banking oligarchs to leverage (literally) off their newfound protected-specifies status to consolidate unrelated industries, such as funds management. And then there is the related wrinkle of whether taxpayers should have to back-stop these non-core activities.
I spent some time discussing these matters with the Australian Financial Review’s senior commentator, Andrew Cornell, last Friday. While I have criticised Andrew in the past for not taking a tough enough line on the regulatory questions spawned by the GFC, he delivered an absolutely brilliant column on this subject on Monday. Cornell echoed the point I have made several times here that since government has agreed to, one way or another, insure away many of the adverse contingencies to which a banking system based on asset-liability mismatches is exposed (ie, they borrow short from depositors and lend long via loans), we ought to in turn reasonably demand that shareholders and management reduce their required rates of return in recognition of those lower risks. In Cornell’s words:
“The Boston Consulting Group's annual review of bank shareholder returns found that Australia's Big Four banks…were the most profitable banks [in the world] over five years…BCG forecasts the biggest threat to bank profitability now is not the crisis but the post-crisis regulatory response, a "regulatory tsunami". This comes back to what is a fair profit for a bank, given its privileged position, having central bank, prudential and taxpayer support. In a fundamental risk-reward analysis, profitability is inextricably linked to the debate about what kinds of banks we want…So-called "narrow banks", with full central bank and prudential backing, stripped of casino functions, would be inherently lower risk. And so investors should expect a lower return on equity. Bank ROEs globally orbited 20 per cent before the crisis, but in part that reflected the expectation they would blow up every decade…So investors would not invest in a bank barely covering its cost of capital because over the cycle they would lose money. But if out-of-crisis ROEs are sufficiently high, investors can still play off the higher risk for reward. Take out that extreme risk and ROEs can be much lower.”
Finally, I featured on SBS TV’s Insight program on housing affordability last night. For those who missed it, you can read the transcript here.
