The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Monday, April 26, 2010

We need a national debate on banking policy...

The lack of intelligent debate around banking and financial services policy in Australia is depressingly disappointing. This hubris is laying the foundations for the next economic catastrophe. Such insouciance was no more evident in the Treasurer’s recent rejection of an important IMF proposal, which has been endorsed by the US and Europe, to sensibly tax the liabilities of too-big-to-fail institutions in response to the learnings from this crisis. The idea is to throw some sand in the wheels of these companies’ taxpayer-supplied fund raising advantages.

Since Australia and Canada proved to be the ‘lucky countries’ during the GFC (and none really more so than the sunburnt isle), many seem to believe that we should be excused from the thoughtful introspection being undertaken around the rest of the world. The prevailing attitude seems to be that we are just smarter than them. In the Treasurer's own words, “The ability of banks in Australia to weather the global financial crisis demonstrated local regulations worked well.”

The problem with this logic is that it ignores chance. That is, it neglects the very large role luck plays in determining the fate of financial outcomes. What would have happened to Australia’s banks had they not been able to rely on our decade-long, ‘wonder down-under’ economic status that obviated much of the need to expand overseas, our highly providential endowments of natural resources, our antipodal position at the footsteps of Asia, or our world-beating population growth? One only has to cast an eye in the direction of the strikingly similar banking and socio-economic system in the mother country to find a sobering counter-factual: wholesale collapse and public nationalisation of many of the UK’s big banks. Was this just a matter of regulatory shortcomings? Were the bankers over there intellectual invalids in comparison to their Antipodean peers? I think not. After all, one of them is running ANZ.

Not enough effort has been invested in understanding why Australia and Canada, which have ostensibly very similar banking systems to the UK, escaped from the crisis mostly unscathed. Could much of this have to do with economic luck as opposed to prescient design? Certainly one of the chief architects of the 1997 Financial System Inquiry, Professor Ian Harper, is brave enough to acknowledge exactly this likelihood. More pointedly, policymakers have to ask themselves the question whether a future, Asian-originated meltdown might wreak the same sort of damage on Australian institutions that the US calamity wrought on their northern hemispherean cousins.

I was not at all surprised by the ACCC’s decision to knock-back NAB’s bid for AXA’s assets, albeit on purportedly technical grounds. In fact, I anticipated it in this discussion of some of the inherent contradictions in that deceptively appealing conception known as ‘diversification’. Core banks stretching out into unrelated areas such as funds management, corporate finance, insurance or Vietnamese credit might be attractive for growth-obsessed shareholders, but perhaps less so for the regulators and taxpayers that at the end of the day have to fork out the catastrophe insurance.

The Weekend Australian forcefully argued that the ACCC decision will compel Australia’s core banks to look overseas for growth opportunities. As regular readers will know, I have railed against an unthinking commitment to this mantra. For some reason, few seem to be asking the reasonable question, Do the major banks really need to grow as quickly as they have in the past? Do they really have to generate 20 per cent plus returns on shareholder equity? This is the crux of the debate we must face. Surely the core banks’ protected species status warrants far stricter controls on the risks they can take?

The Weekend Australian article brought me back to a question that I have pondered too many times to count: why in every piece lauding the banks’ offshore expansion strategies are we not asking ourselves whether these acquisitions will undermine the Australian financial system’s single most important source of strength, as repeatedly identified by the RBA: the primacy of the four major banks’ domestic focus, and the fact that they did not need to expand into foreign territories. The RBA’s latest Financial Stability Review hammers home this theme:

“The overall effect of offshore lending on Australian banks’ total [non performing assets] has been relatively small because overseas exposures only account for around one quarter of their assets. In contrast to many overseas banks, the major Australian banks did not aggressively push beyond traditional geographical or product markets over recent years to seek out higher-yielding, but higher-risk, assets.”

I don’t really see what comparative advantage Australians have in Vietnam, China or Indonesia, which are but three target markets for the major banks. And as one source quoted in The Weekend Australian warned, "Our banks have looked offshore for opportunities but there have been...notable failures." More worryingly, I think pushing into Asian countries with vastly higher rule of law, political and economic hazards will amplify the risks to which the local lenders of last resort—aka taxpayers—confront in the event of a cataclysmic collapse. In this regard, there must be a high probability that an Asian credit crisis will one day materialise. So we might as well start thinking about it today. The Australian banks we presently lionise could well prove to be the roadkill in the next credit market collision.

A final point of hypocrisy is this. We have been told by the RBA and others that we are on the cusp of experiencing a long and unprecedented resources (viz., terms of trade) boom. This has motivated the new minerals tax that will be revealed by the Henry Review next week, and was arguably the central message in Glenn Stevens’s latest speech: policymakers must now turn their minds to ‘managing the upswing’. In Governor Stevens’s words:

“Our task now is one of trying to ensure, so far as we can, that the new economic upswing turns out to be durable and stable…Australia’s terms of trade will, it now appears, probably return during 2010 to something pretty close to the 50-year peak seen in 2008…the fact that we will have reached that level twice in the space of three years suggests there is something more than just a temporary blip at work.”

The resources boom will require enormous new sums of investment capital and credit to underwrite the expansion. So if domestic economic opportunities were sufficient to dominate the attention of our bankers during the last 20-30 years—ignoring the occasional ill-conceived foray overseas—why should we suppose that the even more robust expansion that we are about to embark on will not be equally consuming? The simple truth is that it will.

Australia’s major banks can easily grow their current profits at very reasonable (and, just as crucially, extremely low risk) rates by simply servicing one of the world’s highest growth developed economies, otherwise known as the wonder down under.

More importantly, every dollar of shareholder equity expended by major bank CEOs in establishing operations in India, Vietnam, China or Indonesia quite literally denies Australian businesses and hence the domestic economy of another $10 of debt capital available to fund new investment. So there is a huge opportunity cost associated with our core banks burning shareholder equity in risky jaunts overseas.

We urgently need a national debate around banking policy. The government and opposition must go back to first principles and re-examine what these institutions mean to the domestic economy. As many more chastened policymakers around the world have argued, we have to weigh the future risks banks are permitted to assume against the direct and indirect taxpayer support they expect to receive. And here in Australia we must be vigilant in fighting against a new risk: moral hazard. In the pre-taxpayer guarantee days, moral hazard was thought not to exist. The world is forever changed.