I proposed the idea of a "Son of Wallis" financial system inquiry in this widely-covered July 2009 op-ed for The Age with a bunch of invited co-authors. This was further advanced by Joe Hockey in his excellent October 2010 speech calling for fundamental reforms to the Australian financial system, including his influential "seven point plan", which ended up triggering a high-profile public battle over the banks with Wayne Swan. The AFR reports today that this is getting further traction. In these two op-eds with Mark Bouris (here and here), I also proposed, for the first time I think, that the RBA and APRA's conventional--and quite pervasive--argument that there is a trade-off between financial stability and competition (ie, more competition undermines stability) is actually wrong. I argued that the opposite is true: Australia's financial system would actually be more stable with a larger number of smaller banks (ie, more not less competition). Specifically:
We were compelled to write this op-ed because we're convinced that the policymaking surrounding Australia's banking system has been predicated on a flawed and risky paradigm: the frequently-referenced — by APRA and the RBA — trade-off between "competition" and "financial stability", which ends-up favouring a more concentrated industry.
Today Australia's prosperity relies on four colossal banks — or "oligopolists" — worth around $50 billion each. They control 80-90% of all financial transactions executed across the country. Importantly, the introduction of government guarantees for the first time during the GFC bequeathed them with a unique comparative advantage.
In contrast to their smaller rivals, the four majors are now regarded by credit rating agencies and investors alike as "too-big-to-fail". The majors get the benefit of credit ratings that have been explicitly lifted "two notches" higher than they would otherwise be because Standard & Poor's thinks they alone can depend on "extraordinary government support" in a crisis.
This helps them raise money much more cheaply than their smaller peers, which in turn means it is almost impossible to compete effectively against them. Size thus begets more size.
Some recent advertising campaigns have claimed that "the banks are at war for your home loan". Both the new head of the ACCC, Rod Sims, and we disagree. A few weeks ago Sims concluded,
Normally four players in a market should lead to a lot of competitive activity. In the banking sector it seems to need more because even though there are four of them there is a lack of full and effective competition.
While they rank amongst the 30 largest banks in the world, Australian policymakers have worked surprisingly hard to have the four majors excluded from the extra capital charges that global regulators are sensibly insisting the biggest, and most "systematically important", banks hold.
For a number of years we've suggested this is misguided and symptomatic of a worrying oligarchy between Australian banks and their policymakers. Last month the IMF agreed with us, arguing that Australia's major banks should, in fact, be forced to hold extra capital as systematically important institutions. More capital means less leverage and less taxpayer risk. So why exempt the majors, particularly when they have designs on higher-risk growth strategies overseas?
An additional capital buffer for systematically important banks would also be an intelligent disincentive to becoming too-big-to-fail. And it recognises a point we've made for some time: in many ways the catastrophic risks posed by smaller and simpler banks, like Bendigo & Adelaide, Bank of Queensland, and Members Equity, are a fraction of those threatened by the majors...
That, frankly, is a short-strokes summary of the policy problems we are focussed on. While resolving them will require leadership, we believe that there are tractable solutions. Here are three:
1) Change the policy paradigm: It is often said in financial markets that neither APRA nor the RBA care much about banking competition, and would prefer it if there was only one bank to regulate. Policymakers have been captive to the idea that there is an unavoidable trade-off between improving competition and reducing financial system risks. They are wrong.
As a matter of pure logic, a financial system reliant on four $50 billion banks that are regarded as implicitly government-guaranteed (much like Fannie Mae and Freddie Mac were in the US) is surely less secure, and more prone to moral hazard, than one based on, say, ten, $20 billion banks, each small enough to fail without causing widespread damage. Think of ten pillars as opposed to four.
We learnt from the US experience with Fannie and Freddie that there is a threshold beyond which size becomes a massive "contingent liability" for taxpayers. Like the major banks, Fannie and Freddie could raise money more cheaply than their competition because investors believed they were government-backed. And they were right. Both institutions are now owned by US taxpayers.
The learning from this is that we need to remove the regulatory incentives that actively encourage size of the too-big-to-fail variety. And we should consider, at the very least, explicit breaks on banks becoming too big, and then using this size advantage to horizontally consolidate other industries, such as funds management, financial planning and insurance.
One policy option is a progressive financial taxation regime, such as that being proposed in Europe, which attempts to price the too-big-to-fail subsidy: ie, the bigger you get, the higher the price you pay. Today the system is stacked in the opposite direction: as a bank’s size increases, all its costs decline.
