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."

Tuesday, June 28, 2011

RBA reveals taxpayers directly subsidise Aussie banks

The RBA's Dr Guy Debelle has given another solid, albeit legally flawed, speech today on the liquidity of the banking system and the central bank's role in supporting such. He raises, and then seeks to address, several issues that I have brought to public attention in my writings for Business Spectator over time.

First, Dr Debelle acknowledges that the RBA's liquidity services represent a direct subsidy from taxpayers to the banking system:

"[I]n a stressed situation, that [RBA] rate is still likely to be less than the market rate, as otherwise there would be no need for recourse to the central bank. Thus the rate is penal relative to the normal cost of liquidity provision but not necessarily relative to the stressed market price of funding."

Second, he acknowledges that in acting as "lender of last resort" to banks that cannot fund themselves in the private markets--which Dr Debelle fails to observe meets the legal definition of insolvency--the central bank performs a very odd social function indeed.

In short, the central bank lifts itself above the ordinary operations of the Corporations Act and decides in its unilateral judgment which banks are insolvent and which banks are having what is euphemistically known as a "liquidity" as opposed to "solvency" crisis. I have written about this many times before. Under Australian law, there is no distinction: if you cannot meet your current liabilities, you are trading insolvent. Period.

I am not sure whether either Dr Debelle or the RBA understand this nuance. I am pretty sure I am the only person who has highlighted it, at least publicly in this country. To the extent they do understand this very significant legal and economic distinction, they should at least acknowledge it.

According to the RBA's narrative, the central bank is endowed with tremendous analytical powers--powers superior to all the participants in the market itself, which, it should be noted, have decided to deny reasonable finance to the institutions in question--and, by discriminating between good and bad credits, can offer these same institutions sub-market interest rates and terms. To quote Debelle:

"If a bank is experiencing a problem of illiquidity, the state of its asset portfolio is even more paramount. This relates to one of the fundamental tenets of central banking, most famously associated with Walter Bagehot. Writing in Lombard Street in 1873, Bagehot states that central banks should lend freely (ie, liberally) at a high rate to solvent but illiquid banks that have good collateral."

The third point Debelle makes, but glosses over, is that banks get this taxpayer subsidy because they are engaged in what is known as 'maturity transformation'. That is, they convert our short-term savings into long-term loans, and thus provide the fabric of liquidity upon which the economy so crucially relies. This produces a fundamental business flaw: if we ever demand those savings back, the bank may not be able to repay us. Hence the need for 'central banks', which have been established in developed countries around the world to furnish public sector liquidity support to failing private banks.

As a final point, Dr Debelle makes the case that "the central bank's provision of liquidity can be regarded as a 'public good'" referencing a 2008 paper by two RBA economists. This seems symptomatic of an RBA tendency of avoiding appropriate referencing of third-party work if that material does not originate from within its central banking orbit.

The policy concept of liquidity as a public good was first outlined formally in Australia in a Melbourne Business School paper published by Professor Joshua Gans and myself in early 2008. Fortunately, this paper was referenced by the two RBA economists that Dr Debelle footnotes.

In summary, Dr Debelle, the RBA and other central bankers would do well to drop the historical fiction that a central bank can distinguish between "illiquid" and "insolvent" institutions. Under the law by which all corporations and the RBA must abide, there is, in fact, no such distinction.

The Corporations Act is crystal clear in this respect: you are an insolvent institution if you cannot pay your debts "as and when they become due and payable." Put more bluntly, if you cannot pay them without recourse to the RBA's liquidity facilities, you are insolvent.

The RBA would have us believe that even if a bank cannot repay all of its depositors, or all of its short-term creditors, the bank may not be insolvent if the RBA (an unelected independent statutory authority) deems that the bank has sound assets, and could, potentially, meet its obligations if the RBA supplies that bank with taxpayer-underwritten bridging finance.

Let's call a spade a spade. Banks have business models encumbered by asset-liability mismatches that during liquidity shocks may require taxpayer subsidies. That is one key reason why we have a central bank in the first place: to bail private banks out of financial crises.

Legally and factually flawed central banking spin is only likely to encourage private bankers to believe that they are indeed government guaranteed, and able to tap the RBA's liquidity facilities so long as they remain too big to fail.