Penalising big banks with higher capital rule is perverse

ANY threat to the financial system is likely to come from small lenders, large institutions.

POST the global financial crisis much has been written about banks that are supposedly “too big to fail”. The claim is that senior management, particularly of large banks, having been bailed out from the consequences of poor risk management in the pursuit of short-term profit, now operate on the basis that they are too big to fail.

Governments are concerned that the ever widening ripples of a GFC-type crisis will lead to large economic distress and wider social consequences, leading to intervention. Governments will no doubt continue to intervene in these unusual circumstances but the key point is that they act to protect the economy and society, not individual banks.

When considering the consequence of the government or regulatory response to potential bank failure the assertion that banks don’t fail should be rejected.

What is failure? In Europe chairmen and boards of directors of seriously challenged banks were removed, senior executives sacked and shareholders diluted to nothing or a small fraction of their former holdings. Similarly in the US, forced good bank/bad bank mergers were arranged. Boards of bad banks were removed, senior executives sacked and shareholders radically diluted. Although these seriously challenged banks were not put into formal liquidation — the classical description of failure — they suffered every other characteristic of failure.

The lesson for boards and senior management of banks therefore was not that they could play fast and loose with risk-taking in the pursuit of short-term profits with no concern for the outcome because they would be saved from failure by governments. On every count of the things that are most important to bank senior executives they lost and lost heavily. Are there lessons for Australian banking from the international government and regulatory response to the GFC? There are but they are limited.

First, unlike the US with its confusing multitude of regulators, in Australia there is the authority of a single regulator with the power to step in to manage a bank in danger of collapse due to a serious lack liquidity or write-offs following massive losses from bad loans. Under the Australian Banking Act, banks can be managed out of their problems or slowly wound up under tight regulatory supervision.

Second, a great deal of discussion has centred on the question of the need to increase the capital levels of Australian banks, presumably so that governments are not left to carry any shortfall arising from bank failure due to either gross mismanagement or an abnormally large downswing in the economic cycle. This question has particularly centred on the big four banks that have been erroneously tagged too big to fail.

There is no recognition in this discussion that there have not been any bank failures here for well over a century, through widely different regulatory regimes ranging from hardly any controls to those in place today. This outcome has not been due to government regularly having to inject liquidity or capital into individual banks to save them from failure. Rather it is the consequence of banks’ own risk management coupled with increasing regulatory oversight since the creation of the Reserve Bank of Australia in 1969.

Third, history shows that it is much more likely that any systemic threat to the financial system will start with smaller not the larger financial institutions. Penalising the larger banks with higher capital ratios when for over a century none has failed is perverse, against the public interest, and a weak “me too” following of overseas GFC responses.

Fourth, banks’ mode of operation is based on a fractional capital reserve model. That is, they don’t hold a dollar of capital for every dollar of loans. Banks can successfully do this because they lie at the heart of the payments system. The flow of funds always leads back to them except in a crisis of confidence.

The beneficiaries of this fractional capitalisation are depositors and borrowers because the spread between the banks’ balance sheet funding cost and loan interest is reduced enormously from what would be the case in a high capital reserve banking system. Borrowers’ interest cost are lower and deposit yields are higher. The ultimate winner is the economy and society so unnecessarily pushing up capital ratios has a wider impact that is not so much on banks themselves.

Fifth, an important consequence of higher bank capital ­ratios is that it inevitably leads to the growth of the unregulated financial system. Regulators tend to wash their hands of this often quite rapid growth of financial ­institutions outside their responsibility, but history says that the ­regulators always get pulled into the consequence of the capacity of the unregulated sector to infect the total financial system. Lastly, but by no means least, all the focus on capital adequacy misses the critical point that in most cases ­financial institutional failure is not due to inadequate capital; it is ­inadequate liquidity. This should be an area of much more scrutiny and regulatory concern than ­capital.

And what of the regulators themselves? Regulators need to have a greater component of their management cadre with first line commercial banking experience.

It is the basis of a successful “judgmental” regulatory system for Australian banking that is far superior to going down the US black letter of the law system.

It is these regulatory skills and capabilities that have the best chance of avoiding future GFCs, not inflexible capital requirements. It is this type of judgmental management of the regulated banking system that has the best chance of avoiding future GFC ­experiences.

Bob Edgar is a former deputy chief executive of ANZ Bank.