Our banks are not as solid as we think they are
If the value of your total assets fell by 6 per cent would you be insolvent? If you are sensible probably not. Big companies like Woolworths or BHP would have to endure at least a 40 per cent drop in their assets before their assets were worth less than their liabilities.
Yet Australia’s four major banks would be. If National Australia Bank’s total assets for instance fell in value by 6 per cent to $717 billion, its capital or shareholders’ funds would be more than wiped out.
Such fall is far from impossible given the big four banks’ massive exposure to home lending. The International Monetary Fund prompted lots of dismissive harrumphing from Australia’s big four banks this week when it suggested they held too little capital – the difference between their assets and liabilities.
ANZ’s chairman said extra capital would make the big four banks, which have among the highest returns on equity among any group of large banks in the world, “globally uncompetitive”.
The IMF said the four majors were “highly profitable, enjoying a funding cost advantage derive partly from the implicit government support and earning larger net interest margins than smaller banks and international peers”.
A very large chunk of their $25 billion a year profits arises from their ability to borrow more cheaply thanks to investors’ knowing that hapless taxpayers’ stand ready to bail them out if they falter.
“Significant and protracted difficulties in any one of them would [have] severe repercussions for the entire financial system and the real economy” the Fund added.
It is a little unfair to compare banks with ordinary firms – taking in deposits and lending them out is their core business. But the truth is Australia’s banks, like the bulk of the West’s financial system, are woefully and recklessly undercapitalised.
A century ago and decade thereafter, before prudential regulation was even conceived and only market forces provided discipline, Australia’s banks maintained capital ratios of between 15 per cent and 20 per cent, more than three times what they maintain today.
With harrowing memories of the 1890s, when the Depression wiped out half of Australia’s banks, banks prudently built up their capital ratio to near 20 per cent. When the Great Depression stuck in 1929 not a single bank failed.
A far smaller economic lull in 2008 paralysed the world’s financial system.
Negligent prudential standards are far from unique to Australia: since the beginning of the 20th century capital ratios have fallen by a factor of around five in the United States and the United Kingdom, eliciting a massive increase in the value the contingent claim banks have on taxpayers.
Yet the United Kingdom, Sweden and Switzerland, for example, have realised the error and are jacking up mandatory capital holdings for their biggest banks. Australia’s though will have only to meet the new ‘Basel III’ requirements, a fig leaf of prudence that maintains the status quo.
The pain of boosting capital – the tax system provides a big financial incentive to use debt over equity – would not be meted out on borrowers as the banks claim, but would mainly sap their profits and bonuses. As mandatory capital rose the implicit guarantee taxpayers unwittingly provide would fall, enabling smaller players to compete and preventing the larger players from passing on their higher costs.
Whatever combined costs borrowers, shareholders and managers incurred would be more than offset by the fall in banks’ contingent and grossly unfair claim on taxpayers.
Of course bank shareholders and managers have an incentive to cut capital to bolster profits in the knowledge their gains are unlimited and their losses capped, while taxpayers’ are not.
And banks’ creditors have not exerted much countervailing discipline knowing taxpayers are the ones really carrying the can.
But the mystery is how, with teeming armies of credentialed and highly paid bureaucrats having pored over banks for decades, banks hold vastly less capital now than they did before such oversight even began?
One theory is bureaucrats become captured by the institutions they ‘supervise’, reluctant to upset friends or limit lucrative job opportunities later. For their part, formal regulation means the banks and their creditors absolve themselves from serious prudential introspection, and instead focus on jumping through (or avoiding) the arbitrary and naive hoops regulators set for them.
Remember regulators in their wisdom for decades advised banks against holding any capital against European sovereign debt, much of which is now worthless.
Ideally government wouldn’t regulate banks and wouldn’t save them if they collapsed. But that possibility is a libertarian fantasy given the big government reality. The second best option is to force banks to hold much more capital than they do.
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