The South Australian Major Bank Levy: Arbitrary, unjustified, and harmful for South Australia and the rest of the country

With Sinclair Davidson

Introduction: In the South Australian state budget 2017-18, South Australian Treasurer Tom Koutsantonis announced that the state government intended to introduce a South Australian Major Bank Levy, one of two revenue measures “to help us meet the cost of our significant support for driving economic growth and creating more jobs”. Treasurer Koutsantonis made clear that this levy was explicitly modelled on the Commonwealth government’s Major Bank Levy, which was announced in the May 2017-18 Commonwealth budget and passed the Commonwealth parliament in June.

Banking is a key sector in a modern economy. Banks and the financial markets they serve work to allocate capital across the economy to its most efficient purpose. The health of the banking sector is closely related to the health of the economy in general; likewise, an unstable and inefficient banking sector often causes, or is at least a leading indicator of, turmoil in the general economy. The centrality of banking and financial markets to economic prosperity and recession throughout history is reason to subject public policy proposals that affect banking markets to particular scrutiny.

This paper is an examination of the South Australian Major Bank Levy. The South Australian Major Bank Levy is intended to exactly replicate the Commonwealth Government’s Major Bank Levy but at the state level. Accordingly, it applies an additional 0.015% tax on South Australia’s share of the total value of bank liabilities that are subject to the Commonwealth Major Bank Levy Act 2017. That levy consists of a tax introduced on a range of liabilities held by the five of Australia’s largest banks – the Commonwealth Bank, the ANZ, the National Australia Bank, Westpac and Macquarie Bank. While these banks are not explicitly named in legislation, they are subject to the levy because they each have total liabilities greater than $100 billion – raising the prospect of new banks being added or of existing banks dropping off the list.

Both levies apply to the total liabilities held by each bank with the exception of that bank’s additional Tier 1 capital, its deposits protected by the Financial Claims Scheme (that is, its government guaranteed deposits), an amount equal to the lesser of the derivative asserts and derivative liabilities of each bank, and its exchange settlement account held with the Reserve Bank of Australia.

This paper finds that the South Australian Major Bank Levy:

  • will be economically harmful to a state that has seen a rise in unemployment and a decline in business investment,
  • lacks serious justification in either taxation or banking policy,
  • represents a rollback of the GST compact of 2000 which required South Australia to remove state taxes on banking and financial services,
  • harms the stability of banking in South Australia and Australia more generally,
  • increases ‘regime uncertainty’ for investors, and
  • there are reasons to believe it has already done harm to the South Australian economy.

Not only should the bank levy be rejected by the South Australian parliament, but parliament needs to work to ensure that markets and investors have certainty that such an arbitrary and harmful intervention could not occur in South Australia in the future.

Available in PDF here.

State Government bank levy makes South Australia riskiest place for investment in Australia

Imagine being an international investor looking at Treasurer Tom Koutsantonis’s Budget. You wouldn’t be interested in his infrastructure spend and “future jobs fund”.

You’d immediately hone in on the fact that the South Australian government has doubled down on the Federal Coalition’s bank levy by introducing its own state bank levy.

And you’d immediately understand that this makes SA the riskiest state to invest in, in a country that is looking like an increasingly risky place to invest.

South Australia has the highest unemployment rate in the nation. It needs firms to put their money into the state and create productive private sector jobs. No government spending can substitute for an attractive economic investment climate.

In this, the state’s bank levy is almost comically bad. The federal bank levy is arbitrary, punitive and unjustifiable. Treasurer Scott Morrison groped around for a rationale for taxing the big banks, finally landing on: people “don’t like you”.

Koutsantonis’s tax is even more arbitrary and its rationale even more slight. In his Budget speech, he said that the “banking sector is very profitable” and that given, in his view, the GST should be applied to financial services, SA should expropriate some of the big banks’ money.

But this is nothing more than a rhetorical shell game. The SA bank levy looks nothing like the GST, developed and refined over nearly two decades to be as efficient as possible. The GST is a consumption tax specifically designed to be paid by consumers.

Koutsantonis says he will ban the banks from passing his tax onto consumers. (This is astonishing by itself – the SA government is going to start regulating banks? We ended state-based financial services regulation 20 years ago.)

Finally, the GST was specifically devised in order to get rid of state-based taxes on financial products. These taxes – the bank account debits (BAD) tax and financial institutions duty (FID) – were uniformly agreed to be inefficient, to disproportionately harm the poor, and to harm Australia’s international competitiveness.

Getting rid of the FID and BAD tax was a key part of the GST deal. Is SA going back on that deal? Is it dipping out of the GST compact? How do Koutsantonis and Premier Jay Weatherill think the other states and Commonwealth, should respond?

With the imminent closure of Holden, SA needs to be looking to grow its economy and attract investors. But if there’s one thing investors hate, it is policy uncertainty.

Policy uncertainty is exactly what Koutsantonis has delivered.

Safety and Soundness: An economic history of prudential bank regulation in Australia, 1893-2008

Abstract: This thesis is an economic history of the prudential regulation of banks in Australia between the crash of 1893 and the global financial crisis (GFC) of 2008. It applies two theoretical frameworks in order to characterise the institutions of prudential regulation and identify the sources of regulatory change over the period studied. The institutional possibility frontier is used to characterise regulatory regimes. Three common models of political economy – public interest, public choice, and ideas – are used to identify the causes of changes in those regimes. The thesis uses unexamined and underused archival sources to refine and expand our understanding of regulatory change in the period studied.

As policymakers in the wake of the GFC conceive of new approaches to prudential regulation of banks, it is important to understand where and how prudential regulation has been adopted in the past. Yet no general study of the history of prudential regulation of banks in Australia exists. This thesis is an attempt to provide that study. Prudential regulation in the period covered has swung between extremes: first, from a laissez faire approach to regulatory control, where regulation was both light and poorly administered, to a system of financial repression, where prudential regulation was both heavy and thorough. As the Australian financial market has been opened to foreign entrants and global competition since the 1980s, prudential regulation has been expanded, formalised, and internationalised. Prudential regulation of banking offers a window into broader changes in the way Australian governments have controlled economic activity.

The thesis makes a number of significant contributions to knowledge. First, it finds that, contrary to later claims by the Reserve Bank of Australia, the Curtin government established a bank deposit guarantee in 1945, and was understood to have done so by the parliament and the Commonwealth Bank, which was to administer the guarantee. Second, it offers a new history of the origins of the deregulation movement in Australia, by situating the Fraser government’s 1979 Campbell committee inquiry into financial regulation in the context of a building society crisis and a contest between two visions of Australia’s economic future. Third, it offers the first account of Australia’s rapid adoption of the international Basel Capital Accords in 1988. Fourth, it provides a new interpretation of the development of prudential regulation after the introduction of foreign banks in 1985, which helps identifies the ideological drivers and economic pressures that led to the (re)creation in 2008 of the Australian bank deposit guarantee scheme by the Rudd government.

The thesis also develops a new theoretical approach to analysing changes in political economy. The ‘subjective political economy’ framework aims to integrate diverse ideological viewpoints and motivations into an institutional model of regulatory control. By characterising institutional choices as a trade-off between subjective costs, the thesis shows how changing ideas about the purposes, possibilities, and risks of prudential control drove regulatory changes. Furthermore, the framework provides a way to understand institutional innovation as changing perceived costs places pressure on the institutional choices available.

The thesis finds that the history of prudential regulation of banking in Australia was driven by changing perceptions of the relationship between the state and the economy and the responsibilities of governments to bank depositors. Australians have long seen the relationship between banking and the state as a window to understand political economy more generally. By bringing the Basel adoption and prudential regulatory changes to the front of any account of the period of financial regulatory reform, we can see how the reform movement of the 1980s was characterised less by ‘deregulation’ and more by regulatory evolution and expansion. A reassessment of the changes in prudential regulation since the crisis of 1893 should inform our understanding of the trajectories and development of Australia’s regulatory state.

Available in PDF here.

The Campbell Committee and the origins of ‘deregulation’ in Australia

Published in Australian Journal of Political Science (2016) vol. 51, no. 4, pp. 711-726.

Abstract: The 1981 Australian Financial System Inquiry, known as the Campbell Committee, is widely seen as the start of the reform movement of the 1980s and 1990s. Accounts of its origins have been dominated by a debate about which policy actor can take credit. This paper utilises cabinet and Reserve Bank archives to reassess the origins of the Campbell Committee. The inquiry had its origins in an earlier attempt by the Whitlam government to take federal control of the regulation for non-bank financial institutions and the building society crisis of the mid-1970s. In its response to these political and economic challenges we can identify the moment in which the Fraser cabinet turned towards market-based reform. The political decisions made in the context of crisis set the path for regulatory change in subsequent decades, particularly in the area of prudential regulation, where we have seen regulatory consolidation and expansion rather than ‘deregulation’.

Available at Taylor & Francis Online or Academia (accepted manuscript)

Why Anti-Bank Populism Is A Fundamental Part Of Australia’s Political Culture

It’s not really a surprise that two-thirds of voters support Labor’s royal commission into banking,as the Fairfax/Ipsos poll found yesterday. Anti-bank populism is a fundamental part of Australia’s political culture.

Back in 2012 Essential asked voters how, specifically, they would like the banks to be controlled. Ninety per cent wanted the government to fix bank fees. Eighty-one per cent wanted the government to fix the salaries of bank CEOs. Seventy-four per cent wanted to forcefully peg interest rates to the Reserve Bank’s monthly interest rate determinations.

It seems likely that voters would welcome a return to the pre-1980s regulatory regime where the government fixed interest rates and micromanaged the products and investments of the banks – where credit was scarce and you had to beg banks for a loan.

So this fortnight’s debate over the royal commission into banks and the government’s alternative – to boost the powers and funding of the Australian Securities and Investment Commission (ASIC) – is not just a minor election year spat.

It’s a revealing window into how the government changed the way it controls business over the last few decades.

The market-oriented reform of the 1980s and 1990s revitalised the Australian economy after the stagflation of the 1970s. But in the wake of that reform grew up a complex regulatory state that pleases no one.

Now control of the economy has been delegated to arms-length independent regulators. They oversee vast regulatory regimes that create uncertainty and impose heavy costs, while at the same time doing nothing to satisfy the anti-corporate populists who imagine that industries like banking have been left up to the “free market”.

We can debate how heavily regulated companies should be, but surely we can agree that the regulation should be transparent.

Take, for instance, the complaint last week in the Sydney Morning Herald by Allan Fels – himself a former regulator – that ASIC has failed to be the “tough cop” on the corporate beat because it has been too eager to sign negotiated settlements with the firms it is supposed to regulate. Fels would rather ASIC take more firms to court.

No doubt many readers nodded in approval, the report further confirming their belief that ASIC is soft and that we need a royal commission.

But the idea that the increasing use of negotiated settlements and so-called “enforceable undertakings” is a sign of regulatory softness is bizarre.

The practice of negotiating enforceable undertakings – essentially promises made by firms to do certain actions which can be enforced in court – was developed to give regulators discretion to be more intrusive, not less.

The idea is this: rather than going to court every time the regulator wants a firm to do something, it can negotiate. Negotiation is cheaper for all involved, but it also gives the regulator more power. With a negotiated settlement, the regulator can persuade firms to do more than the letter of the law would require: do this, and we won’t take you to court.

Enforceable undertakings are a big part of the “responsive regulation” idea that was supposed to strengthen the power of regulatory agencies. ASIC is a big fan of responsive regulation.

Now, in my view, this sort of regulatory practice is bad policy. Firms should know exactly what is lawful and what is unlawful. Regulation shouldn’t be a matter of discretion – it should be clear and unambiguous. Uncertainty is bad for the economy.

But it’s bad politics, too. Recall that old aphorism: not only must justice be done, it must also be seen to be done. Regulatory agencies spend their life negotiating in private with firms rather than publicly enforcing clear rules in court. No wonder voters think those agencies are a bit hopeless.

We can debate how heavily regulated companies should be, but surely we can agree that the regulation should be transparent.

Into that political void has fallen Bill Shorten and his royal commission into banks – an exercise that appears more about adverse publicity rather than a genuine desire for reform.

After all, if Shorten had any grand regulatory dreams for the sector he had ample opportunity to chase them in the three years he spent as Minister for Financial Services and Superannuation.

But it is hard to imagine a royal commission that did not recommend more regulation. They’re structurally designed that way. Lawyers tend to be more sympathetic to legal controls on market transactions than the economists that dominate most other forms of banking inquiry.

The Coalition government has its own policy to strengthen ASIC – with new powers, a new funding model, and some more resources.

None of these options is likely to resolve the deeper problem – that the discretionary, arms-length, ambiguous regulatory state offers nothing but uncertainty to firms and the public.

No wonder voters don’t have confidence in the system. No wonder they like the idea of a populist royal commission.

The Curtin–Chifley Origins of the Australian Bank Deposit Guarantee

Published in Agenda (2015) vol. 22, no. 1, pp. 21-43

Abstract: In 2008, the Australian government introduced a guarantee of bank deposits. However, in 1945 the Curtin–Chifley government had already introduced what it believed was an explicit bank deposit guarantee. Using archival material, this paper shows how it was understood to be a guarantee by the cabinet, Labor parliamentarians, and the Commonwealth Bank. The guarantee was an important yet almost entirely forgotten part of the Curtin–Chifley government’s social reform program. This paper uncovers the origins of the perception of a deposit guarantee in this forgotten 1945 debate, the attempts by policymakers and the Commonwealth Bank to roll back those perceptions in subsequent decades, and the Rudd government’s reversion to an explicit guarantee scheme in 2008.

Available at Agenda

Why Politicians Ride The Wave Of Anti-Bank Populism

Australia’s banks are launching a new campaign to educate policymakers and regulators about the ins and outs of their business, the Australian Financial Review reported on Monday.

The banks feel defensive since the debate over the Future of Financial Advice (FOFA) reforms, in which they were depicted as semi-corrupt fraudsters preying on the elderly and uninformed, and the recent outrage over mortgage interest rate rises.

Good luck to them. This seems a more productive use of their public relations dollar than campaigns on climate change.

But if this campaign breaks the deep connection between Australian politics and anti-bank populism, it will be the first to do so in 12 decades.

The banking crisis of 1893 set in train more than a century of populist political demagoguery about banking.

Our modern Labor mythologists sometimes skip over the comically propagandistic “money power” doctrine that formed such a large part of Labor politics in the first half of the 20th century. According to money power ideologists, a cabal of bankers – British bankers, Jewish bankers – owned every major industry and asset and controlled Australian politics.

The money power doctrine was not an obscure theory held only at the margins of Australian politics.

Jack Lang, the former NSW premier and Paul Keating’s mentor, was a money power conspiracy theorist.

John Curtin’s mentor, the Scullin government minister Frank Anstey, was the author of an anti-banking, anti-Semitic book called the Kingdom of Shylock (have a look at the digitised version, if you want to be stunned at how overtly racist Australian labour thought it could be).

Driven by this sort of thinking, in 1945 Curtin government introduced burdensome and harmful regulatory controls on Australian banking that slowed economic development and pushed ordinary borrowers into the shadow banking sector for decades.

While it is true that some economists excited by the possibilities of the new Keynesian economic thinking had urged Labor to introduce banking restrictions, it was the crude money power populism that led to the most harmful of those controls: caps on interest rates and an outright ban on foreign banks in Australia.

Anti-bank hostility even played a role in the deregulation of banking four decades later. When Keating ended the ban on foreign banks in 1985, he did so because he believed it would undercut the “drones” of the Australian banking industry. The banks had been made lazy and powerful because of the protection his Labor predecessors had granted to them.

When the Reserve Bank decided to break the back of inflation in the early 1990s, exacerbating on one of the worst economic downturns in Australian history, Keating directed popular anger towards the banks.

A 1991 inquiry into banks – A Pocket Full of Change – encouraged people to send in their complaints with bank services, interest rates, customer relations. Anything they could think of. Nearly a 1000 submissions and complaints were sent in. This distracted attention from the government decisions that caused the crisis in the first place.

A Pocket Full of Change is largely forgotten now. But in retrospect it was very significant.

Our semi-regular freak-out about whether banks are adequately passing on Reserve Bank interest rate cuts can be traced back to Keating’s decision to recast old money power rhetoric in a new guise: to present banks and bankers as uniquely profit hungry and exploitative, and to do so as cover for government policy.

Hence the recent kerfuffle about the major banks’ decision to increase mortgage rates independent of the Reserve Bank.

The Reserve Bank’s cash rate has been held steady at 2 per cent since May 2015. But in October the big four banks decided to increase the interest rates they charged on variable mortgages. Westpac went first, and the rest followed. Bill Shorten thinks that this increase was “just corporate greed”.

But the rate increases are explicitly in response to a policy decision by the Australian Prudential Regulatory Authority that the banks should hold more capital against mortgages. Of course the banks were going to pass the cost of that regulatory requirement onto consumers.

Have the banks raised rates more than they need to, as Scott Morrison tried to argue? Given thelikelihood of even more stringent capital requirements in the near future, it’s hard to blame the banks for being cautious.

In the debate over the FOFA reforms much was made of the need to protect uninformed investors from predatory financial advisors. It’s true that many people don’t understand the world of finance and banking.

But this doesn’t just make them vulnerable to unscrupulous financiers. It also makes them vulnerable to unscrupulous politicians who want to obscure the consequences of their own policy decisions.

If the banks want to change that dynamic, they’re going to have to shift the weight of a century of Australian history.

Why Should We Join Another Development Bank?

Over the weekend Australia announced it will be part of the initial negotiations on the Asian Infrastructure Investment Bank (AIIB).

The AIIB is a global financial institution intended to rival the World Bank and the International Monetary Fund (IMF). The idea is that the AIIB will fund large scale infrastructure development in the region.

But if the AIIB is anything like the World Bank or IMF, then the new body is certain to be heavily politicised, bureaucratic, and imperialistic.

The AIIB is a China-led initiative, so unsurprisingly the bulk of discussion about Australia’s participation in the AIIB has been filtered through a geopolitical prism.

The United States doesn’t want us to join. But then our closest, fondest ally doesn’t have much diplomatic high ground to stand on here.

In Brisbane last year the US gave the Australian government a swipe when Barack Obama tried to make climate change a centrepiece of the Australian-led G20 meeting. Obama did this against the advice of his embassy. So after that very deliberate diplomatic jab, it’s hard to see why their sensitivities about China should be our concern.

And anyway, the US is hardly working to make existing international institutions any better. For instance, the IMF badly needs reform. But the US Congress has a veto over any IMF reform. That intransigence is in part why Britain signed up to the AIIB earlier in March.

Still, it’s easy to understand why the United States is upset.

The establishment of the International Monetary Fund and the World Bank at the Bretton Woods conference in 1944 represented a formal shift in economic power from the United Kingdom to the United States.

Britain had a leading role under the gold standard but Word War II ended that. After Bretton Woods, American leadership of the international economy was reflected in the role of the dollar and the country’s influence over the IMF and World Bank.

Seventy years on, the United States is resisting any sense that it might have its historical role usurped by China.

But the geopolitical symbolism of the AIIB is one thing. Whether the AIIB is a good idea is quite another.

As a general rule, we ought be very sceptical of an economic institution explicitly intended to pursue political, rather than economic, purposes.

The AIIB is part of China’s Economic Belt and Silk Road program to build a regional network of infrastructure that would counterbalance the United States.

So already the AIIB is starting with political goals in mind. Ignore whatever governance structures are imposed on the AIIB by Australia and Britain and other western participants. The AIIB’s investment decisions are almost certainly going to be made on the basis of strategic and political factors, rather than what investments are most economically viable or effective.

How do we know this? Well, because we’ve had 70 years’ experience with the equivalent institutions of the World Bank and IMF.

The IMF and the World Bank are inefficient and interfering and deeply politicised. Often they create the problems they are intended to resolve.

The World Bank has the modest goal of ending extreme poverty. To do so it finances projects in the developing world. This 2006 US News and World Report investigation uncovered a bevy of inefficiencies, wasteful programs, accounting problems, bureaucratic featherbedding, and quasi-corrupt practices in the World Bank. No wonder, as the economist Adam Lerrick points out, “After half a century and more than US$500 billion, there is little to show for World Bank efforts.” Unsurprisingly the World Bank wants more money.

The IMF offers financial assistance to countries in economic strife. But that assistance comes with bureaucratic interference, as the IMF tries to reshape the country they are assisting. Sometimes IMF reforms are worthy, sometimes they are not. But they are always imposed as a condition of assistance, often against the democratic wishes of the people.

The anti-democratic nature of IMF intervention is made worse when it combines with the “moral hazard” created by IMF bailouts. Domestic policymakers feel they can act recklessly because the IMF will save them if they get into trouble.

Development banks are supposed to fund projects that the private sector deem too risky. But a project which is too risky for the private sector remains risky even once funded by a development bank. The projects these banks fund too often fall prey to corruption and poor management. That’s why private investors don’t want to get involved in the first place.

Last week the Wall Street Journal rhetorically asked, “Why does the world need another development bank?”

For China, the answer is to enhance its geopolitical influence. The question Australia needs to ask is: why are we getting involved?

The Murray Inquiry Wants Regulation – But Why?

Financial sector inquiries have played a peculiarly central role in Australian history.

In 1937 the Royal Commission into Monetary and Banking Systems set the framework for what was to become Australia’s insular and credit-constrained post-war economy in the Menzies era.

The Campbell committee, which reported to the Fraser government in 1981, was an even bigger deal. It sparked the deregulation era that opened Australia’s economy to the world.

Yet it’s unlikely that historians will see Abbott Government’s Financial System Inquiry in these sorts of epoch-defining terms. The inquiry, chaired by former Commonwealth Bank chief David Murray, released its final report on the weekend.

Here’s why.

In 1979 Keith Campbell was asked to conduct his inquiry “in view of the importance of the efficiency of the financial system for the Government’s free enterprise objectives and broad goals for national economic prosperity.”

Campbell and his fellow committee members took those three words – “free enterprise objectives” – and ran hard with them. They presented a program of wholesale deregulation of the financial sector so ambitious it had to wait for the Hawke government to implement it almost in its entirety.

Joe Hockey didn’t offer David Murray anything as direct as that.

Rather, Murray had the rather anodyne command to offer recommendations for “an efficient, competitive and flexible financial system, consistent with financial stability, prudence, public confidence and capacity to meet the needs of users.”

Indeed, the philosophy of financial regulation was one of the things the terms of reference was asked to decide. (To “refresh the philosophy, principles and objectives underpinning the development of a well-functioning financial system”.)

So it’s hard to be shocked that the Murray inquiry has recommended big regulatory increases.

Indeed, David Murray told ABC’s 7:30 last night his inquiry represented a “paradigm shift” away from the regulatory philosophy of the Howard government’s more market-trusting Wallis inquiry.

Murray’s central recommendation is that banks should be required to hold more capital as a buffer against a future financial crisis.

The idea is that higher capital will lead to fewer bank failures and therefore less pressure on the government to bail out banks. (I wrote about the inevitability of government bank bailouts on The Drum when the Murray inquiry released its interim report.)

Murray says that at most this would only reduce Australia’s GDP by less than 0.1 per cent. Sounds piddly, right? But as regulatory imposts go, that would constitute one of the single largest new regulatory burdens in the last few decades.

Yes, larger capital buffers might reduce the whole privatise-the-profits, socialise-the-losses problem. But here’s the thing: Australia hasn’t had a proper bank crisis for 121 years. The last was in 1893. Neither the Great Depression nor the Global Financial Crisis saw any major bank failures in Australia.

Now, there’s nothing to say that we’re not on the brink of a catastrophic bank collapse. And all else being equal resilient banks are better banks.

But we shouldn’t delude ourselves into thinking that we understand why banking crises hurt so badly, nor the best regulatory restraints to place on banks to help them ride out those crises.

The very idea of “systemic” significance is a relatively new one.

At best, it’s a hypothesis based on observations about what seems to have happened during the Global Financial Crisis. At worst, it’s a collection of guesses about what could have happened if the American government hadn’t bought up toxic assets.

By calling for higher capital, the Murray inquiry is really just following the cues of the international Basel committee, which now drives financial regulation around the world.

Murray wants to make Australian banks “unquestionably strong” by ensuring they’re in the top 25 per cent of global banks when it comes to capital buffers. So Australia’s theory about what constitutes a safe bank is pegged to whatever other banks are doing.

This sort of cocktail napkin reasoning is a bit of a worry.

But that’s how it is. Governments regulate banks like they regulate everything else – according to a bunch of common assumptions, stylised factoids about the past, and half-remembered textbook theory.

As the economist and historian George Selgin wrote on the weekend, all these debates about banking rest on a collection of assumptions about how banks would act in a free market – assumptions almost never explicitly stated, let alone borne out by the historical record.

In the United States, massive, nation-wide banking failures during the Great Depression led to the establishment of a national deposit insurance scheme. The idea has been copied around the world, including in Australia.

But many scholars now blame deposit insurance for the fragility of the banking system. (See, for instance, here.)

One forgotten aspect of the Campbell committee was that while it recommended deregulation almost everywhere, it also recommended new controls to make banks more stable.

Yet as two scholars wrote at the time, the failure of the Campbell committee to back its call for more control with careful economic analysis was “disconcerting”.

One could say the exact same thing about the Murray inquiry.

Politics, Not Policy, Will Decide Who Gets Bailed Out

What can we do about “too big to fail”?

The interim report of the Commonwealth’s Financial System Inquiry, chaired by David Murray and released last week, spends a fair bit of time talking about this puzzle.

“Too big to fail” describes financial institutions, mostly banks, which have become so large and so deeply integrated into the financial system that if we let them collapse they would take everything else with them.

If a corporation is too big to fail, then, it follows, taxpayers have to bail them out.

It’s quite a problem. A market economy is supposed to be dynamic, full of entries and exits. Firms that add economic value thrive. Those that do not go broke.

So bailing out failed companies makes the economy less efficient. More gallingly, it redistributes money from the poor to the rich. And it creates “moral hazard” – a belief by management that ultimately they won’t have to pay for their mistakes.

Moral hazard is a particularly severe problem for banks. Banks trade on risk. A bank’s basic job is to transform short-term highly liquid deposits into long-term extremely illiquid loans. Too much of the latter will prevent redemption of the former.

Too big to fail encourages banks to make riskier loans. Why wouldn’t they? They’re not the ones bearing the cost of failure. Taxpayers are.

So it would be great to get rid of too-big-to-fail. Or at least limit it somehow. The Murray Inquiry has a few ideas: higher capital requirements for bigger institutions, for instance, or new procedures for when banks do fail.

But the question isn’t what should we do about too-big-to-fail but what can we do about it.

And the answer to that question is almost certainly nothing.

Because no matter what the Murray Inquiry recommends – no matter what policy the Government or Reserve Bank or Australian Prudential Regulatory Authority imposes today – the decision of which firms to bail out and which to let fall will be made by the policymakers of the future, according to their own whims, and mindful of political, not economic, considerations.

Simply put, there are no ways to credibly constrain future governments from deeming an institution too big to fail.

Nowhere is that clearer than in the United States.

After the savings and loans crisis of the late 1980s, American policymakers decided to put some limits on the availability of government bailouts. The result was the Federal Deposit Insurance Corporation Improvement Act 1991. This law was supposed to set rules under which an institution would be considered too big to fail.

But those carefully constructed limits fell apart when the Global Financial Crisis hit. Consumed by panic, the American government bailed out not only banks but money market funds and Fannie Mae and Freddie Mac – two bodies that were theoretically and legally owned by private shareholders but were implicitly backed by a government guarantee.

Now American policymakers say they’ve come up with a new system supposed to constrain too big to fail – the 2010 Dodd-Frank Act. Will it work? Don’t bet your house savings account on it.

We’re lucky in Australia to have gone the better part of a century without a high-profile bank failure. But we’re hardly immune to the political pressures that have created the too big to fail problem.

One predecessor of the Murray Inquiry, the Fraser government’s Campbell Committee, argued the responsibility of the government is to keep alive the system as a whole, not prop up individual institutions. Banks should be allowed to go under.

But who gets bailed out is a decision made by politicians not economists.

In 1990 the Farrow Group – a Victorian group of building societies whose most prominent member was the Pyramid building society – got into serious trouble. In July 1990 John Cain’s Victorian government gave it the bailout it wanted, guaranteeing more than $1 billion of unsecured deposits. (The full story is told in this paper).

Was the Farrow Group too big to fail? The Cain government said it was – it was “systemically significant”, to use our contemporary econocrat buzzword.

Systematic significance is a term of art, and not a very clear one. Since the Global Financial Crisis systematic significance has become a totem of financial regulation. The idea is that too big to fail isn’t just about size, but more about integration.

There’s been a cottage industry of academics trying to figure out how to tell which institutions are systemically significant.

No doubt they’re all doing great, insightful work. But the fact remains these studies of systemic significance are just a lot of after-the-fact reasoning.

It was policymakers – not scholars – who came up with the idea that some institutions were just too interconnected with the financial system to collapse peacefully.

Like pornography, politicians and bureaucrats know systemic significance when they see it. The Victorian government just knew the Farrow Group was too important to collapse. The American Federal Reserve just knew that they had to bail out the private money market funds.

Yes, systemically significant institutions get bailed out – but their significance should refer to the political system, not the financial system.

No matter what the Murray Inquiry decides, in the middle of a panic political expedience is going to beat carefully crafted rules every time.