Tag: money and banking

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.

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.

In February 1998, John Howard’s cabinet agreed to support American military action against Saddam Hussein. But three months later, in May, officials from Reserve Bank were secretly offering the Iraqi tyrant our unique plastic bank note technology.

This stupefying discovery was contained in the most recent Fairfax and Four Corners investigation, which aired last Monday night. Yes, the Reserve Bank scandal is worse if you put it in context.

Allegations that Reserve Bank subsidiaries used bribery to secure banknote contracts in foreign countries have been around for years. But bribery is one thing. This is something else. One arm of the Australian government – the central bank, no less – was trying to cut deals with a dictatorship that the rest of the Australian government was preparing to go to war with.

(At least the body at the centre of the last Iraq scandal, the Australian Wheat Board, was a private company. It did not travel on official passports. It did not represent the Australian government.)

Even more amazing – it was the Reserve Bank’s responsibility to enforce financial sanctions against Iraq.

The Reserve Bank’s actions in Iraq reveal a massive, endemic governance problem that goes beyond this scandal to the structure of the Australian regulatory state.

After the 1991 Gulf War and subsequent United Nations embargo, Iraq could no longer import its bank notes from printers in Britain and Russia. So the Central Bank of Iraq cobbled together its own printing equipment to do the job. The notes they produced were nicknamed “Saddam” bills – plastered with the tyrant’s face, they were easily counterfeited, badly devalued, and so poorly made that the ink ran.

In the late 1990s, the Iraqi central bank started looking around for a supplier to replace its shabby currency outright. Saddam Hussein was shown polymer notes. He loved them. So representatives of the Reserve Bank’s printing division popped over to Baghdad to spruik our merchandise.

Its trip had to be secret because, while they were there, 190 Australian troops were on the other side of the Kuwait border waiting for orders to attack.

The United States eventually passed the Iraq Liberation Act, and Bill Clinton ordered a bombing campaign in December that year.

The Reserve Bank is not just one of the most important government agencies. It is also the premier independent agency. It has been deliberately separated from the traditional Westminster lines of ministerial control. It does not take directions from elected representatives.

This governance structure is supposed to eliminate political interference in Reserve Bank decisions. But it also reduces accountability.

The two Reserve Bank subsidiaries involved in the scandal are even further removed from parliamentary oversight. Securency, which makes the high-quality plastic film, was a private firm founded in 1996 and 50 per cent owned by the Reserve Bank. (In damage control, the bank bailed out of Securency earlier this year.)

Note Printing Australia takes Securency’s film and produces banknotes and passports. It was originally a division of the Reserve Bank itself but was corporatised – that is, spun off and converted into a commercial corporation, seeking a market rate of return, but still wholly owned by the central bank.

And when did this corporatisation happen? July 1998. That is, while the division secretly had outstanding business with the Ba’athist government of Iraq.

The scandal occurred at the very moment when all the responsible institutions were being granted further independence; that is, being reformed to be less directly accountable to our elected representatives.

The Reserve Bank itself had just passed a major milestone. In 1996, Peter Costello released a statement on the conduct of monetary policy which formally confirmed the central bank’s independence from government. This was a big deal. It had been less than a decade since Paul Keating had bragged he had the Reserve Bank “in my pocket”.

While most commentators have focused on the monetary implications of this institutional change, the Iraq scandal shows that the central bank believed it could act independently of Australia’s foreign policy as well.

For the last few decades it has been fashionable to praise “independence” as a desirable attribute for regulators, bureaucracies and central banks.

The appeal is obvious. Politicians are venal creatures. The further we keep them away from government the better. The result of bureaucratic independence is – at its best – a technocratic rejection of politics.

But at its worst, independence fosters unaccountable bureaucratic fiefdoms pursuing their own agendas, backed x`by the full force of government but unconstrained by democratic norms like ministerial responsibility and public accountability.

In other words, exactly what we can see in the Reserve Bank scandal.

In its memo reporting back from the May 1998 Iraq trip, the Reserve Bank officials acknowledged that no banknotes could be delivered to Iraq until the United Nations embargo was lifted. But “nothing was stopping us to sign a contract and have products (banknotes, machines, etc) manufactured”.

You can imagine them patting themselves on the back for such clever, disingenuous reasoning. The Department of Foreign Affairs and Trade was not as impressed.

So why are we only hearing about all this now?

The investigations so far have made much of the failure of the Australian Securities and Investment Commission to chase down the bribery allegations. Once again, context makes it worse.

ASIC is one of the big three mega-regulators, along with the ACCC and APRA. All are blessed with formal independence from government. And all were being reformed in the early Howard years.

ASIC only gained its current form in (you guessed it) 1998, when it was given a new suite of powers and responsibilities. It has since gained a reputation for being capricious and draconian. In its actions against AWB, the judge accused it of bringing justice into disrepute.

Yet it has let this scandal slide. But don’t worry. According to ASIC, “the public can be completely and utterly confident in ASIC’s actions.”

We’re supposed to take it on faith that one independent government agency has fully investigated possible wrongdoing by another independent government agency.

There is nothing in the Reserve Bank scandal that should make us comfortable with how Australian democracy functions.

As the 20th century opened there were 18 central banks around the world. One hundred years later there were 173.

But none of them have as tight a grip on the political culture as Australia’s Reserve Bank.

No other country grants so much mystical significance to their central bank’s interest rate decisions. We are obsessed.

Last Tuesday the bank lowered the cash rate to 3 per cent, releasing another torrent of claims and counterclaims. Wayne Swan declared it was testimony to his great management of the economy. Joe Hockey said the rates had been dropped to “emergency levels”. Retail banks were threatened. Peter Costello’s name was invoked.

Politicians have deified the Reserve Bank. It’s unusual for a politician to publicly second guess the board’s encyclicals. Happily, commentators do not share their faith. So last week, as always, columns were written and talking heads talked. Is the bank’s board being bold, prudent, reckless, negligent? Take your pick.

We’re so used to these theatrics that we don’t realise how unusually Australian it all is.

But compare how foreign politicians and parties view their interest rate movements.

For the British Conservative Party, low interest rates are merely a feature of a healthy economy – and not a particularly central one. Here’s a Google search of the Conservative Party website. The most concrete claim they make is that their hard-won fiscal credibility keeps interest rates low.

The Australian Liberal Party’s website shows a completely different picture. Here, low interest rates are themselves the goal. Interest rates will be lower under the Coalition. They’re higher under Labor. Gillard finally admits she has forced up interest rates. And on and on and on.

We can play the same game with the labour parties, although to be fair the difference is not as stark. Here’s the ALP, and here are their British cousins.

And the Americans? Well, in the 32,000 word, 55 page Republican Party platform (PDF), interest rates are mentioned … once. Even though it’s pretty plausible that extremely low Federal Reserve rates were a major cause of the financial crisis.

So yes, Australians are a bit different. Interest rates are the bread and butter of the political contest – as Australian as asylum seekers. The federal Liberal campaign in 2004 was almost entirely structured around interest rates.

In April this year Bill Shorten even suggested that knowledge of Reserve Bank meetings was central to political leadership in this country. Yes, we smugly all laughed as Shorten tried to correct Tony Abbott’s factual error with his own factual error (the bank meets the firstTuesday of every month, not the second). But more important was why Shorten thought Abbott’s mistake was a big deal: “when you want to be the alternative Prime Minister of Australia, interest rates is just such an important issue”.

And all this rhetoric for something governments have almost no control over.

The Reserve Bank is independent; it makes its decisions in private, pretending to know nothing of the busy political world outside its boardroom. When parties take credit for rate cuts or damn their opponents for rate rises, they are simply bluffing. They have no direct control over the rates. They have little indirect either. Of all the sources of inflation in a modern, open, liberal economy, national governments can only really influence one or two.

In other words, our politicians are playing a game with pieces they don’t control, but it’s worse than that. If rates go up, mortgage holders will hate it. If they go down, then the economy may be going down as well, but the Mum and Dad homeowner will be delighted. Throw into this mix the typical contrarian lines: the economy is “over-heating”; what about retirees? Nobody can win this game, but everybody is desperate to play.

A more interesting issue has arisen in recent years: we’re learning that even the Reserve Bank has only so much power over economy-wide interest rates.

Australia grew accustomed to the big four banks dancing to the tune of the Reserve Bank’s decisions. During the Howard years rate cuts were dutifully passed on to consumers. But history may record that as an anomaly – a short decade where retail banks and the central bank were aligned.

We tend to imagine anything that lasts a few years is natural and permanent. But Australia’s banking sector is still evolving since the financial liberalisation of the 1980s. So too is the Reserve Bank itself; it only achieved full independence in 1996.

When the Global Financial Crisis came, the close relationship between banks and the central bank broke. Few regretted this breakup more than the Labor Government. Now we have the embarrassing spectacle of a Government trying to bully mortgage rates down, and an Opposition pretending they possess a magic hammer that would set the banking system straight again.

Nothing frustrates politicians like powerlessness. For much of the 20th century, governments were able to control prices across the economy. They had many levers to do so – tariffs and taxes and quotas and so forth – and the public expected governments to pull those levers.

But the 20th century was a long time ago. The Reserve Bank cash rate is one of the few centrally planned prices left, and even then it set by a body independent of the government of the day.
When the Reserve Bank cut rates last week, Wayne Swan proclaimed this was the early Christmas present Australia’s hard-working families deserved.

But if rate cuts are gifts, does that mean rate rises are punishments? Of course not. Sometimes prices go up and sometimes prices go down. Our political culture needs to stop being so futilely obsessed with the Reserve Bank.

The Basel Committee on Banking Supervision is about to introduce its Basel III accords, global regulatory standards which govern how much capital banks are required to hold.

But it’s not typically a great idea to introduce huge regulatory increases when the world is on the brink of economic collapse.

And the Institute of International Finance (IIF) suggests Basel III implementation could slice 3.2 per cent of GDP in Europe, North America, Japan and the United Kingdom in the next five years alone, and leave the global economy with 7.5 million fewer jobs.

Sure, the IIF represents more than 400 banks, so they would say that. Governments admit it will slow the economy, but by much less. (They would say that too.)

Basel III was developed in haste after the financial crisis. Like its predecessor, Basel II, its purpose is to ensure banks have an adequate buffer of capital if there is a bank run.

Regulators say capital requirements are necessary because governments insure bank deposits. The idea of deposit insurance is to guarantee depositors won’t lose their money if the bank goes under. But the insurance also means banks and their customers don’t wear the cost of wild speculation and risky banking practices. So regulators believe banks need to be compelled to be prudent.

In other words, a new regulation introduced to patch up the unintended consequences of older regulations.

The existence of Basel II in the lead-up to the financial crisis has always been a gaping hole in the theory that we should blame a lack of regulation.

But it’s worse. The Basel II Accords – designed to keep the banks secure, designed to protect the depositors against excessive risk-taking, designed by some of the world’s most intelligent people – were the primary cause of the crisis in the first place.

That is the conclusion of Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation by the political scientist Jeffrey Friedman and the economist Wladimir Kraus. The book was released in October.

Friedman and Kraus’s argument complicates both left and right crisis narratives. The causes of the housing bubble are well known: policies to boost home ownership, low interest rates, and Freddie Mac and Fannie Mae’s 71 per cent stake of the non-traditional mortgage market.

But explaining the housing bubble is just the half of it. You have to explain how that bubble turned into a banking crisis.

Basel II actively encouraged banks to hoard mortgages. Its capital buffer rules weighted mortgages far higher than business or consumer loans. When the bubble burst, the banks were holding a disproportionate number of dodgy mortgages because they’d been urged to do so.

This is not a completely new story. Friedman and Kraus give it empirical support. They show that American bankers weren’t actually that reckless. They favoured what they imagined to be safer, more expensive assets over cheaper, riskier ones. And the banks were nowhere near as leveraged as they had a legal right to be under Basel II.

Furthermore, it wasn’t “irrationality” that caused the crisis. That widespread theory assumes bankers and regulators had enough information to know what they were doing was bad, but they all went crazy and did it regardless. The irrationality thesis has no explanatory power.

It was just that everybody – regulators, bankers, politicians, investors – thought highly-rated mortgages were a lot safer than they were.

So how did the banking crisis become an economic crisis? Basel II, after all, was supposed to halt a contagion at Wall Street’s edge.

Friedman and Kraus argue that Basel rules are inherently contradictory. The capital buffers which Basel requires aren’t buffers at all. The idea behind capital buffers is, again, that if there is a run on a bank, the bank will be able to dip into reserves to survive. But if it uses those reserves, even in a crisis, it will suddenly be under Basel’s required capital threshold, and will be legally penalised.

As one economist pointed out, there has been little “consideration of the paradox that the buffer function of regulatory capital is limited because this capital is needed to satisfy the regulator”. When the banks hit Basel’s capital minimums in the last months of 2008, credit froze, and the “real” economy started to hurt.

So it is sickly perverse that Basel III’s main purpose is to raise capital minimums even higher. And analysts from the Cato Institute have argued that it “retains many of the weaknesses of its predecessors” – particularly “a highly gameable weighting system” that led to the hoarding of mortgages in the first place.

Basel III shows that governments are trying to fix the finance sector’s problem before they’ve figured out what the problem actually is. The first and most important question has to be why the crisis occurred. Answering that takes reflection.

But legislators work faster than academic economists. Already by 2009 politicians were running down new regulatory paths. In February that year Kevin Rudd had concluded that Basel II was “inadequate” and that it needed a successor. This is meaningless. All regulations were inadequate at stopping the crisis.

Anybody who says they’ve got a handle on the causes of a crisis that big and that complicated in its immediate aftermath is wrong. And they’re being deceitful if they say they know how to fix it.

The United States Congress passed the Dodd-Frank financial reform act six months before its own Financial Crisis Inquiry Commission released its report into the causes of the crisis.

Such is the false confidence of regulators and politicians.

Basel III standards are about to be disseminated around the world. There is no reason to believe that the economic system will be any safer or more stable. And it could be a lot poorer.