Dear Readers,
I will be away until January 10th, 2011. Hopefully the world will not implode in that time.
For your reading pleasure over Christmas, following this post are the nine leading entries to the Son of Wallis Challenge. The winner, Kaon Li, is first but the others are not presented in any particular order. Thanks to all who contributed.
Au revoir and enjoy your break. I encourage you to return next year, there are some very exciting plans afoot for this humble blog...
Thanks for reading.
David
Thursday, December 23, 2010
Son of Wallis Challenge (SOW) Winner - Kaon Li
A long time ago, there was a farmer who broke his hoe while farming. He took his tool to the blacksmith but he did not have the one gold coin for the repair. The farmer promised the blacksmith to pay double after the harvest, but the blacksmith was a cautious man and refused the offer.
Facing total ruin, the farmer attempted to drown himself by walking into a lake. As the water reached his neck, an apparition appeared in front of him.
“I am the fairy of the lake. Why do you seek death?”
Overcoming his initial shock, the farmer told the fairy his sorry tale. The fairy considered the situation and told the farmer: “I shall give you a gold coin tomorrow, if you promise you’ll give me two gold coins after the harvest. Be warned!! If you fail to provide the coins as pomised, you will be cursed!!”
Elated at his salvation, the farmer gave up all thought of suicide and returned home.
That same night, the fairy appeared in the blacksmith’s dream. “Blacksmith”, said the fairy, “throw a gold coin into the lake tomorrow, and you’ll receive two gold coins after the harvest”.
The blacksmith woke up next morning and threw a gold coin into the lake as urged, which the fairy in turn handed to the farmer. The gold coin allowed the farmer to repair his hoe to grow his crops. At harvest time, the farmer sold his produce and returned the two gold coins to the fairy. The blacksmith was visited in another dream from the fairy to collect his two gold coins, and everyone was happy.
The fairy’s name is banking. When people don’t believe in fairies, the banking system collapses, and we have a financial crisis.
The wholesale funding guarantee offered by the Australian government was the ‘least worse’ option during the GFC. The Irish government started off a global bank run when they guaranteed the liabilities of the Irish banks. After that, only government guaranteed banks could borrow.
While giving certainty to foreign investors during a crisis is critical, the current government guarantee is a lousy way of doing it. It is crony capitalism: profit is privatized, risk is socialized. Although the risk does not show up on the balance sheet of the Government, it is there nevertheless and, as Ireland has shown, it can cripple a country.
The guarantee saved the Australian financial system, however it cemented the ‘too big to fail’ status of the Australian banks. The cost paid by the banks to the Australian government for the guarantee did not and does not address ‘moral hazard’. The banks simply pass the cost along to Australian borrowers.
We need a better deterrent mechanism.
With the global economy stablizing, it is time to ask why the Australian government guaranteed wholesale debt at 100% anyway? If the investor wants 100% security, they should be buying Australian Government bonds. We need a scheme that can impose a ‘haircut’ on the bond holders. My proposal is for the Australian government to support the bank wholesale fundings with a variable 3 month bond swap option. Let me explain how it works.
All wholesale funding of Australian financial institutions will now receive a partial government guarantee. The value of the guarantee with depend on the maturity and credit rating of the institution, and it’ll change every day. For example, a ‘AAA’ bond from one of the big 4 will be guaranteed up to 97c, but Bendigo Bank will only be 95c to the dollar.
The guarantee takes the form of a swap option with a Government bond in 3 month’s time. If the bond holder chooses to exercise the option, the interest rate for the previous 3 months will be forfeited, and the bonds will be exchanged. The bondholder can also hold onto the bond instead, costing them nothing. In effect, it’s a free insurance policy for the bondholder with an excess of 3 month bond revenue.
However, the guarantee is not costless. If the bond is swapped, the financial institution will automatically issue a preference share to the Government of the same value. If the total value of the preference share exceeds the market capitalization of the bank, it’ll become Government owned.
Loss of ownership is a powerful antidote to moral hazard.
Furthermore, a number of ‘phantom board members’, in proportion to the total amount of government guaranteed funds, will be added to the financial institution at their AGM. The phantom position will be filled by a selection of members from the Federal parliament. The spectacle of Bob Katter speaking his mind to the CBA board at the AGM should make the bank very, very reluctant to abuse the facility.
It’ll also make great television.
Beyond the ability to enforce haircuts, the swap option also allows the Australian government to signal the market by adjusting the option swap. By decreasing the guarantee amount, the market will buy less wholesale bonds, and vice versa. Ater all, the market loves complicated yield curves. Unlike CDS, the option swap is also impossible to turn into another ‘financial derivative’ because there is no revenue stream!!
After tackling the issue of wholesale funding, let’s move on to mortgage securitisation.
Securitisation worked in the US for over 70 years prior to the GFC. Originally it served an important role of spreading geographic risk due to the fractured nature of the US banking system. The system failed when the rating agencies start giving fraudulent mortgages a ‘AAA’ rating. They forgot what a mortgage is. A mortgage is a contract based on a person’s ability to pay, backed up by the house. The financial institutions got it backwards, and treated mortgages as loans on the value of the house, backed up by the mortgage holder.
Mortgages for people with no income, no assets, or job should not exist. It is fraud. To prevent a recurrence, we need much stricter criteria on which mortgages can be securitised. This can be done by requiring the mortgages to be at least 3 years old, and with 25% paid off.
As more of a mortgage is paid off, the risk of the mortgage defaulting decreases, so the interest rate should decrease as well. Currently the interest rate charges remains the same throughout the loan, which is a loophole. The proposed system uses lower interest rates as a reward for those who qualify for securitisation. This will encourage the mortgage holder to obtain a mortgage they can afford, and discourage equity loans. To further balance the risk, those with a larger market share must keep their loans longer before they can be securitised. This will prevent the banks from hogging the housing market, and they might even start lending to business again.
It will also means Australians will live in smaller houses. With our population increase, that is what we must do. The current lifestyle is unsustainable.
Now some notes on Wayne Swan’s proposal.
The elimination of exit fees discourages competition. The banks are winning market share because they can get their money cheaper. This in itself is not a bad thing, except the big 4 are pushing a housing bubble instead of lending to businesses. APRA should impose a higher capital ratio on banks who lend too much to a particular sector, but that is totally missing in the plans.
The GFC was caused by a lack of regulation, and the Australian Government want to solve the problem by LESS regulation? The ‘covered bond’ idea is stupid and dangerous. ‘A’ rated financial institutions cannot create a ‘AAA’ security except through a flawed mathematic model: the kind of model which lead to the GFC. Also, deposits are government guaranteed, so creating this ‘ultra special’ class of creditor means taxpayer ends up the loser.
Securitisation removes the risk from the financial institution. With a covered bond, the risk remains while the asset is reduced. It’s a con job.
Finally, when you lower the interest rate, the Reserve Bank simply have to raise the interest rate more to get the same effect on the economy. What is the logic of that? It is not the job of the Australian government to encourage people into buying a bigger house that they cannot afford. What Australia needs is a mining tax to slow down the mining sector, and lock up all the tax proceeds so it does not overheat the economy.
What Wayne Swan and Hockey offer is nothing but crass economic populism.
Facing total ruin, the farmer attempted to drown himself by walking into a lake. As the water reached his neck, an apparition appeared in front of him.
“I am the fairy of the lake. Why do you seek death?”
Overcoming his initial shock, the farmer told the fairy his sorry tale. The fairy considered the situation and told the farmer: “I shall give you a gold coin tomorrow, if you promise you’ll give me two gold coins after the harvest. Be warned!! If you fail to provide the coins as pomised, you will be cursed!!”
Elated at his salvation, the farmer gave up all thought of suicide and returned home.
That same night, the fairy appeared in the blacksmith’s dream. “Blacksmith”, said the fairy, “throw a gold coin into the lake tomorrow, and you’ll receive two gold coins after the harvest”.
The blacksmith woke up next morning and threw a gold coin into the lake as urged, which the fairy in turn handed to the farmer. The gold coin allowed the farmer to repair his hoe to grow his crops. At harvest time, the farmer sold his produce and returned the two gold coins to the fairy. The blacksmith was visited in another dream from the fairy to collect his two gold coins, and everyone was happy.
The fairy’s name is banking. When people don’t believe in fairies, the banking system collapses, and we have a financial crisis.
The wholesale funding guarantee offered by the Australian government was the ‘least worse’ option during the GFC. The Irish government started off a global bank run when they guaranteed the liabilities of the Irish banks. After that, only government guaranteed banks could borrow.
While giving certainty to foreign investors during a crisis is critical, the current government guarantee is a lousy way of doing it. It is crony capitalism: profit is privatized, risk is socialized. Although the risk does not show up on the balance sheet of the Government, it is there nevertheless and, as Ireland has shown, it can cripple a country.
The guarantee saved the Australian financial system, however it cemented the ‘too big to fail’ status of the Australian banks. The cost paid by the banks to the Australian government for the guarantee did not and does not address ‘moral hazard’. The banks simply pass the cost along to Australian borrowers.
We need a better deterrent mechanism.
With the global economy stablizing, it is time to ask why the Australian government guaranteed wholesale debt at 100% anyway? If the investor wants 100% security, they should be buying Australian Government bonds. We need a scheme that can impose a ‘haircut’ on the bond holders. My proposal is for the Australian government to support the bank wholesale fundings with a variable 3 month bond swap option. Let me explain how it works.
All wholesale funding of Australian financial institutions will now receive a partial government guarantee. The value of the guarantee with depend on the maturity and credit rating of the institution, and it’ll change every day. For example, a ‘AAA’ bond from one of the big 4 will be guaranteed up to 97c, but Bendigo Bank will only be 95c to the dollar.
The guarantee takes the form of a swap option with a Government bond in 3 month’s time. If the bond holder chooses to exercise the option, the interest rate for the previous 3 months will be forfeited, and the bonds will be exchanged. The bondholder can also hold onto the bond instead, costing them nothing. In effect, it’s a free insurance policy for the bondholder with an excess of 3 month bond revenue.
However, the guarantee is not costless. If the bond is swapped, the financial institution will automatically issue a preference share to the Government of the same value. If the total value of the preference share exceeds the market capitalization of the bank, it’ll become Government owned.
Loss of ownership is a powerful antidote to moral hazard.
Furthermore, a number of ‘phantom board members’, in proportion to the total amount of government guaranteed funds, will be added to the financial institution at their AGM. The phantom position will be filled by a selection of members from the Federal parliament. The spectacle of Bob Katter speaking his mind to the CBA board at the AGM should make the bank very, very reluctant to abuse the facility.
It’ll also make great television.
Beyond the ability to enforce haircuts, the swap option also allows the Australian government to signal the market by adjusting the option swap. By decreasing the guarantee amount, the market will buy less wholesale bonds, and vice versa. Ater all, the market loves complicated yield curves. Unlike CDS, the option swap is also impossible to turn into another ‘financial derivative’ because there is no revenue stream!!
After tackling the issue of wholesale funding, let’s move on to mortgage securitisation.
Securitisation worked in the US for over 70 years prior to the GFC. Originally it served an important role of spreading geographic risk due to the fractured nature of the US banking system. The system failed when the rating agencies start giving fraudulent mortgages a ‘AAA’ rating. They forgot what a mortgage is. A mortgage is a contract based on a person’s ability to pay, backed up by the house. The financial institutions got it backwards, and treated mortgages as loans on the value of the house, backed up by the mortgage holder.
Mortgages for people with no income, no assets, or job should not exist. It is fraud. To prevent a recurrence, we need much stricter criteria on which mortgages can be securitised. This can be done by requiring the mortgages to be at least 3 years old, and with 25% paid off.
As more of a mortgage is paid off, the risk of the mortgage defaulting decreases, so the interest rate should decrease as well. Currently the interest rate charges remains the same throughout the loan, which is a loophole. The proposed system uses lower interest rates as a reward for those who qualify for securitisation. This will encourage the mortgage holder to obtain a mortgage they can afford, and discourage equity loans. To further balance the risk, those with a larger market share must keep their loans longer before they can be securitised. This will prevent the banks from hogging the housing market, and they might even start lending to business again.
It will also means Australians will live in smaller houses. With our population increase, that is what we must do. The current lifestyle is unsustainable.
Now some notes on Wayne Swan’s proposal.
The elimination of exit fees discourages competition. The banks are winning market share because they can get their money cheaper. This in itself is not a bad thing, except the big 4 are pushing a housing bubble instead of lending to businesses. APRA should impose a higher capital ratio on banks who lend too much to a particular sector, but that is totally missing in the plans.
The GFC was caused by a lack of regulation, and the Australian Government want to solve the problem by LESS regulation? The ‘covered bond’ idea is stupid and dangerous. ‘A’ rated financial institutions cannot create a ‘AAA’ security except through a flawed mathematic model: the kind of model which lead to the GFC. Also, deposits are government guaranteed, so creating this ‘ultra special’ class of creditor means taxpayer ends up the loser.
Securitisation removes the risk from the financial institution. With a covered bond, the risk remains while the asset is reduced. It’s a con job.
Finally, when you lower the interest rate, the Reserve Bank simply have to raise the interest rate more to get the same effect on the economy. What is the logic of that? It is not the job of the Australian government to encourage people into buying a bigger house that they cannot afford. What Australia needs is a mining tax to slow down the mining sector, and lock up all the tax proceeds so it does not overheat the economy.
What Wayne Swan and Hockey offer is nothing but crass economic populism.
SOW - Rory McKeown
Individuals and companies have been incentivised perversely across the banking industry, and being led by a corrupt banking ideology, Australia has paid a price for this. It could should shape itself as a role model for banking leadership by implementing the following proposals, and creating incentives for small banks, and securitized bonuses. Until these factors are dealt with the banking industry will always claim more free market economic is a good thing. Unfortunately when it goes wrong, free market economics is the last thing they are prepared to confront. Their logic went something like this:
• we have assets on our books that are not what we thought they are, we are now undercapitalised.
• If people know this, they will remove their money from our bank, this will cause a bank run.
• If we collapse, banks X and Y will collapse as well because they have assets we sold to them.
(IV) If we all collapse, your banking system will collapse.
(V) If the banking system collapses, your country will collapse. Therefore, you must help us.
Any cohesive solution to preventing this occurring again must deal with preventing this logic to ever hold true.
• How did the banks end up with these “faulty” assets?
A big topic, but lets consider a simple process. A retail bank lends to customers to purchase a house. The securitizers at an investment bank then buy these loans and package them into an issue, create the securizitaion vehicle and sell tranches to other institutions. Based on a rating given by an “authorised” entity banks and other institutions then pay an appropriate risk premium for the bundle of coupons all the individual retail borrowers pay. The advantage of this is that pension funds and insurance companies can invest in these assets which claim to be as secure as corporate bonds. At every point in this process, an individual is basing his expected year-end bonus on these deals going through: the retail bank adviser, the securitiser. the ratings agency advisor,the fund manager. However the security is expected to last on average 20 years.
Hence there is a duration mismatch in the risk profile of the individual and the institution. Any solution to the current banking crisis must minimize this risk.
The retail bank and the securitising institution should be forced to take a substantial piece of any “synthetic” product (e.g. 20% each). These “mirco-issues” should contain a piece of each tranche, in effect replicating exactly the payoffs for each institution. Bonuses for their employees should be paid annually from the coupons of these micro-issues. If the bank wishes to pay them more, then let them take a bigger share of the coupon, however they should be very aware that their own personal wealth is intimately linked to the product that they are creating.
(II) How can a retail bank end up with assets of ambiguous quality on it's books?
Were a retail bank to package and hold it's own debt, the loan quality of the book should be clear. They verified and created the mortgages. Instead were third parties are used to sell mortgages the quality is likely to decrease: the downside incentives for third party individuals are massively outweighed by volume related pay incentives. Hence a loan book of false creditworthiness and overestimated earnings claims.
The other side of this is large retail banks wanting to play in the interbank markets, buying and selling securities in a hope to create “alpha”. This has been sanctioned by executives at the top level who see peers performances and bonuses and hope to create the same for themselves. Buy buying poor quality opaque products with artificially secure ratings and apparently high yields, these executives encouraged their own staff to take bigger risks.
All of this was implicitly made possible by banks trusting ratings that proved to be in the short term “cheap”, but in the long run very expensive.
The rating agency model is completely conflicted where an agency is authorized by the government to define the quality of a securitized product. As the rating individuals involved see their year end bonus defined by the quality of the ratings they give, clearly they will always be proposed to “do business”, rather than “do analysis”. As they are government sponsored, a competing independent agency is always considered a lesser value analysis. The author proposes an end to “certified ratings agencies”, and an open platform for securitisation vehicles to present the credit worthiness of their underlying mortgages. Hence independent analysis houses can access this information and provide independent reports to funds and banks who are interested in these products. The increased competition and reputational damage of poor analysis would likely cause margins to drop, and prosecutions for misratings are much more likely to happen in the free market. Suing the government is generally an exercise in futility, as each department displays no fault with bureaucratic aplomb.
(III) & (IV) Why are the banks so interconnected, and how can this be prevented?
The banking system is highly connected via the repo and swaps markets. The fall of one institution could mean the fall of all, as the asset book of a bank becomes less determinable as it's counter-parties default. As it becomes less determinable, the reserve ratio requirements and mark to market accounting become even more problematic. The bank is essentially bankrupt. For a small bank, this is a problem for counter-parties, but for a large bank, it is a system threating collapse.
The author proposes that banks be taxed not in proportion to their size, but in proportion to their connectedness to the market. Each trade entered into must be registered with a central institution, where the deal is valued in terms of risk and size. The total risk to the system of an institution should be composed of it's own outstanding debt, and a proportionate amount of it's nearest neighbours.
Hence as interconnectedness in terms of size and risk increase, the institutions forming this risk nexus should be taxed appropriately more.
A tax such as this on profits before wages that is relative to the proportion of risk that the institution poses to the system, not to itself. Given the current scale of the banks, this taxation would effectively be extremely punitive on bank earnings, however as executives realize a small institution is more profitable to them as an individual, they would be incentivised to start their own small banks.
The overall effect should be to force bankers into competition rather than into collaboration by preventing large institutions from making huge profits.
Trading with institutions in a jurisdiction which does not manage risk in the same way should be allowed, but have an extremely high risk profile to reflect the risk of the unknown.
Without uniformity in global systemic risk management, a crisis in one area can cause a crisis in another. It could be argued that America exported toxic debt and fetid banking. If a jurisdiction (aka fiscal area) is not prepared to impose risk curbs on its bank, local banks should be incentivised to avoid trading within the region.
• How can any country become so dependent on one industry?
Money has been the lifeblood of economies across the world for centuries. However if the control of money is centralized, the greater the risk a failure at this control point will effectively destroy the system. As discussed above the scale of large banks is now an implicit threat to any country that allows them to grow out of proportion to the economy that they exist in. And it must be asked how much do the executives know about their business? How can they continue to work in the financial services industry while overseeing a period that has effectively jeopardized the whole system? The claim is that who else can understand the complexities of modern finance? It's obvious that these people cant.
Bankers must face serious financial and personal losses in the face of failure.
The author proposes a stringent set of examinations similar to an actuary or a barrister for any person who wishes to become an executive of a bank. They should include banking history, economic theory and financial mathematics. Qualification should come at only serious personal cost (i.e. many years of personal study), and should be stripped away immediately in the event of failure. Top bankers should by law have undergone a training regime as rigorous as top surgeons or judges. As the recent crisis has shown, their role in society is in many was more powerful than other people in serious positions of responsibility.
To conclude:
Measure and tax systemic risk
Align incentives to financial products sold and created across their lifetime
Ensure that bankers know their business, and are barred from the industry on failure.
In any other business, most notably the current wave of environmentalism, taxation and responsibility are seen as good things. Why not banking?
• we have assets on our books that are not what we thought they are, we are now undercapitalised.
• If people know this, they will remove their money from our bank, this will cause a bank run.
• If we collapse, banks X and Y will collapse as well because they have assets we sold to them.
(IV) If we all collapse, your banking system will collapse.
(V) If the banking system collapses, your country will collapse. Therefore, you must help us.
Any cohesive solution to preventing this occurring again must deal with preventing this logic to ever hold true.
• How did the banks end up with these “faulty” assets?
A big topic, but lets consider a simple process. A retail bank lends to customers to purchase a house. The securitizers at an investment bank then buy these loans and package them into an issue, create the securizitaion vehicle and sell tranches to other institutions. Based on a rating given by an “authorised” entity banks and other institutions then pay an appropriate risk premium for the bundle of coupons all the individual retail borrowers pay. The advantage of this is that pension funds and insurance companies can invest in these assets which claim to be as secure as corporate bonds. At every point in this process, an individual is basing his expected year-end bonus on these deals going through: the retail bank adviser, the securitiser. the ratings agency advisor,the fund manager. However the security is expected to last on average 20 years.
Hence there is a duration mismatch in the risk profile of the individual and the institution. Any solution to the current banking crisis must minimize this risk.
The retail bank and the securitising institution should be forced to take a substantial piece of any “synthetic” product (e.g. 20% each). These “mirco-issues” should contain a piece of each tranche, in effect replicating exactly the payoffs for each institution. Bonuses for their employees should be paid annually from the coupons of these micro-issues. If the bank wishes to pay them more, then let them take a bigger share of the coupon, however they should be very aware that their own personal wealth is intimately linked to the product that they are creating.
(II) How can a retail bank end up with assets of ambiguous quality on it's books?
Were a retail bank to package and hold it's own debt, the loan quality of the book should be clear. They verified and created the mortgages. Instead were third parties are used to sell mortgages the quality is likely to decrease: the downside incentives for third party individuals are massively outweighed by volume related pay incentives. Hence a loan book of false creditworthiness and overestimated earnings claims.
The other side of this is large retail banks wanting to play in the interbank markets, buying and selling securities in a hope to create “alpha”. This has been sanctioned by executives at the top level who see peers performances and bonuses and hope to create the same for themselves. Buy buying poor quality opaque products with artificially secure ratings and apparently high yields, these executives encouraged their own staff to take bigger risks.
All of this was implicitly made possible by banks trusting ratings that proved to be in the short term “cheap”, but in the long run very expensive.
The rating agency model is completely conflicted where an agency is authorized by the government to define the quality of a securitized product. As the rating individuals involved see their year end bonus defined by the quality of the ratings they give, clearly they will always be proposed to “do business”, rather than “do analysis”. As they are government sponsored, a competing independent agency is always considered a lesser value analysis. The author proposes an end to “certified ratings agencies”, and an open platform for securitisation vehicles to present the credit worthiness of their underlying mortgages. Hence independent analysis houses can access this information and provide independent reports to funds and banks who are interested in these products. The increased competition and reputational damage of poor analysis would likely cause margins to drop, and prosecutions for misratings are much more likely to happen in the free market. Suing the government is generally an exercise in futility, as each department displays no fault with bureaucratic aplomb.
(III) & (IV) Why are the banks so interconnected, and how can this be prevented?
The banking system is highly connected via the repo and swaps markets. The fall of one institution could mean the fall of all, as the asset book of a bank becomes less determinable as it's counter-parties default. As it becomes less determinable, the reserve ratio requirements and mark to market accounting become even more problematic. The bank is essentially bankrupt. For a small bank, this is a problem for counter-parties, but for a large bank, it is a system threating collapse.
The author proposes that banks be taxed not in proportion to their size, but in proportion to their connectedness to the market. Each trade entered into must be registered with a central institution, where the deal is valued in terms of risk and size. The total risk to the system of an institution should be composed of it's own outstanding debt, and a proportionate amount of it's nearest neighbours.
Hence as interconnectedness in terms of size and risk increase, the institutions forming this risk nexus should be taxed appropriately more.
A tax such as this on profits before wages that is relative to the proportion of risk that the institution poses to the system, not to itself. Given the current scale of the banks, this taxation would effectively be extremely punitive on bank earnings, however as executives realize a small institution is more profitable to them as an individual, they would be incentivised to start their own small banks.
The overall effect should be to force bankers into competition rather than into collaboration by preventing large institutions from making huge profits.
Trading with institutions in a jurisdiction which does not manage risk in the same way should be allowed, but have an extremely high risk profile to reflect the risk of the unknown.
Without uniformity in global systemic risk management, a crisis in one area can cause a crisis in another. It could be argued that America exported toxic debt and fetid banking. If a jurisdiction (aka fiscal area) is not prepared to impose risk curbs on its bank, local banks should be incentivised to avoid trading within the region.
• How can any country become so dependent on one industry?
Money has been the lifeblood of economies across the world for centuries. However if the control of money is centralized, the greater the risk a failure at this control point will effectively destroy the system. As discussed above the scale of large banks is now an implicit threat to any country that allows them to grow out of proportion to the economy that they exist in. And it must be asked how much do the executives know about their business? How can they continue to work in the financial services industry while overseeing a period that has effectively jeopardized the whole system? The claim is that who else can understand the complexities of modern finance? It's obvious that these people cant.
Bankers must face serious financial and personal losses in the face of failure.
The author proposes a stringent set of examinations similar to an actuary or a barrister for any person who wishes to become an executive of a bank. They should include banking history, economic theory and financial mathematics. Qualification should come at only serious personal cost (i.e. many years of personal study), and should be stripped away immediately in the event of failure. Top bankers should by law have undergone a training regime as rigorous as top surgeons or judges. As the recent crisis has shown, their role in society is in many was more powerful than other people in serious positions of responsibility.
To conclude:
Measure and tax systemic risk
Align incentives to financial products sold and created across their lifetime
Ensure that bankers know their business, and are barred from the industry on failure.
In any other business, most notably the current wave of environmentalism, taxation and responsibility are seen as good things. Why not banking?
SOW - Sam Birmingham
1. Wholesale Debt: Risks & Benefits
Australian lenders have increasingly relied on wholesale debt markets to fund the expansion of domestic loan books.
Benefits of wholesale debt issuance include:
• Expanded Lending: There is a finite pool of domestic funding (equity capital, customers deposits, etc) available to retail lenders. In the absence of further capital, domestic lending would be severely curtailed, with negative implications for asset values, business investment and so on.
• Efficiency: The globalisation of finance and development of wholesale debt markets provides retail lenders with access to significantly larger and more efficient pools of capital.
• Price: As a consequence of these efficiencies, retail lenders are (or at least should be) able to secure funding at a lower cost than would otherwise be the case.
However, sourcing capital from wholesale debt markets is not without risk. Such risks include:
• Liquidity Events: In the event of another GFC-type situation, the liquidity of wholesale debt markets could be severely constrained – particularly in circumstances where foreign debt providers are pressured to repatriate funds to support their local economy. Such global liquidity events leave our lenders starved of capital – potentially at a time when they need it most.
• Maturity Profiles: As is typical of the liability side of retail lenders’ balance sheets, there tends to be a mismatch between the maturity profile of wholesale debt and the assets that it is used to fund. When such mismatches occurred in the GFC, banks were forced to roll over short-term wholesale debt at significantly higher margins – putting pressure on their profitability and/or customers’ finances in the process.
• Currency Risk: Unless appropriately hedged, the AU$ burden of foreign currency-denominated debt could increase in the event that our currency depreciates. As with global liquidity events (above), such situations tend to occur when our domestic economy can least afford it.
These risks can be mitigated by increasing the pool of domestic savings upon which retail lenders’ might draw to fund their lending activities. This could be achieved in various ways: from providing tax concessions on bank deposits and boosting superannuation savings, to freeing up franking credits or establishing a sovereign wealth fund. 2. Government Guarantee of Bank’s Wholesale Debt
On 12th October 2008, the Rudd Government announced the guarantee of deposits up to $1m in authorised deposit-taking institutions (“ADIs”), as well as guaranteeing wholesale debt securities issued by ADIs, in exchange for a fee. This guarantee applied for debt terms up to five years, with the fee based upon the credit rating of the security in question (from 70bp for AA-rated issues to 150bp for BBB and unrated issues).
The window for guaranteed wholesale debt issues closed on 31st March, 2010. At this time, the amount of guaranteed debt outstanding was $166b – equating to approximately 7% of total ADI liabilities – the vast majority of which was long-term debt (maturities from 15 months to 5 years).
From a revenue perspective, the fees paid by ADIs who took advantage of the guarantee contribute some $100m per month to Government’s coffers
(Note: This amount will steadily decline until 5 years after the last guaranteed debt securities were issued, as guaranteed debts expire / are rolled over). Nonetheless, it must be noted that this income is not earned without risks to the nation’s finances.
Guaranteed debt represents a significant contingent liability on the Government’s balance sheet. Whilst the likelihood of the guarantee being called upon may still seem remote to many, one can’t help but be reminded of the Irish Government’s ill-fated guarantee of its own banking sector… *ahem*
3. Role of Securitisation
To the extent that it provides for the efficient allocation of capital, securitisation is an example of productive financial innovation.
However, over recent decades the securitisation market grew to such an extent that its overall benefits were outweighed by the risks involved in bundling up huge volumes of securities where risks were poorly understood and severely mispriced (until the GFC saw them re-priced, that is).
These ballooning risks were largely a consequence of misaligned incentives and responsibilities, and a lack of transparency:
• Issuers were encouraged to sell ever-increasing volumes of the securities in order to “feed the beast” – with sales staff and their managers enjoying massive bonuses as a result of their efforts;
• Ratings agencies were paid by the issuer, giving rise to perceptions that their ratings were more generous than should have been the case;
• And so on.
Given that securitisation played such a significant role in fuelling the global property boom, subsequent sub-prime meltdown in the US and the ensuing Global Financial Crisis, it would be easy to write off securitisation as “the spawn of the devil” and throw it in the financial innovation trash-can.
But should that really be the case? After all, securitisation can be beneficial to the extent that it provides for the efficient allocation of capital.
The problem is that it came to play far too central a role in financial markets – with all lending institutions relying on it to some degree and business models of certain non-bank lenders imploding when securitisation markets froze.
If securitisation is to continue, regulators should give special consideration to:
Concentration of Risk
Regulators must first consider the overall volume of funding sourced via securitisation programs and the risk that reliance on such programs places on the lending market as a whole.
Further, they should consider the importance of securitisation to individual institutions – particularly those who rely heavily on securitised funding and (as was the case with RAMS during the GFC) who may not be able to survive in the event of dislocations in securitisation markets.
In such situations, regulators should give consideration not only to the financial circumstances of the lender in question, but also to their position within the overall mortgage market and ensuring that a suitable level of competition is maintained.
Perhaps lenders who rely more heavily on securitisation could also be required to set aside additional capital under capital adequacy provisions?
Government Support
Through the AOFM, our Government has now agreed to provide up to $20b ($4b of which was announced by Treasurer Wayne Swan this past weekend) of liquidity to the domestic RMBS market. However, we have not yet had a legitimate debate on the extent to which taxpayers should be “on the hook” for any defaults under this program.
If the Government feels the need to “step in” to stimulate this market (ie. there is insufficient demand for RMBS from private investors), doesn’t that answer the question as to whether these securities are appropriately priced and that the Government may be exposing taxpayers to an unreasonable risk of capital losses?
How appropriate is it for the Government to invest in RMBS, particularly in circumstances where there may be better uses for limited Government funds?
Is this program solely designed to ward off an imminent housing market collapse, or does it genuinely enhance competition?
And from a generational equity perspective, young Australians already face sky-high house prices and previously unfathomable debt burdens in order to simply “get a foot in the property market”… Should we really be shackling these generations with the risk of capital loss on such public investments on top of their own private losses in the event of a housing market decline?
4. Restoring Competition
Before considering how best to return competition to the financial services sector, one must first consider whether competition has actually diminished.
Admittedly, since wholesale debt markets froze during the GFC and non-banks have subsequently struggled to finance the expansion of their mortgage books, up to 90% of home loans have been written by “The Big Four” banks. At the same time, our major lenders have increased their variable interest rates beyond the scope of RBA rate hikes on a number of occasions… But is this really a product of the lack of competition?
I submit that it is not so much a lack of competition that is the problem, but a lack of sustainable competition.
In response to the Treasurer’s reform package announced over the weekend, Bank of Queensland CEO, Graham Liddy, argued that:
“You can access funding today, but it’s still the cost that is the anti-competitive issue”
Similarly, in its submission to the Senate Inquiry into Competition in the Banking Sector, CUA argued that:
“(O)ne of the major factors restricting competition within the Australian banking sector is the difficulty CUA and other customer-owned financial institutions have in accessing reasonably priced funding from both domestic and overseas markets.
Sadly, both BOQ and CUA fail to grasp the difference between competition and sustainable competition.
Let us consider for a moment that the levels of competition prior to the GFC were not sustainable – after all, the business models of various non-bank lenders who aggressively drove margins down over the preceding years collapsed as soon as (excessively) cheap money sources dried up.
Accordingly, the goal of reform should not be to return the competitive framework to pre-GFC levels.
Furthermore, the goal of sustainable competition should not be driven solely by price considerations (ie. interest rate changes) and allegations of “blatant gouging” (I’m looking at you, Joe Hockey).
After all, relying on competition to drive down lending margins is not sustainable anyway, because once borrowers expect that the reductions will continue, they feel confident to assume a larger debt and any “savings” are quickly capitalised into higher asset prices… Then we’re back to square one.
Australian lenders have increasingly relied on wholesale debt markets to fund the expansion of domestic loan books.
Benefits of wholesale debt issuance include:
• Expanded Lending: There is a finite pool of domestic funding (equity capital, customers deposits, etc) available to retail lenders. In the absence of further capital, domestic lending would be severely curtailed, with negative implications for asset values, business investment and so on.
• Efficiency: The globalisation of finance and development of wholesale debt markets provides retail lenders with access to significantly larger and more efficient pools of capital.
• Price: As a consequence of these efficiencies, retail lenders are (or at least should be) able to secure funding at a lower cost than would otherwise be the case.
However, sourcing capital from wholesale debt markets is not without risk. Such risks include:
• Liquidity Events: In the event of another GFC-type situation, the liquidity of wholesale debt markets could be severely constrained – particularly in circumstances where foreign debt providers are pressured to repatriate funds to support their local economy. Such global liquidity events leave our lenders starved of capital – potentially at a time when they need it most.
• Maturity Profiles: As is typical of the liability side of retail lenders’ balance sheets, there tends to be a mismatch between the maturity profile of wholesale debt and the assets that it is used to fund. When such mismatches occurred in the GFC, banks were forced to roll over short-term wholesale debt at significantly higher margins – putting pressure on their profitability and/or customers’ finances in the process.
• Currency Risk: Unless appropriately hedged, the AU$ burden of foreign currency-denominated debt could increase in the event that our currency depreciates. As with global liquidity events (above), such situations tend to occur when our domestic economy can least afford it.
These risks can be mitigated by increasing the pool of domestic savings upon which retail lenders’ might draw to fund their lending activities. This could be achieved in various ways: from providing tax concessions on bank deposits and boosting superannuation savings, to freeing up franking credits or establishing a sovereign wealth fund. 2. Government Guarantee of Bank’s Wholesale Debt
On 12th October 2008, the Rudd Government announced the guarantee of deposits up to $1m in authorised deposit-taking institutions (“ADIs”), as well as guaranteeing wholesale debt securities issued by ADIs, in exchange for a fee. This guarantee applied for debt terms up to five years, with the fee based upon the credit rating of the security in question (from 70bp for AA-rated issues to 150bp for BBB and unrated issues).
The window for guaranteed wholesale debt issues closed on 31st March, 2010. At this time, the amount of guaranteed debt outstanding was $166b – equating to approximately 7% of total ADI liabilities – the vast majority of which was long-term debt (maturities from 15 months to 5 years).
From a revenue perspective, the fees paid by ADIs who took advantage of the guarantee contribute some $100m per month to Government’s coffers
(Note: This amount will steadily decline until 5 years after the last guaranteed debt securities were issued, as guaranteed debts expire / are rolled over). Nonetheless, it must be noted that this income is not earned without risks to the nation’s finances.
Guaranteed debt represents a significant contingent liability on the Government’s balance sheet. Whilst the likelihood of the guarantee being called upon may still seem remote to many, one can’t help but be reminded of the Irish Government’s ill-fated guarantee of its own banking sector… *ahem*
3. Role of Securitisation
To the extent that it provides for the efficient allocation of capital, securitisation is an example of productive financial innovation.
However, over recent decades the securitisation market grew to such an extent that its overall benefits were outweighed by the risks involved in bundling up huge volumes of securities where risks were poorly understood and severely mispriced (until the GFC saw them re-priced, that is).
These ballooning risks were largely a consequence of misaligned incentives and responsibilities, and a lack of transparency:
• Issuers were encouraged to sell ever-increasing volumes of the securities in order to “feed the beast” – with sales staff and their managers enjoying massive bonuses as a result of their efforts;
• Ratings agencies were paid by the issuer, giving rise to perceptions that their ratings were more generous than should have been the case;
• And so on.
Given that securitisation played such a significant role in fuelling the global property boom, subsequent sub-prime meltdown in the US and the ensuing Global Financial Crisis, it would be easy to write off securitisation as “the spawn of the devil” and throw it in the financial innovation trash-can.
But should that really be the case? After all, securitisation can be beneficial to the extent that it provides for the efficient allocation of capital.
The problem is that it came to play far too central a role in financial markets – with all lending institutions relying on it to some degree and business models of certain non-bank lenders imploding when securitisation markets froze.
If securitisation is to continue, regulators should give special consideration to:
Concentration of Risk
Regulators must first consider the overall volume of funding sourced via securitisation programs and the risk that reliance on such programs places on the lending market as a whole.
Further, they should consider the importance of securitisation to individual institutions – particularly those who rely heavily on securitised funding and (as was the case with RAMS during the GFC) who may not be able to survive in the event of dislocations in securitisation markets.
In such situations, regulators should give consideration not only to the financial circumstances of the lender in question, but also to their position within the overall mortgage market and ensuring that a suitable level of competition is maintained.
Perhaps lenders who rely more heavily on securitisation could also be required to set aside additional capital under capital adequacy provisions?
Government Support
Through the AOFM, our Government has now agreed to provide up to $20b ($4b of which was announced by Treasurer Wayne Swan this past weekend) of liquidity to the domestic RMBS market. However, we have not yet had a legitimate debate on the extent to which taxpayers should be “on the hook” for any defaults under this program.
If the Government feels the need to “step in” to stimulate this market (ie. there is insufficient demand for RMBS from private investors), doesn’t that answer the question as to whether these securities are appropriately priced and that the Government may be exposing taxpayers to an unreasonable risk of capital losses?
How appropriate is it for the Government to invest in RMBS, particularly in circumstances where there may be better uses for limited Government funds?
Is this program solely designed to ward off an imminent housing market collapse, or does it genuinely enhance competition?
And from a generational equity perspective, young Australians already face sky-high house prices and previously unfathomable debt burdens in order to simply “get a foot in the property market”… Should we really be shackling these generations with the risk of capital loss on such public investments on top of their own private losses in the event of a housing market decline?
4. Restoring Competition
Before considering how best to return competition to the financial services sector, one must first consider whether competition has actually diminished.
Admittedly, since wholesale debt markets froze during the GFC and non-banks have subsequently struggled to finance the expansion of their mortgage books, up to 90% of home loans have been written by “The Big Four” banks. At the same time, our major lenders have increased their variable interest rates beyond the scope of RBA rate hikes on a number of occasions… But is this really a product of the lack of competition?
I submit that it is not so much a lack of competition that is the problem, but a lack of sustainable competition.
In response to the Treasurer’s reform package announced over the weekend, Bank of Queensland CEO, Graham Liddy, argued that:
“You can access funding today, but it’s still the cost that is the anti-competitive issue”
Similarly, in its submission to the Senate Inquiry into Competition in the Banking Sector, CUA argued that:
“(O)ne of the major factors restricting competition within the Australian banking sector is the difficulty CUA and other customer-owned financial institutions have in accessing reasonably priced funding from both domestic and overseas markets.
Sadly, both BOQ and CUA fail to grasp the difference between competition and sustainable competition.
Let us consider for a moment that the levels of competition prior to the GFC were not sustainable – after all, the business models of various non-bank lenders who aggressively drove margins down over the preceding years collapsed as soon as (excessively) cheap money sources dried up.
Accordingly, the goal of reform should not be to return the competitive framework to pre-GFC levels.
Furthermore, the goal of sustainable competition should not be driven solely by price considerations (ie. interest rate changes) and allegations of “blatant gouging” (I’m looking at you, Joe Hockey).
After all, relying on competition to drive down lending margins is not sustainable anyway, because once borrowers expect that the reductions will continue, they feel confident to assume a larger debt and any “savings” are quickly capitalised into higher asset prices… Then we’re back to square one.
SOW - Andrew Selby Smith
1) What are the risks and benefits of large bank wholesale debt and how should each be addressed?
The risk is that the capital borrowings by the large banks to meet their prudential liquidity requirements are generally shorter term than the mortgage assets that the banks are borrowing against. This leads to bank risk as the banks do not own the capital that they are using to secure their assets - which would be a much more desirable state of affairs. The benefit is that these borrowings provide a home for Australian capital, for which the RBA would otherwise need to sell Commonwealth Government securities - but this is a statement of fact rather than of any particular benefit - there is no reason why the RBA cannot increase their sales of securities in order to soak up foreign capital lookingfor a home.
2) What, precisely, is the ongoing status of the Federal government guarantee to the large banks' wholesale debts and what are the implications for the Budget?
The effect of the guarantee is to increase the security of bank borrowings by reducing the default risk to the owners of the foreign capital. This has run-on effects of enabling the banks to continue their mortgage credit creation and of putting off any correction. The main implication to the Budget is in the case of widespread mortgage defaults, or in the case of a bank run. If either of these happen, then the RBA will be required to spend more capital into existence, in order to make good on bad debt. This will have the effect of increasing the money supply - but the short term issue of excess supply can readily be handled by increasing bond sales in order to soak up the excess capital in the system. The long term issue is that increased capital creation, or increased volumes of securities, increases the potential claims on real Australian assets by the holders of the capital or the securities.
3) Given securitisation was at the centre of the GFC, what role should it play in renewed competition?
It should be banned outright - it is disturbing that an originating bank can pass the risk on to some other party who was not involved in the assessment of the original mortgage loan. The risk should remain with the party who benefits from the taking of that risk, and who is best placed to assess the level of that risk - in this case the originating bank.
The banking system needs to be overhauled, according to a principle that risk remains with the party responsible for the original creation of that risk.
Competition is a red herring - the widespread discussion of competition in the banking sector appears to be based on the idea that there is a limited supply of credit available for loan. This is not correct. The amount of credit that can be loaned into existence is limited solely by the willingness of the banks to make those loans, and by the willingness of borrowers to borrow. In the absence of foreign capital, the capital required to back these loans can be paid to the banks through RBA repurchases of securities held by the banks, as part of their interest rate control role. This would be a natural consequence of the interest rate control mechanism targeting a specific level of capital reserves in the system. This process is only limited by the volume of securities held by the banks that can be exchanged for capital.
Based on the fact that banks can effectively loan credit into existence at no cost, and charge for this service, a convincing argument can be made that credit should be under the control of Government, rather than under the control of private corporations.
I propose that rather than guaranteeing bank funding, the Government should put an additional condition on this guarantee - that if the guarantee is called upon, the shareholders and management will be wiped out and the bank pass to Commonwealth ownership and control. This creates a strong incentive for the shareholders and owners to ensure that the bank remains solvent, even at the extent of significant haircuts to the value of their personal holdings of bank shares. Once the bank passes to Commonwealth control, it should remain under Commonwealth control, all bank credit converted to real capital, and bank fees and charges abolished. In addition, all management should be paid public sector salaries to continue to run the bank - as an accounting exercise rather than as a risk-assessment and risk-taking exercise.
It is scandalous that we have allowed the commercial banks to take control of the credit creation process, when credit and money are properly community assets, that we require for the purchase of food, accommodation, health care, education, and the many other things that we require to live healthy and satisfying lives. Instead, credit creation has become a mechanism by which the banks have been able to turn Australian assets, such as housing, into vehicles for massive private bank profits.
4) How can competition be returned to the financial services sector, as well as balanced against the need for stability in the light of the first three questions?
Competition is a red herring, as discussed in the answer to the last question. The interests of the Australian community are NOT best served by having the credit creation process under private control. OUr money and credit supply need to remain under community control, through the agent of our Commonwealth Government. Having Government control of the banking system, and at the very least significant constrictions on credit creation, would serve to dramatically reduce risk in our banking system.
The lack of free credit creation can be easily compensated for by Federal spending of capital into existence, in order to create employment, encourage desirable activities and infrastructure creation, and to provide a sufficient money supply for the functioning of the Australian economy. Excess money supply can be guarded against by having a floating rent tax, which is levied on the productive assets of the entire Australian community - that is, our mineral resources, our fossil fuel resources and our land. A floating rent tax would have the advantage of increasing the efficiency with which resources are used - which, particularly in the case of suburban land, would be highly desirable. A floating rent tax would also be easily adjustable to adjust the rate of withdrawal of capital from the system - an essential counterpoint to control of Government spending.
This arrangement would have the intriguing benefit of providing a range of spending and taxing rates that maintain a constant volume of capital in the economy - one with a low taxing and low spending Government, and another with a high taxing and high spending Government. Such an arrangement has real potential to ensure an adequate money supply for all Australians, and also to enable heavy investment in the infrastructure required by an Australia beginning to face up to the realities of climate change and energy depletion. The rate of credit flow through the economy could be very effectively controlled by this mechanism - with money flow rates decreased to match reductions in available resources, since economic activity will need to reduce to match reduced resource and energy availability as they begin to decline, while still not reducing the ability of Australian citizens to buy the essentials of daily life. Government would also have significant discretion over where money is spent into existence - in an economy subject to a food shortage, for instance, the Government could pay credit to all Australian citizens in order to enable them to buy food, while still maintaining the taxing mechanism for capital removal - this would have the effect of directing economic activity towards food production.
The recent focus on "bank competition" is far too narrow, and should be widened instead to a general community discussion in which we gain a collective understanding of how the Australian financial system operates, and in which we begin to see money as a tool that can be used to attain desirable social, environmental, technological and infrastructural objectives, rather than as a desirable thing of itself - as is the case with the current obsession with high house prices!
The risk is that the capital borrowings by the large banks to meet their prudential liquidity requirements are generally shorter term than the mortgage assets that the banks are borrowing against. This leads to bank risk as the banks do not own the capital that they are using to secure their assets - which would be a much more desirable state of affairs. The benefit is that these borrowings provide a home for Australian capital, for which the RBA would otherwise need to sell Commonwealth Government securities - but this is a statement of fact rather than of any particular benefit - there is no reason why the RBA cannot increase their sales of securities in order to soak up foreign capital lookingfor a home.
2) What, precisely, is the ongoing status of the Federal government guarantee to the large banks' wholesale debts and what are the implications for the Budget?
The effect of the guarantee is to increase the security of bank borrowings by reducing the default risk to the owners of the foreign capital. This has run-on effects of enabling the banks to continue their mortgage credit creation and of putting off any correction. The main implication to the Budget is in the case of widespread mortgage defaults, or in the case of a bank run. If either of these happen, then the RBA will be required to spend more capital into existence, in order to make good on bad debt. This will have the effect of increasing the money supply - but the short term issue of excess supply can readily be handled by increasing bond sales in order to soak up the excess capital in the system. The long term issue is that increased capital creation, or increased volumes of securities, increases the potential claims on real Australian assets by the holders of the capital or the securities.
3) Given securitisation was at the centre of the GFC, what role should it play in renewed competition?
It should be banned outright - it is disturbing that an originating bank can pass the risk on to some other party who was not involved in the assessment of the original mortgage loan. The risk should remain with the party who benefits from the taking of that risk, and who is best placed to assess the level of that risk - in this case the originating bank.
The banking system needs to be overhauled, according to a principle that risk remains with the party responsible for the original creation of that risk.
Competition is a red herring - the widespread discussion of competition in the banking sector appears to be based on the idea that there is a limited supply of credit available for loan. This is not correct. The amount of credit that can be loaned into existence is limited solely by the willingness of the banks to make those loans, and by the willingness of borrowers to borrow. In the absence of foreign capital, the capital required to back these loans can be paid to the banks through RBA repurchases of securities held by the banks, as part of their interest rate control role. This would be a natural consequence of the interest rate control mechanism targeting a specific level of capital reserves in the system. This process is only limited by the volume of securities held by the banks that can be exchanged for capital.
Based on the fact that banks can effectively loan credit into existence at no cost, and charge for this service, a convincing argument can be made that credit should be under the control of Government, rather than under the control of private corporations.
I propose that rather than guaranteeing bank funding, the Government should put an additional condition on this guarantee - that if the guarantee is called upon, the shareholders and management will be wiped out and the bank pass to Commonwealth ownership and control. This creates a strong incentive for the shareholders and owners to ensure that the bank remains solvent, even at the extent of significant haircuts to the value of their personal holdings of bank shares. Once the bank passes to Commonwealth control, it should remain under Commonwealth control, all bank credit converted to real capital, and bank fees and charges abolished. In addition, all management should be paid public sector salaries to continue to run the bank - as an accounting exercise rather than as a risk-assessment and risk-taking exercise.
It is scandalous that we have allowed the commercial banks to take control of the credit creation process, when credit and money are properly community assets, that we require for the purchase of food, accommodation, health care, education, and the many other things that we require to live healthy and satisfying lives. Instead, credit creation has become a mechanism by which the banks have been able to turn Australian assets, such as housing, into vehicles for massive private bank profits.
4) How can competition be returned to the financial services sector, as well as balanced against the need for stability in the light of the first three questions?
Competition is a red herring, as discussed in the answer to the last question. The interests of the Australian community are NOT best served by having the credit creation process under private control. OUr money and credit supply need to remain under community control, through the agent of our Commonwealth Government. Having Government control of the banking system, and at the very least significant constrictions on credit creation, would serve to dramatically reduce risk in our banking system.
The lack of free credit creation can be easily compensated for by Federal spending of capital into existence, in order to create employment, encourage desirable activities and infrastructure creation, and to provide a sufficient money supply for the functioning of the Australian economy. Excess money supply can be guarded against by having a floating rent tax, which is levied on the productive assets of the entire Australian community - that is, our mineral resources, our fossil fuel resources and our land. A floating rent tax would have the advantage of increasing the efficiency with which resources are used - which, particularly in the case of suburban land, would be highly desirable. A floating rent tax would also be easily adjustable to adjust the rate of withdrawal of capital from the system - an essential counterpoint to control of Government spending.
This arrangement would have the intriguing benefit of providing a range of spending and taxing rates that maintain a constant volume of capital in the economy - one with a low taxing and low spending Government, and another with a high taxing and high spending Government. Such an arrangement has real potential to ensure an adequate money supply for all Australians, and also to enable heavy investment in the infrastructure required by an Australia beginning to face up to the realities of climate change and energy depletion. The rate of credit flow through the economy could be very effectively controlled by this mechanism - with money flow rates decreased to match reductions in available resources, since economic activity will need to reduce to match reduced resource and energy availability as they begin to decline, while still not reducing the ability of Australian citizens to buy the essentials of daily life. Government would also have significant discretion over where money is spent into existence - in an economy subject to a food shortage, for instance, the Government could pay credit to all Australian citizens in order to enable them to buy food, while still maintaining the taxing mechanism for capital removal - this would have the effect of directing economic activity towards food production.
The recent focus on "bank competition" is far too narrow, and should be widened instead to a general community discussion in which we gain a collective understanding of how the Australian financial system operates, and in which we begin to see money as a tool that can be used to attain desirable social, environmental, technological and infrastructural objectives, rather than as a desirable thing of itself - as is the case with the current obsession with high house prices!
SOW - Robert Coulter
1. Background
1. What my comments address.
1.1 The thrust of the 4 published questions (Business Day 24/11/10-David Llewellyn-Smith) raises basically 2 issues against a GFC backdrop.
1.2 First Issue -The risks and benefits of Australian 4 pillar banks (“4PB”) and their present wholesale debt fund raising strategies including the use/future use of Federal Government guarantee.
1.3 Second Issue- Increased competition in the financial services sector with the measure of success being progressing the ability of the non 4 PB competitors: smaller banks and others being able to compete on a more equal footing by reducing their cost of funds in those market sectors in which there is a capacity against the 4 PB. The role of securitization in this process.
1.4 Both issues must have regard to the continued stability of the financial sector.
2. Some General Observations
2.1 This article takes into account the Federal treasure’s policy paper published 12/12/10
2. 2 The test of commercial reality should be applied to any changes to be introduced in legislative form or by widening of powers in ACCC & APRA.
2.3 Any quarantining by the Federal Government of an area of fund raising or lending by application of law may cause an aberration in market forces with unknown unquantified outcomes.
2.4 It is interesting to note how various Governments reacted to the GFC for their major banks-UK took equity, USA loan funds and equity and Australia by guarantee.
2.5 What are the substantive issue(s) in this debate and hue & cry surrounding it?
In my view, having read most of the headlines and articles in the media and other public forums it comes down to the Government attempting to unravel what is perceived to be a monopolistic market place in which the 4 PB operate, created, in part, by successive Governments for the stability of the financial sector as a whole. This is to be achieved by legislative changes which are yet to presented and debated but now subject of announced policy. This is in response to a perception that the heirachery of the 4 PB are acting indifferently and hence arrogantly, to requests from the Government over some time to loosen up competition. One of the platforms of attack from the Government and others is that the 4 PB should accept as a yardstick for cost of fund increases/decreases by adopting the RBA determined amount of + or – cash deposit rate changes. A mechanism in place to arrest inflation and relevant only in part to cost of fund calculations. It is reported that over the last 12 months nearly all lenders have increased their lending margin over the RBA yardstick. It is interesting to note that the RBA, in its recent submission to the Senate Banking enquiry, put forward a view concerning the most recent rise of 25 basis points that all that was justified in real cost of fund increases by the 4 PB was no more than the increase in the RBA’s increase in deposit rate. This could mean that the RBA considers that the 4 PB are a little over the odds in pleading justification this time around.
A sobering thought is if the 4 PB through their boards and senior management had been a little more street-wise then this entire ruckus perhaps could have been avoided and their respective shareholders and rating agencies could have concluded business as usual.
3. Issue one
3.1The balance sheet of a Bank and any other competitor is all important for commercial well being; credit rating; stock market value; interbank limits; credit risk standing for depositor of funds; and regulatory supervision. Prior to, during and since the GFC, the 4 PB measured up well under all of the above criteria. A commentator recently said that 45% of the funding book should be funded offshore with the 4 PB doubling their size and diversifying offshore to remain a competitive force in world standings and provide for a better mix of income streams.
3.2 Large wholesale debt can be offshore and onshore. The form of borrowing is diversified, with staggered maturities and an expectation of rollovers on maturity. Therefore, the cost of funds can be just as diversified in measurement. Matched book borrowing and lending defines with certainty the earn margin.
3.3 The RBA cash deposit rate is only one factor in funding costs and this appears to be common ground by those aware of the commercial issues.
3.4 The principle risks of 4 PB wholesale debts are:
Offshore
-borrowing to fund onshore transactions-currency exchange rate-risk management contracts and systems can be engaged to minimize risk
-lack of liquidity on rollovers (GFC experience) and as a consequence substantial increased funding costs (these were largely avoided though use of Fed Government guarantee). What would have been the outcome if no guarantee had been made available? The 4 PB say that new replacement wholesale debt, without the Fed Guarantee is at a higher cost due to market place forces and no doubt this is the case. A free market place determines the cost of supply.
Onshore
-the need to have an ever increasing deposit base is diminished in real terms
3.5 The principle benefits of 4 PB wholesale debts are:
-Should be cheaper in reasonable times as a source of funds. Offshore business makes it necessary to have foreign wholesale debt.
-Can structure hybrid instruments as a tool in capital adequacy.
-Can have a range of staggered maturities which is good for liquidity pressures and also relevant to profile of lending/investment book.
There are pros and cons; however as in common with most large corporates they have to access foreign debt as a source of funding their book.
It will be business as usual for the large 4 PB without the Fed guarantee. However it may be some comfort that the same may be available if anything approaching a GFC (tantamount to a threat to systemic failure) was to present itself in the future. The mechanism is now proven.
4. Issue Two
4.1 This is the more interesting side of the debate.
4.2 All things being equal on marketing, efficiency, and service from all competitors to a notional borrower for a house / business loan what is the broad thrust of requested main changes to be made to boost competition?
From submissions made by various parties from the non 4 PB competitors and others appearing before the current Senate Banking enquiry-raise these points:-
-capital adequacy rules should be revisited in home mortgage sector. In short APRA should loosen up to get more leverage on increased debt and therefore the recycling of funds for new loans. If this change was made only for the small end then it would be a structural intervention.
-Revitalizing the securitization market (the selling of securities in mortgage backed securities with AAA rating) by 2 measures. First to increase funding from the Federal Government over and above the $16B recently made available and secondly to “encourage” the participation of new investors such as super funds in addition to the traditional institutional investors. This would help in accessing liquidity at reasonable pricing. This process has been interrupted by the GFC and regeneration needs to be continued. This is a non structural intervention.
-Immediately reduce the cost of the Fed Guarantee where currently employed. It permits more competitive pricing and the lender makes presumably the same margin. The only party losing out is the tax payer through a lower return.
-Guarantee the mortgage insurance on loans subject of securitization thereby reducing costs. This is a structural intervention.
-The facilitation of changing a lender relationship on a cost effective and timely basis. “A separate survey from Essential research found 37 per cent of bank customers had considered leaving a major bank after this month’s interest rate rises in excess of Reserve Bank movements”. This can be a structural intervention.
-A new borrowing vehicle, initially supported by 25 credit unions, which has been in the making for 12 months and is targeting $1B of new funds for mortgage lending with funding targeted from Super funds and global markets the offered security being a rated financial instrument. APRA, it is reported is comfortable. The form of requested Government support is to be a cornerstone investor. It is hoped that familiarity and market acceptance will be taken up by the other players in this grouping which “there are 126 credit unions and mutual building societies in Australia representing $73 B worth of assets, 4.6 million members and more than 7% of the new home loan market”. This will assist in reducing the cost of funds. This is not a structural intervention.
-An extension of the Fed guarantee to wholesale debt instruments, presumably on / offshore, to provide a AAA rating for the non 4 PB competitors. To support the establishment of a 5th pillar to be competitive against the 4 PB. This is a structural intervention.
-Remove ban on sale of covered bonds.
4.3 Financial Stability
There seems to be some common ground on caution of structural intervention;
-UBS said the “5th pillar idea is potentially risky and would require massive increase in activity from small lenders. To be a credible 5th force with a 10% share of all mortgages and deposits, credit unions would have to raise their lending from $50B today to $144B in 4 years. Achieving this growth while keeping leverage ratios intact would require ‘them’ to find an extra $8B of capital to go more than double the $5.9B the sector holds”.
-Abacus spokesperson (represents credit unions and building societies) “As well as highlighting the funding task, the 5th pillar idea also posed potential risk to financial stability. Competition and financial stability had an inverse relationship as demonstrated in recent years”.
-The 4 PB in their respective submissions to the Senate Banking enquiry amongst other things stated in response to the 5th pillar idea
-unintended consequences could result in the taking of bigger and possibly dangerous risks in chasing market share.
5. The Fed Treasurer’s policy statement released 12/12/10 (format partially adopted from SMH 13/12/10)
What’s in?
As to lowering cost of funds-Deposit guarantee extended indefinitely, although threshold of $1m could change
-Government protected deposit logo to be available
-Government to increase its investment pool for securitization from $16B to $20B
-All banks are able to sell covered bonds
As to increasing competition
-Inquiry into account number portability
-Mutual’s fast tracked to become banks
-Increased power to ASIC & ACCC to better monitor & prosecute signaling
-Standard fact sheet to be supplied by all banks for mortgage offers
What’s not?
-No guarantee for wholesale debt
-Outright ban on mortgage exit fees (to change existing contracts without compensation unconstitutional)
-“tracker mortgages” with fixed margins
-Limits on how much banks can charge
-Australia Post competing as a bank
-New financial system enquiry
-Bank super profits tax
-The creation of a 5 th PB (perhaps just to complicated)
5. Some conclusions
5.1The jury is still out as to whether or not there is a lack of competitive forces under the present regime. Most recent statistics indicate that the non 4 PB competitors are writing more new home mortgage loans than the 4 PB
5.2 No structural changes should occur unless they have been thought through.
The Fed guarantee for the non 4 PB competitors is available on deposits (not available for wholesale debt) and is proposed to be issued in perpetuity. Its role into the future would be interventionist in a market place which seems to be regenerating from the GFC.
5.3 The Fed Guarantee will cause a 2 tier credit standing which is completely unjustified commercially and from a stability viewpoint. What happens if the Government looses its AAA to a lower rating? Does this automatically transfer to rating the cost of funds of the non 4 PB.This can be a by-product of being on the Government teat.
5.4 The creation of a 5th PB seems to have been shelved. Bank of Queensland chief executive was quoted today stating that the concept had been put back 15 years by the policy statement.
5.5 It will lead to more defacto controls at operational level, due to the conditions that will attach to the Fed Guarantee and which maybe come more onerous over time.
5.6 If I was a non 4 PB competitor and was given the option of using a Fed Guarantee I would have 2 loan books-one with and the other without same. Regulatory supervision is necessary but keeps the bureaucrats out of the operational side of the business. All things being equal there must be a point in time when the cost of the Fed Guarantee equates to a rating differential cost and its continued use is not necessary. This is more than likely will be the outcome as the strong regulatory regime continues at all relevant times.
5.7 In any event the 4 PB ratings enable them to borrow cheaper-it comes with the turf.
5.8 Variable rate interest is an option that a borrower takes and with it the ups and downs that accompany this financial risk.
5.9 The substantive point is the Government is using the tax payer’s money to be a partner in the banking system. This is against the fundamental recommendation of the Wallis commission. Isolating the GFC, what has changed to support on a perpetuity basis Government intervention?
5.10 If the Government can intervene in this industry, then what is next?
5.11 The debate and hue and cry, except for some non structural fixes which should be selected and implemented, seems to me to be one big furphy.Change should not be by way of structural intervention.
5.11 Surely it is not a plot to nationalize by stealth Are they that clever?
The quotes have all been extracted from various editions of SMH/ Business Day.
1. What my comments address.
1.1 The thrust of the 4 published questions (Business Day 24/11/10-David Llewellyn-Smith) raises basically 2 issues against a GFC backdrop.
1.2 First Issue -The risks and benefits of Australian 4 pillar banks (“4PB”) and their present wholesale debt fund raising strategies including the use/future use of Federal Government guarantee.
1.3 Second Issue- Increased competition in the financial services sector with the measure of success being progressing the ability of the non 4 PB competitors: smaller banks and others being able to compete on a more equal footing by reducing their cost of funds in those market sectors in which there is a capacity against the 4 PB. The role of securitization in this process.
1.4 Both issues must have regard to the continued stability of the financial sector.
2. Some General Observations
2.1 This article takes into account the Federal treasure’s policy paper published 12/12/10
2. 2 The test of commercial reality should be applied to any changes to be introduced in legislative form or by widening of powers in ACCC & APRA.
2.3 Any quarantining by the Federal Government of an area of fund raising or lending by application of law may cause an aberration in market forces with unknown unquantified outcomes.
2.4 It is interesting to note how various Governments reacted to the GFC for their major banks-UK took equity, USA loan funds and equity and Australia by guarantee.
2.5 What are the substantive issue(s) in this debate and hue & cry surrounding it?
In my view, having read most of the headlines and articles in the media and other public forums it comes down to the Government attempting to unravel what is perceived to be a monopolistic market place in which the 4 PB operate, created, in part, by successive Governments for the stability of the financial sector as a whole. This is to be achieved by legislative changes which are yet to presented and debated but now subject of announced policy. This is in response to a perception that the heirachery of the 4 PB are acting indifferently and hence arrogantly, to requests from the Government over some time to loosen up competition. One of the platforms of attack from the Government and others is that the 4 PB should accept as a yardstick for cost of fund increases/decreases by adopting the RBA determined amount of + or – cash deposit rate changes. A mechanism in place to arrest inflation and relevant only in part to cost of fund calculations. It is reported that over the last 12 months nearly all lenders have increased their lending margin over the RBA yardstick. It is interesting to note that the RBA, in its recent submission to the Senate Banking enquiry, put forward a view concerning the most recent rise of 25 basis points that all that was justified in real cost of fund increases by the 4 PB was no more than the increase in the RBA’s increase in deposit rate. This could mean that the RBA considers that the 4 PB are a little over the odds in pleading justification this time around.
A sobering thought is if the 4 PB through their boards and senior management had been a little more street-wise then this entire ruckus perhaps could have been avoided and their respective shareholders and rating agencies could have concluded business as usual.
3. Issue one
3.1The balance sheet of a Bank and any other competitor is all important for commercial well being; credit rating; stock market value; interbank limits; credit risk standing for depositor of funds; and regulatory supervision. Prior to, during and since the GFC, the 4 PB measured up well under all of the above criteria. A commentator recently said that 45% of the funding book should be funded offshore with the 4 PB doubling their size and diversifying offshore to remain a competitive force in world standings and provide for a better mix of income streams.
3.2 Large wholesale debt can be offshore and onshore. The form of borrowing is diversified, with staggered maturities and an expectation of rollovers on maturity. Therefore, the cost of funds can be just as diversified in measurement. Matched book borrowing and lending defines with certainty the earn margin.
3.3 The RBA cash deposit rate is only one factor in funding costs and this appears to be common ground by those aware of the commercial issues.
3.4 The principle risks of 4 PB wholesale debts are:
Offshore
-borrowing to fund onshore transactions-currency exchange rate-risk management contracts and systems can be engaged to minimize risk
-lack of liquidity on rollovers (GFC experience) and as a consequence substantial increased funding costs (these were largely avoided though use of Fed Government guarantee). What would have been the outcome if no guarantee had been made available? The 4 PB say that new replacement wholesale debt, without the Fed Guarantee is at a higher cost due to market place forces and no doubt this is the case. A free market place determines the cost of supply.
Onshore
-the need to have an ever increasing deposit base is diminished in real terms
3.5 The principle benefits of 4 PB wholesale debts are:
-Should be cheaper in reasonable times as a source of funds. Offshore business makes it necessary to have foreign wholesale debt.
-Can structure hybrid instruments as a tool in capital adequacy.
-Can have a range of staggered maturities which is good for liquidity pressures and also relevant to profile of lending/investment book.
There are pros and cons; however as in common with most large corporates they have to access foreign debt as a source of funding their book.
It will be business as usual for the large 4 PB without the Fed guarantee. However it may be some comfort that the same may be available if anything approaching a GFC (tantamount to a threat to systemic failure) was to present itself in the future. The mechanism is now proven.
4. Issue Two
4.1 This is the more interesting side of the debate.
4.2 All things being equal on marketing, efficiency, and service from all competitors to a notional borrower for a house / business loan what is the broad thrust of requested main changes to be made to boost competition?
From submissions made by various parties from the non 4 PB competitors and others appearing before the current Senate Banking enquiry-raise these points:-
-capital adequacy rules should be revisited in home mortgage sector. In short APRA should loosen up to get more leverage on increased debt and therefore the recycling of funds for new loans. If this change was made only for the small end then it would be a structural intervention.
-Revitalizing the securitization market (the selling of securities in mortgage backed securities with AAA rating) by 2 measures. First to increase funding from the Federal Government over and above the $16B recently made available and secondly to “encourage” the participation of new investors such as super funds in addition to the traditional institutional investors. This would help in accessing liquidity at reasonable pricing. This process has been interrupted by the GFC and regeneration needs to be continued. This is a non structural intervention.
-Immediately reduce the cost of the Fed Guarantee where currently employed. It permits more competitive pricing and the lender makes presumably the same margin. The only party losing out is the tax payer through a lower return.
-Guarantee the mortgage insurance on loans subject of securitization thereby reducing costs. This is a structural intervention.
-The facilitation of changing a lender relationship on a cost effective and timely basis. “A separate survey from Essential research found 37 per cent of bank customers had considered leaving a major bank after this month’s interest rate rises in excess of Reserve Bank movements”. This can be a structural intervention.
-A new borrowing vehicle, initially supported by 25 credit unions, which has been in the making for 12 months and is targeting $1B of new funds for mortgage lending with funding targeted from Super funds and global markets the offered security being a rated financial instrument. APRA, it is reported is comfortable. The form of requested Government support is to be a cornerstone investor. It is hoped that familiarity and market acceptance will be taken up by the other players in this grouping which “there are 126 credit unions and mutual building societies in Australia representing $73 B worth of assets, 4.6 million members and more than 7% of the new home loan market”. This will assist in reducing the cost of funds. This is not a structural intervention.
-An extension of the Fed guarantee to wholesale debt instruments, presumably on / offshore, to provide a AAA rating for the non 4 PB competitors. To support the establishment of a 5th pillar to be competitive against the 4 PB. This is a structural intervention.
-Remove ban on sale of covered bonds.
4.3 Financial Stability
There seems to be some common ground on caution of structural intervention;
-UBS said the “5th pillar idea is potentially risky and would require massive increase in activity from small lenders. To be a credible 5th force with a 10% share of all mortgages and deposits, credit unions would have to raise their lending from $50B today to $144B in 4 years. Achieving this growth while keeping leverage ratios intact would require ‘them’ to find an extra $8B of capital to go more than double the $5.9B the sector holds”.
-Abacus spokesperson (represents credit unions and building societies) “As well as highlighting the funding task, the 5th pillar idea also posed potential risk to financial stability. Competition and financial stability had an inverse relationship as demonstrated in recent years”.
-The 4 PB in their respective submissions to the Senate Banking enquiry amongst other things stated in response to the 5th pillar idea
-unintended consequences could result in the taking of bigger and possibly dangerous risks in chasing market share.
5. The Fed Treasurer’s policy statement released 12/12/10 (format partially adopted from SMH 13/12/10)
What’s in?
As to lowering cost of funds-Deposit guarantee extended indefinitely, although threshold of $1m could change
-Government protected deposit logo to be available
-Government to increase its investment pool for securitization from $16B to $20B
-All banks are able to sell covered bonds
As to increasing competition
-Inquiry into account number portability
-Mutual’s fast tracked to become banks
-Increased power to ASIC & ACCC to better monitor & prosecute signaling
-Standard fact sheet to be supplied by all banks for mortgage offers
What’s not?
-No guarantee for wholesale debt
-Outright ban on mortgage exit fees (to change existing contracts without compensation unconstitutional)
-“tracker mortgages” with fixed margins
-Limits on how much banks can charge
-Australia Post competing as a bank
-New financial system enquiry
-Bank super profits tax
-The creation of a 5 th PB (perhaps just to complicated)
5. Some conclusions
5.1The jury is still out as to whether or not there is a lack of competitive forces under the present regime. Most recent statistics indicate that the non 4 PB competitors are writing more new home mortgage loans than the 4 PB
5.2 No structural changes should occur unless they have been thought through.
The Fed guarantee for the non 4 PB competitors is available on deposits (not available for wholesale debt) and is proposed to be issued in perpetuity. Its role into the future would be interventionist in a market place which seems to be regenerating from the GFC.
5.3 The Fed Guarantee will cause a 2 tier credit standing which is completely unjustified commercially and from a stability viewpoint. What happens if the Government looses its AAA to a lower rating? Does this automatically transfer to rating the cost of funds of the non 4 PB.This can be a by-product of being on the Government teat.
5.4 The creation of a 5th PB seems to have been shelved. Bank of Queensland chief executive was quoted today stating that the concept had been put back 15 years by the policy statement.
5.5 It will lead to more defacto controls at operational level, due to the conditions that will attach to the Fed Guarantee and which maybe come more onerous over time.
5.6 If I was a non 4 PB competitor and was given the option of using a Fed Guarantee I would have 2 loan books-one with and the other without same. Regulatory supervision is necessary but keeps the bureaucrats out of the operational side of the business. All things being equal there must be a point in time when the cost of the Fed Guarantee equates to a rating differential cost and its continued use is not necessary. This is more than likely will be the outcome as the strong regulatory regime continues at all relevant times.
5.7 In any event the 4 PB ratings enable them to borrow cheaper-it comes with the turf.
5.8 Variable rate interest is an option that a borrower takes and with it the ups and downs that accompany this financial risk.
5.9 The substantive point is the Government is using the tax payer’s money to be a partner in the banking system. This is against the fundamental recommendation of the Wallis commission. Isolating the GFC, what has changed to support on a perpetuity basis Government intervention?
5.10 If the Government can intervene in this industry, then what is next?
5.11 The debate and hue and cry, except for some non structural fixes which should be selected and implemented, seems to me to be one big furphy.Change should not be by way of structural intervention.
5.11 Surely it is not a plot to nationalize by stealth Are they that clever?
The quotes have all been extracted from various editions of SMH/ Business Day.
SOW - Russell Bradshaw
This article mainly relates to the following terms of reference for the Son of Wallis Challenge:
3. Given securitisation was at the centre of the GFC, what role should it play in renewed competition? 4. How can competition be returned to the financial services sector, as well as balanced against the need for stability in the light of the first three questions?
The paper will aim to show that de-regulation, originally designed to stimulate competition merely led to mis-pricing of credit resulting in sub-optimal lending practices and massive risk transfers. The crux of the argument is that credit risk can’t be qualitatively “transformed” (as assumed within the market based competition for lending), instead it just gets absorbed or “transferred”. Securitisation is the means of masking underlying fundamental credit risk and for facilitating massive risk transfers to unsuspecting counterparties.
Intermediation and risk in banking
One of the major functions of a bank is its role of intermediation, whereby the requisite demands of lenders and borrowers are brought together for mutual benefit. This intermediation can be split in to two key functions for banks. The first is maturity transformation, whereby banks borrow money in the short-term (e.g. instantly available deposits) and lend out over the long-term (e.g. a 20-year mortgage). This places a bank in the unfortunate position of being vulnerable to a liquidity squeeze whereby lenders could withdraw deposits quicker than a bank could liberate its assets. In return for handling this transformation (borrowing short and lending long), banks are rewarded through extracting a profit, provided that this trust is honoured.
The second role is deemed to be one of risk transformation. In this capacity, a bank undertakes to control or mitigate the different levels of risk that it holds as assets (e.g. loans). This takes the role of the bank trying to protect itself from the potential abuse of trust by borrowers. By choosing the word “transformation“ one is led to believe that banks can perform tangible changes to the extent of risk that they are exposed to, however a better choice of word would be risk mitigation. The table below shows the various strategies that banks undertake for risk mitigation:
Risk management strategy (after Buckle & Thompson p.66)
Underlying risk management strategy
Screening for bad loans
Risk avoidance
Pooling risks (large number of loans)
Dilution / absorption of risk
Diversifying risk (supply to different types of borrower)
Containment / absorption of risk across the loan book
Holding sufficient capital
Containment / absorption of risk over time
As we can see, it is clear that risk in its pure and aggregate sense is not strictly acquired by banks and then mystically detoxified into a safer level. To believe otherwise, is to assume that banks can “spread risk and somehow magically evaporate it in the vast complexity of the financial galaxy” (Perez 2009). Banks receive the right to profit from appropriately containing or avoiding risk, not because of their ability to convert the risk to a less hazardous state. Therefore risk is not qualitatively transformed in the way that maturity has been changed. Instead banks either avoid the risk in the first place or absorb the stochastic nature of default / delinquency through the appropriate dilution of risk in their loan pool or by holding a sufficient cushion of capital to smooth losses over time. If presented with the prospects of weaker quality loan issuance, the institution’s only choices would be to demand a higher risk premium (commensurate with the default risk) or decline to originate (therefore avoid) the loan.
The rise of Securitisation
The previous description of banking intermediation is often referred to as the “originate and hold” model (O&H) as banks would not trade or sell-on the loans that they had initiated. Recent deregulation of the banking sector has led to the feasibility of trading loans on a secondary market, also known as the “originate and distribute model” (O&D). This has led to a fragmentation of the loan process into the following key steps:
Loan origination
Administration
Credit risk assessment
Secondary market funding (e.g. Asset Backed Securities)
This market structure has resulted in increasing proportions of loans becoming packaged up and traded as securities. The objective was to reduce banking costs for customers by promoting greater competition and liquidity. Tasks that would normally be the integrated responsibility of banks would become dissected, with one of the most critical aspects, the pricing of risk and the supervision of borrower behaviour, placed within the hands of the market.
However, none of the “perceived benefits” offered to justify O&D (lower entry barriers, increased competition, increased liquidity etc.) actually addresses the fundamental issues of adverse selection and moral hazard brought about by the abdication of loan responsibility. Ultimately, with credit risk assessment becoming separated from credit risk responsibility it takes an extreme stretch of the imagination to believe that this approach would lead to anything other than a decline in the quality of loan evaluation:
“Lack of screening incentive created by the separation of origination from the ultimate bearer of the default risk has been a contributing factor to the current mortgage crisis.” Fritz-Morgenthal (2008)
What begins as a belief that risk can be tamed through the wonder of the market was to be proved wholeheartedly incorrect. Evidence collected and published on the cusp of the crisis in 2008 demonstrated that there were already warning signs of adverse selection and moral hazard occurring in this practice. Berndt & Gupta (2008) demonstrate that securitised loans severely underperformed:
“We find that borrowers with an active secondary market for their loans underperform their peers by about 9% per year in terms of annual, risk-adjusted abnormal returns, over a three year period subsequent to the initial sale of their loans.” Berndt & Gupta (2008)
The very structure of securitisation is facilitating the exploitation of the asymmetric information concerns that have dogged banking for centuries. Firstly borrowers themselves may be making inferior loan judgements. Observed rises in equity release loans, credit card loans and car loans may instead just be providing artificially stimulated consumption demand, rather than genuine economic investment.
Secondly, the accusations that loan originating firms tended to ignore potentially worrying borrower circumstances is not unfounded. This is particularly pertinent given that in many circumstances banks earn on a fee basis, and therefore have no incentive to weigh up aspects relating to the long term repayment structure. Under these conditions then, the phenomenal growth in debt witnessed these last 20 years may not be all fully attributable to genuine economic investment and instead could be the symptom of poorly judged credit issuing.
Transferring poor quality risk
The evidence provided by Berndt & Gupta leads to the highly portentous conclusion that loan quality is compromised under secondary market handling. The empirical findings give credence to the following risk management model:
The crux of the model is that the aggregate quantity and quality of credit issuance within a market is inversely related (Warburton p47, p49). Rationing of credit is believed to result in an overall improved status of portfolio quality, whereas an increase of total credit issuance is connected with worsening quality. As stated above, an O&H approach is prevented from risk transfer practices, therefore the expansion and contraction of credit issuance is limited by the direct participants’ ability to absorb risk. However, in an O&D environment, rising quantity of credit issuance is feasible by accepting (potentially mis-priced) declines of credit quality, assisted on the part of the issuer through the practice of risk transfer.
Conclusion
The turning over of banking functions to a seemingly competitive market has at best yielded superficial hopes of improved customer choice but, more importantly, has masked a more serious issue of the mis-selling of credit and gargantuan risk transfer to the public purse:
“The virtual elimination of the credit quality spread, in all its dimensions, ought to be regarded as a source of fear and trembling, not a celebration of capital market efficiency.” (Warburton p.174)
To accept that securitisation (even under promised conditions of increased supervision / sanitisation) is necessary for modern banking is to implicitly condone the continued growth of debt levels of potentially deteriorating quality. Not only are they a risk in themselves to banking stability but it is clear that they pose a more substantial systemic risk to the nation by providing the means for even further debt expansion as well as the obfuscation of risk ownership and exposure levels.
Writing in 1999, Peter Warburton stated that:
“The highly developed consumer credit and securitised loan markets of the USA provide an acid test of credit quality developments throughout the Western world.” (p.175)
And so far, it seems that they have failed that test. The pursuit of competition through de-regulation has done little more than let the speculation genie out of the bottle. But this is no pantomime, as the consequences of this policy action could be felt for many years to come.
3. Given securitisation was at the centre of the GFC, what role should it play in renewed competition? 4. How can competition be returned to the financial services sector, as well as balanced against the need for stability in the light of the first three questions?
The paper will aim to show that de-regulation, originally designed to stimulate competition merely led to mis-pricing of credit resulting in sub-optimal lending practices and massive risk transfers. The crux of the argument is that credit risk can’t be qualitatively “transformed” (as assumed within the market based competition for lending), instead it just gets absorbed or “transferred”. Securitisation is the means of masking underlying fundamental credit risk and for facilitating massive risk transfers to unsuspecting counterparties.
Intermediation and risk in banking
One of the major functions of a bank is its role of intermediation, whereby the requisite demands of lenders and borrowers are brought together for mutual benefit. This intermediation can be split in to two key functions for banks. The first is maturity transformation, whereby banks borrow money in the short-term (e.g. instantly available deposits) and lend out over the long-term (e.g. a 20-year mortgage). This places a bank in the unfortunate position of being vulnerable to a liquidity squeeze whereby lenders could withdraw deposits quicker than a bank could liberate its assets. In return for handling this transformation (borrowing short and lending long), banks are rewarded through extracting a profit, provided that this trust is honoured.
The second role is deemed to be one of risk transformation. In this capacity, a bank undertakes to control or mitigate the different levels of risk that it holds as assets (e.g. loans). This takes the role of the bank trying to protect itself from the potential abuse of trust by borrowers. By choosing the word “transformation“ one is led to believe that banks can perform tangible changes to the extent of risk that they are exposed to, however a better choice of word would be risk mitigation. The table below shows the various strategies that banks undertake for risk mitigation:
Risk management strategy (after Buckle & Thompson p.66)
Underlying risk management strategy
Screening for bad loans
Risk avoidance
Pooling risks (large number of loans)
Dilution / absorption of risk
Diversifying risk (supply to different types of borrower)
Containment / absorption of risk across the loan book
Holding sufficient capital
Containment / absorption of risk over time
As we can see, it is clear that risk in its pure and aggregate sense is not strictly acquired by banks and then mystically detoxified into a safer level. To believe otherwise, is to assume that banks can “spread risk and somehow magically evaporate it in the vast complexity of the financial galaxy” (Perez 2009). Banks receive the right to profit from appropriately containing or avoiding risk, not because of their ability to convert the risk to a less hazardous state. Therefore risk is not qualitatively transformed in the way that maturity has been changed. Instead banks either avoid the risk in the first place or absorb the stochastic nature of default / delinquency through the appropriate dilution of risk in their loan pool or by holding a sufficient cushion of capital to smooth losses over time. If presented with the prospects of weaker quality loan issuance, the institution’s only choices would be to demand a higher risk premium (commensurate with the default risk) or decline to originate (therefore avoid) the loan.
The rise of Securitisation
The previous description of banking intermediation is often referred to as the “originate and hold” model (O&H) as banks would not trade or sell-on the loans that they had initiated. Recent deregulation of the banking sector has led to the feasibility of trading loans on a secondary market, also known as the “originate and distribute model” (O&D). This has led to a fragmentation of the loan process into the following key steps:
Loan origination
Administration
Credit risk assessment
Secondary market funding (e.g. Asset Backed Securities)
This market structure has resulted in increasing proportions of loans becoming packaged up and traded as securities. The objective was to reduce banking costs for customers by promoting greater competition and liquidity. Tasks that would normally be the integrated responsibility of banks would become dissected, with one of the most critical aspects, the pricing of risk and the supervision of borrower behaviour, placed within the hands of the market.
However, none of the “perceived benefits” offered to justify O&D (lower entry barriers, increased competition, increased liquidity etc.) actually addresses the fundamental issues of adverse selection and moral hazard brought about by the abdication of loan responsibility. Ultimately, with credit risk assessment becoming separated from credit risk responsibility it takes an extreme stretch of the imagination to believe that this approach would lead to anything other than a decline in the quality of loan evaluation:
“Lack of screening incentive created by the separation of origination from the ultimate bearer of the default risk has been a contributing factor to the current mortgage crisis.” Fritz-Morgenthal (2008)
What begins as a belief that risk can be tamed through the wonder of the market was to be proved wholeheartedly incorrect. Evidence collected and published on the cusp of the crisis in 2008 demonstrated that there were already warning signs of adverse selection and moral hazard occurring in this practice. Berndt & Gupta (2008) demonstrate that securitised loans severely underperformed:
“We find that borrowers with an active secondary market for their loans underperform their peers by about 9% per year in terms of annual, risk-adjusted abnormal returns, over a three year period subsequent to the initial sale of their loans.” Berndt & Gupta (2008)
The very structure of securitisation is facilitating the exploitation of the asymmetric information concerns that have dogged banking for centuries. Firstly borrowers themselves may be making inferior loan judgements. Observed rises in equity release loans, credit card loans and car loans may instead just be providing artificially stimulated consumption demand, rather than genuine economic investment.
Secondly, the accusations that loan originating firms tended to ignore potentially worrying borrower circumstances is not unfounded. This is particularly pertinent given that in many circumstances banks earn on a fee basis, and therefore have no incentive to weigh up aspects relating to the long term repayment structure. Under these conditions then, the phenomenal growth in debt witnessed these last 20 years may not be all fully attributable to genuine economic investment and instead could be the symptom of poorly judged credit issuing.
Transferring poor quality risk
The evidence provided by Berndt & Gupta leads to the highly portentous conclusion that loan quality is compromised under secondary market handling. The empirical findings give credence to the following risk management model:
The crux of the model is that the aggregate quantity and quality of credit issuance within a market is inversely related (Warburton p47, p49). Rationing of credit is believed to result in an overall improved status of portfolio quality, whereas an increase of total credit issuance is connected with worsening quality. As stated above, an O&H approach is prevented from risk transfer practices, therefore the expansion and contraction of credit issuance is limited by the direct participants’ ability to absorb risk. However, in an O&D environment, rising quantity of credit issuance is feasible by accepting (potentially mis-priced) declines of credit quality, assisted on the part of the issuer through the practice of risk transfer.
Conclusion
The turning over of banking functions to a seemingly competitive market has at best yielded superficial hopes of improved customer choice but, more importantly, has masked a more serious issue of the mis-selling of credit and gargantuan risk transfer to the public purse:
“The virtual elimination of the credit quality spread, in all its dimensions, ought to be regarded as a source of fear and trembling, not a celebration of capital market efficiency.” (Warburton p.174)
To accept that securitisation (even under promised conditions of increased supervision / sanitisation) is necessary for modern banking is to implicitly condone the continued growth of debt levels of potentially deteriorating quality. Not only are they a risk in themselves to banking stability but it is clear that they pose a more substantial systemic risk to the nation by providing the means for even further debt expansion as well as the obfuscation of risk ownership and exposure levels.
Writing in 1999, Peter Warburton stated that:
“The highly developed consumer credit and securitised loan markets of the USA provide an acid test of credit quality developments throughout the Western world.” (p.175)
And so far, it seems that they have failed that test. The pursuit of competition through de-regulation has done little more than let the speculation genie out of the bottle. But this is no pantomime, as the consequences of this policy action could be felt for many years to come.
SOW - Heath Behncke
Australian politicians reacting to out of cycle mortgage re-pricing perceive a lack of banking competition as the reason. The more likely answer is a rising cost of capital and ongoing structural change in bank funding globally. The evidence is clear when you look at banking systems around the globe. We are not alone. In fact, Australian’s are experiencing mild structural changes in comparison to consumers in other major banking systems.
Australia being overweight investment opportunities, therefore requiring overseas investors, in a mostly intermediated financial system (i.e. funded by the banks), further compounds the impact of structural change, and is likely to equate to ongoing funding pressures.
While Australia’s financial system fared well through the GFC, the downturn was mild by historical standards due to the increasing ties with Asia (China in particular), as evidenced by the historically high terms of trade. At some point though, commodity income will wane and offshore investors will question the sustainability of the Australian economy, inevitably testing the true strength of Australia’s financial system. Australia’s ability to sustainability fund our economy through such a period is likely to be tested.
Poor lending on a large scale in the US (similar to the experience of Australian Banks in the early 1990s), is driving structural change in global wholesale funding markets. Investors are asking for higher returns to compensate for higher levels of risk. As a consequence the cost of capital globally has increased. Therefore, Australian banking which sources approximately 21% of total funding from offshore wholesale markets, is currently experiencing a predominantly liability driven crisis, as the higher cost of funding (i.e. higher returns to wholesale investors and deposit providers) is pushed through the system.
Australian banks have responded by changing prices for lending, deposits and raising capital. In particular, the record profits of 2010 for the Australian Major Banks need to be considered in the context of much larger capital bases post the GFC. Approximately $30bn of additional equity (over and above retained earnings) was raised over the 3 year period to 2010, resulting in capital bases expanding by some 65%, from $85bn in 2007 to $140bn in 2010. Therefore, while the $22bn in profits for 2010 is a record result in absolute terms, and $6bn or 38% higher than 2007, the Return on Equity (ROE) has actually fallen to 16%, approximately 2% points below the average ROE in the 10 years prior to the GFC.
Thus, Australian Major Banks to date, are yet to return to pre-GFC profitability, although this is also a reflection of where they are in the loan loss cycle. Looking forward, as bad debts move to more normal levels, the ROE for the Australian Major Banks is likely to move back to the averages for the 10 years prior to the GFC.
Market commentators have tended to credit higher net interest margins as the reason for record bank profits. However group net interest margins for the Australian Major Banks over the 3 years to 2010 have only increased by approximately 3% from 2.19% to 2.26%. The real driver of the 38% uplift in profit is a direct result of Australia’s Major Banks stepping into the void created by wholesale funding markets, thereby underwriting system credit for the past 3 years. Undeniably, a desirable outcome given the dislocations experienced in other financial systems around the globe, particularly wholesale dependent systems such as the US (in excess of 50% of system credit pre-GFC).
In response to the resurgence in re-intermediation (i.e. borrowing through the banking system), Australian depositors have benefited directly from the reassessment of risk globally through significantly higher deposit rates. A transfer from borrowers to depositors (as witnessed by effectively flat bank net interest margins) has occurred, to encourage depositors to invest: a clear illustration of how capital can be allocated rationally within a free market banking system. Understandably, we are hearing plenty of stories from mortgage holders who are bearing the cost, however little from depositors that are banking the gain (mind the pun). Keep in mind the banking system had outstanding mortgage balances of approximately $1 trillion, and deposit balances of $1.4 trillion at 31 October 2010.
The Federal Government guarantee on wholesale debt used by Australian Banks to raise approximately $166bn, is often cited as a handout (although Australian Banks are currently paying approximately $1bn pa for the use of the guarantee), and indicative of the implicit support mechanism underpinning the perennial moral hazard issue in the Government-banking relationship.
The Irish, for reasons that are now clear, dragged the vast majority of Governments worldwide into guaranteeing bank debt whether they required it or not. Once the Irish Government had credit enhanced bank debt, investors saw a low risk opportunity globally. Furthermore, the world’s highest rated banks, the Irish Banks, had the opportunity of tapping a new class of investor who invested only in Government paper. As asset classes globally were experiencing a flight to quality, the typical near term human response during a downturn, funds were relatively more available to investors in only the highest rate (or lowest risk) securities such as Government paper. Therefore, banks worldwide would face a material funding disadvantage, and therefore other Governments had to follow.
Australia, alongside other parts of the world, was also starting to experience a depositor flight to quality, prior to the introduction of the guarantees. Depositors were choosing the Major Banks, just as investors in the Australian share market were gravitating to large cap blue chip stocks in late 2008. Hence, the introduction of guarantees on bank deposits within the Australian Banking system to engender Confidence, the key ingredient in any system based on paper promises.
In Australia, the conservative risk based capital framework employed by the banking regulator has worked very well. The learnings from the asset-led banking crisis of the early 1990’s and subsequent financial system enquiry placed Australia in a strong position. In fact, global bank regulation on capital is moving to align more with Australian standards, a strong endorsement of APRA’s oversight.
We need to take the lessons from the current liability driven banking crisis Australia is experiencing, to develop a funding framework much like our well regarded capital framework. The GFC has highlighted, that in a far more integrated global financial system, the requirement for understanding, monitoring and regulating total system funding has become more important. This is particularly true for a small open economy, overweight investment opportunities, in a financial system funded mostly by bank intermediation that is becoming increasingly reliant on offshore funding (approximately $517bn at 31st October 2010).
Under the new Basel III regulations, the international banking regulator has already announced guidelines for banks on funding (such as the net stable funding ratio) and liquidity. However, Australia needs to be on the front foot in developing funding guidelines that may go further than international regulation is currently suggesting given the structure of our domestic financial system. Central to funding guidelines would be a clear understanding of the Character of Funding, which is critical for managing the asset-liability mismatch implicit in banking rather than the typical understanding implied by name i.e. securtisation, domestic wholesale, offshore wholesale, deposits etc.
It is unfortunate that wholesale funding, and securitisation markets in particular, have been tarnished due to the GFC. Wholesale funding markets are important conduits for competitive forces to drive change, as the Australian mortgage market experienced in the years prior to the GFC. Residential mortgage back securities exploited subsidies within the banking system, a clear market inefficiency. Australians are better off today as a result. The benefits are clear, so how do we develop domestic wholesale funding markets to be dependable and sustainable?
Australian listed companies quickly recapitalised during the GFC, raising $110bn in equity in addition to the $30bn raised by the banks, representing approximately 10% of the $1.4 trillion in Australia equity market capitalisation. Without our world leading superannuation system this outcome would be harder to replicate. But, what about our domestic debt markets, how did they perform during the GFC? To date more information, and debate has centred on developments in equity markets than Australian debt markets.
Furthermore, Australia’s domestic debt markets seem underdeveloped relative to other major economies as the domestic bond market is smaller ($1.15 trillion at 31st October 2010), than our equity market, whereas in most major economies it is the other way around. And given our growing reliance on offshore wholesale funding (increased from 16% at the time of the Wallis enquiry to 21% today), what risk does this present to our financial system? Also, does it make sense for $1 trillion in residential mortgages to be funded entirely through the banking system? Australia needs to form a view on these types of questions to address funding sustainability.
Stream Three, under the Governments announced reforms for Competitive and Sustainable Banking represents a good starting point, but more needs to be done. An enquiry into funding solutions for the Australian economy is required, with the aim of lowering Australia’s cost of capital, through the broadening, deepening and strengthening of Australia’s funding options. This will go a long way to improving economic resilience and prosperity, while generating sustainable economic growth and promoting bank competition.
Australia being overweight investment opportunities, therefore requiring overseas investors, in a mostly intermediated financial system (i.e. funded by the banks), further compounds the impact of structural change, and is likely to equate to ongoing funding pressures.
While Australia’s financial system fared well through the GFC, the downturn was mild by historical standards due to the increasing ties with Asia (China in particular), as evidenced by the historically high terms of trade. At some point though, commodity income will wane and offshore investors will question the sustainability of the Australian economy, inevitably testing the true strength of Australia’s financial system. Australia’s ability to sustainability fund our economy through such a period is likely to be tested.
Poor lending on a large scale in the US (similar to the experience of Australian Banks in the early 1990s), is driving structural change in global wholesale funding markets. Investors are asking for higher returns to compensate for higher levels of risk. As a consequence the cost of capital globally has increased. Therefore, Australian banking which sources approximately 21% of total funding from offshore wholesale markets, is currently experiencing a predominantly liability driven crisis, as the higher cost of funding (i.e. higher returns to wholesale investors and deposit providers) is pushed through the system.
Australian banks have responded by changing prices for lending, deposits and raising capital. In particular, the record profits of 2010 for the Australian Major Banks need to be considered in the context of much larger capital bases post the GFC. Approximately $30bn of additional equity (over and above retained earnings) was raised over the 3 year period to 2010, resulting in capital bases expanding by some 65%, from $85bn in 2007 to $140bn in 2010. Therefore, while the $22bn in profits for 2010 is a record result in absolute terms, and $6bn or 38% higher than 2007, the Return on Equity (ROE) has actually fallen to 16%, approximately 2% points below the average ROE in the 10 years prior to the GFC.
Thus, Australian Major Banks to date, are yet to return to pre-GFC profitability, although this is also a reflection of where they are in the loan loss cycle. Looking forward, as bad debts move to more normal levels, the ROE for the Australian Major Banks is likely to move back to the averages for the 10 years prior to the GFC.
Market commentators have tended to credit higher net interest margins as the reason for record bank profits. However group net interest margins for the Australian Major Banks over the 3 years to 2010 have only increased by approximately 3% from 2.19% to 2.26%. The real driver of the 38% uplift in profit is a direct result of Australia’s Major Banks stepping into the void created by wholesale funding markets, thereby underwriting system credit for the past 3 years. Undeniably, a desirable outcome given the dislocations experienced in other financial systems around the globe, particularly wholesale dependent systems such as the US (in excess of 50% of system credit pre-GFC).
In response to the resurgence in re-intermediation (i.e. borrowing through the banking system), Australian depositors have benefited directly from the reassessment of risk globally through significantly higher deposit rates. A transfer from borrowers to depositors (as witnessed by effectively flat bank net interest margins) has occurred, to encourage depositors to invest: a clear illustration of how capital can be allocated rationally within a free market banking system. Understandably, we are hearing plenty of stories from mortgage holders who are bearing the cost, however little from depositors that are banking the gain (mind the pun). Keep in mind the banking system had outstanding mortgage balances of approximately $1 trillion, and deposit balances of $1.4 trillion at 31 October 2010.
The Federal Government guarantee on wholesale debt used by Australian Banks to raise approximately $166bn, is often cited as a handout (although Australian Banks are currently paying approximately $1bn pa for the use of the guarantee), and indicative of the implicit support mechanism underpinning the perennial moral hazard issue in the Government-banking relationship.
The Irish, for reasons that are now clear, dragged the vast majority of Governments worldwide into guaranteeing bank debt whether they required it or not. Once the Irish Government had credit enhanced bank debt, investors saw a low risk opportunity globally. Furthermore, the world’s highest rated banks, the Irish Banks, had the opportunity of tapping a new class of investor who invested only in Government paper. As asset classes globally were experiencing a flight to quality, the typical near term human response during a downturn, funds were relatively more available to investors in only the highest rate (or lowest risk) securities such as Government paper. Therefore, banks worldwide would face a material funding disadvantage, and therefore other Governments had to follow.
Australia, alongside other parts of the world, was also starting to experience a depositor flight to quality, prior to the introduction of the guarantees. Depositors were choosing the Major Banks, just as investors in the Australian share market were gravitating to large cap blue chip stocks in late 2008. Hence, the introduction of guarantees on bank deposits within the Australian Banking system to engender Confidence, the key ingredient in any system based on paper promises.
In Australia, the conservative risk based capital framework employed by the banking regulator has worked very well. The learnings from the asset-led banking crisis of the early 1990’s and subsequent financial system enquiry placed Australia in a strong position. In fact, global bank regulation on capital is moving to align more with Australian standards, a strong endorsement of APRA’s oversight.
We need to take the lessons from the current liability driven banking crisis Australia is experiencing, to develop a funding framework much like our well regarded capital framework. The GFC has highlighted, that in a far more integrated global financial system, the requirement for understanding, monitoring and regulating total system funding has become more important. This is particularly true for a small open economy, overweight investment opportunities, in a financial system funded mostly by bank intermediation that is becoming increasingly reliant on offshore funding (approximately $517bn at 31st October 2010).
Under the new Basel III regulations, the international banking regulator has already announced guidelines for banks on funding (such as the net stable funding ratio) and liquidity. However, Australia needs to be on the front foot in developing funding guidelines that may go further than international regulation is currently suggesting given the structure of our domestic financial system. Central to funding guidelines would be a clear understanding of the Character of Funding, which is critical for managing the asset-liability mismatch implicit in banking rather than the typical understanding implied by name i.e. securtisation, domestic wholesale, offshore wholesale, deposits etc.
It is unfortunate that wholesale funding, and securitisation markets in particular, have been tarnished due to the GFC. Wholesale funding markets are important conduits for competitive forces to drive change, as the Australian mortgage market experienced in the years prior to the GFC. Residential mortgage back securities exploited subsidies within the banking system, a clear market inefficiency. Australians are better off today as a result. The benefits are clear, so how do we develop domestic wholesale funding markets to be dependable and sustainable?
Australian listed companies quickly recapitalised during the GFC, raising $110bn in equity in addition to the $30bn raised by the banks, representing approximately 10% of the $1.4 trillion in Australia equity market capitalisation. Without our world leading superannuation system this outcome would be harder to replicate. But, what about our domestic debt markets, how did they perform during the GFC? To date more information, and debate has centred on developments in equity markets than Australian debt markets.
Furthermore, Australia’s domestic debt markets seem underdeveloped relative to other major economies as the domestic bond market is smaller ($1.15 trillion at 31st October 2010), than our equity market, whereas in most major economies it is the other way around. And given our growing reliance on offshore wholesale funding (increased from 16% at the time of the Wallis enquiry to 21% today), what risk does this present to our financial system? Also, does it make sense for $1 trillion in residential mortgages to be funded entirely through the banking system? Australia needs to form a view on these types of questions to address funding sustainability.
Stream Three, under the Governments announced reforms for Competitive and Sustainable Banking represents a good starting point, but more needs to be done. An enquiry into funding solutions for the Australian economy is required, with the aim of lowering Australia’s cost of capital, through the broadening, deepening and strengthening of Australia’s funding options. This will go a long way to improving economic resilience and prosperity, while generating sustainable economic growth and promoting bank competition.
SOW - Peter Rieder
The international economic and financial crisis revealed several inadequacies in Australian banking and financial regulation. Large Australian banks remain dependent on international investors to secure wholesale debt. Demand for securitisation increased in the decade before the economic and financial crisis. The Australian Government responded to the unprecedented uncertainty after the collapse of Lehman Brothers by providing a guarantee to ensure the stability of financial institutions, particularly the large banks. The guarantee reduced competition in the financial industry with large banks benefiting from lower costs of borrowing. The introduction of a covered bond market, increasing household savings and creating a retail corporate bond market will provide diverse sources of finance for Australian banks to enhance competition and maintain financial stability.
Wholesale debt has become an important source of finance for large Australian banks. Since 2007, wholesale debt from domestic and international institutions increased by 7 percent and composes almost 25 percent of funding for banks. Large Australian banks utilise wholesale debt to refinance maturing debt and increase liquidity. The perception wholesale debt is more stable than short term debt resulted in the increase in wholesale debt by large banks. Since mid 2007 the cost of wholesale debt has increased. The cost of three year bonds issued in Australia increased to 220 basis points higher than the government yield and 280 basis points for bonds issued in international markets.
Large Australian banks have become dependent on international wholesale debt markets for finance. The Reserve Bank of Australia estimated international investors provide $320 billion or approximately 70 percent of Australian banking wholesale long term requirements in May 2010. Large banks constituted a large proportion of the amount. International investors perceive the dependence on international capital to finance Australian banks wholesale debt risky with the price of risk premiums increasing with institutions repricing risk. Ric Battellino, Deputy Governor of the Reserve bank of Australia asserted Australian banks understand the risks of wholesale debt and it contributed to their relative good performance through the international financial crisis.
International investors may consider Australia’s household debt levels a possible risk. International investors possessed $645 billion of wholesale debt and deposits in May 2010. If the European sovereign debt crisis expands or investors consider the high household debt is unsustainable the large banks may incur higher interest costs and the size of loans would be smaller. Australia’s total mortgage debt in April 2010 was $1.1 trillion and consumer debt was $141 billion. Reducing household debt will require a change in consumer preferences. Households will have to increase savings and extinguish debt.
The Australian Government introduced the Guarantee Scheme for Large Deposits and Wholesale Funding to provide stability for long term liabilities and preserve the flow of international capital. The response undermined the principle espoused in the Wallis Inquiry not permitting public finance to underwrite banking capital. Between October 2008 and March 2010 the Australian Government provided continuous credit and access to finance for financial institutions. The Guarantee assumed responsibility for debt with a rolling maturity date of five years. A fee of 70 basis points per annum applied to AA rated institutions. A fee of 100 basis points per annum applied to A rated institutions and a fee of 150 basis points per annum applied to BBB rated and unrated institutions. The increased cost of financing for smaller and regional banks resulted in the ‘crowding out’ of smaller institutions from the wholesale debt market. It strengthened the position of the larger banks. The Australian Government estimated large banks raised approximately $160 billion and smaller banks raised approximately $32 billion during the Guarantee Scheme.
The Australian Government decided to withdraw the Guarantee Scheme on 31 March 2010. The decision was prompted by the large banks reduction in borrowing. No further guaranteed wholesale liabilities or term deposits will be issued. Liabilities assumed by the guarantee scheme will remain guaranteed until maturity or purchased and extinguished by the issuer. The Guarantee Scheme will be responsible for guaranteeing at -call deposits until it ceases in 2015. The Treasurer estimates the banks paid $5.5 billion in fees for utilising the scheme excluding early payments.
The wholesale guarantee is likely to adversely affect fiscal policy. It contributed to the deficit budget. The mid-year economic and fiscal outlook published by Treasury in early November 2010 announced total liabilities of the scheme amounted to $148.7 billion in October 2010. It decreased from $169.9 billion in April 2010. The decrease in large deposits exceeding $ 1million resulted in the decline in total liabilities. Treasury stated the guarantee scheme and liabilities posed a risk for fiscal policy in the unlikely event an Australian bank became insolvent. Surplus budgets are required to reduce the impact of a future crisis.
Securitisation became an important source of financing for smaller banks. Securitisation is the practice of combining various types of contractual debt, such as residential mortgages and offering the debt to bond markets. The increasing demand for Australian residential mortgage backed securities prior to 2007 resulted in international issuance constituting more than half of outstanding Australian residential backed mortgage securities. International structured investment vehicles (SIVs) constituted a significant proportion of international investor capital. SIVs utilised short term financing and invested in long term assets, such as residential mortgage backed securities, a business strategy vulnerable to the reappraisal of risk. The decrease in finance and exposure to poor performing assets and inadequate liquidity compelled many SIVs to liquidate their portfolios and sell Australian residential mortgage backed securities in the secondary market. In 2010, $18 billion of residential mortgage backed securities has been issued compared to $45 billion in 2008.
Securitisation will remain an important part of the financial industry. However, the size of the securitisation market will most probably be smaller. Mortgage originators and smaller bank relied on securitisation for finance. Smaller banks constituted 33 percent of the residential mortgage backed securities market before mid 2007 and provided 40 percent of the issuance. The Australian securitisation market was tarnished by the high level of delinquencies, opaque nature and complicated security structures of American mortgage backed securities. The majority of Australian residential backed mortgages are supported by prime loans and almost all are protected by lender’s mortgage insurance. A revitalised securitisation market emphasising AAA rated residential mortgage backed securities could provide an opportunity for smaller banks, some credit unions and building societies to compete with large banks. Small banks were able to compete with large banks prior to 2007 when liquidity was greater and the cost of funding was lower.
Introducing an Australian covered bond market would provide a source of liquidity for financial institutions. Covered bonds are debt securities endorsed by a pool of banks assets. The cost of raising funds in wholesale markets has increased since the beginning of the international financial crisis and the sovereign debt crisis in Europe. The Banking Act 1959 does not allow Australian banks to issue covered bonds. The legislation intends to protect depositors and avoid customers withdrawing funds in the event of a ‘run’ on banks. An amendment to the Banking Act would be required to permit Australian banks to issue covered bonds. Bank assets would have to be separated. The capital available to depositors would be reduced. The Australian Prudential Regulation Authority would be involved in regulating the covered bond market. It would be responsible for ensuring a degree of protection for depositors and creating a market for investors of high rated debt products.
Increasing household savings would provide banks with a larger source of deposits. The low level of household savings compelled large banks to utilise wholesale debt. Wholesale debt financed the strong demand for business and household lending. Since 2002, the level of household savings has increased. Several factors have contributed to the increase in household savings. A significant increase in income growth accompanying an improvement in the terms of trade, moderation in the growth of capital gain, a sustained increase in the level of real interest rates until 2008 and households are aware of the risk concerning the high level of household debt.
The Henry Review recommended several initiatives to increase household savings. The introduction of a personal savings discount of 40 percent would apply to interest earned from bank deposits. It will also include residential rental income, capital gains and interest expense from listed share investments. Another recommendation involves widening the exemption for interest withholding tax for finance raised by banks operating in Australia from international sources. The recommendations provide incentives for households to increase savings and allow banks to diversify their funding requirements.
A strong corporate bond market could reduce Australian banks dependence on international wholesale debt markets and improve competition. Corporate bonds provide investors with the opportunity to invest in Australia’s public debt rather than bank debt. The Australian Securities Exchange has requested permission to create government and retail corporate bond markets. The retail corporate bond market could utilise superannuation savings to finance investment in the banking sector and reduce Australian banking reliance on international wholesale debt. Government approval to trade Commonwealth Government Securities on the Australian Securities Exchange would provide retail investors with a visible market price for investments issued by Australian corporations and persuade them to diversify savings in the fixed income market.
Wholesale debt has become an important source of finance for large Australian banks. Since 2007, wholesale debt from domestic and international institutions increased by 7 percent and composes almost 25 percent of funding for banks. Large Australian banks utilise wholesale debt to refinance maturing debt and increase liquidity. The perception wholesale debt is more stable than short term debt resulted in the increase in wholesale debt by large banks. Since mid 2007 the cost of wholesale debt has increased. The cost of three year bonds issued in Australia increased to 220 basis points higher than the government yield and 280 basis points for bonds issued in international markets.
Large Australian banks have become dependent on international wholesale debt markets for finance. The Reserve Bank of Australia estimated international investors provide $320 billion or approximately 70 percent of Australian banking wholesale long term requirements in May 2010. Large banks constituted a large proportion of the amount. International investors perceive the dependence on international capital to finance Australian banks wholesale debt risky with the price of risk premiums increasing with institutions repricing risk. Ric Battellino, Deputy Governor of the Reserve bank of Australia asserted Australian banks understand the risks of wholesale debt and it contributed to their relative good performance through the international financial crisis.
International investors may consider Australia’s household debt levels a possible risk. International investors possessed $645 billion of wholesale debt and deposits in May 2010. If the European sovereign debt crisis expands or investors consider the high household debt is unsustainable the large banks may incur higher interest costs and the size of loans would be smaller. Australia’s total mortgage debt in April 2010 was $1.1 trillion and consumer debt was $141 billion. Reducing household debt will require a change in consumer preferences. Households will have to increase savings and extinguish debt.
The Australian Government introduced the Guarantee Scheme for Large Deposits and Wholesale Funding to provide stability for long term liabilities and preserve the flow of international capital. The response undermined the principle espoused in the Wallis Inquiry not permitting public finance to underwrite banking capital. Between October 2008 and March 2010 the Australian Government provided continuous credit and access to finance for financial institutions. The Guarantee assumed responsibility for debt with a rolling maturity date of five years. A fee of 70 basis points per annum applied to AA rated institutions. A fee of 100 basis points per annum applied to A rated institutions and a fee of 150 basis points per annum applied to BBB rated and unrated institutions. The increased cost of financing for smaller and regional banks resulted in the ‘crowding out’ of smaller institutions from the wholesale debt market. It strengthened the position of the larger banks. The Australian Government estimated large banks raised approximately $160 billion and smaller banks raised approximately $32 billion during the Guarantee Scheme.
The Australian Government decided to withdraw the Guarantee Scheme on 31 March 2010. The decision was prompted by the large banks reduction in borrowing. No further guaranteed wholesale liabilities or term deposits will be issued. Liabilities assumed by the guarantee scheme will remain guaranteed until maturity or purchased and extinguished by the issuer. The Guarantee Scheme will be responsible for guaranteeing at -call deposits until it ceases in 2015. The Treasurer estimates the banks paid $5.5 billion in fees for utilising the scheme excluding early payments.
The wholesale guarantee is likely to adversely affect fiscal policy. It contributed to the deficit budget. The mid-year economic and fiscal outlook published by Treasury in early November 2010 announced total liabilities of the scheme amounted to $148.7 billion in October 2010. It decreased from $169.9 billion in April 2010. The decrease in large deposits exceeding $ 1million resulted in the decline in total liabilities. Treasury stated the guarantee scheme and liabilities posed a risk for fiscal policy in the unlikely event an Australian bank became insolvent. Surplus budgets are required to reduce the impact of a future crisis.
Securitisation became an important source of financing for smaller banks. Securitisation is the practice of combining various types of contractual debt, such as residential mortgages and offering the debt to bond markets. The increasing demand for Australian residential mortgage backed securities prior to 2007 resulted in international issuance constituting more than half of outstanding Australian residential backed mortgage securities. International structured investment vehicles (SIVs) constituted a significant proportion of international investor capital. SIVs utilised short term financing and invested in long term assets, such as residential mortgage backed securities, a business strategy vulnerable to the reappraisal of risk. The decrease in finance and exposure to poor performing assets and inadequate liquidity compelled many SIVs to liquidate their portfolios and sell Australian residential mortgage backed securities in the secondary market. In 2010, $18 billion of residential mortgage backed securities has been issued compared to $45 billion in 2008.
Securitisation will remain an important part of the financial industry. However, the size of the securitisation market will most probably be smaller. Mortgage originators and smaller bank relied on securitisation for finance. Smaller banks constituted 33 percent of the residential mortgage backed securities market before mid 2007 and provided 40 percent of the issuance. The Australian securitisation market was tarnished by the high level of delinquencies, opaque nature and complicated security structures of American mortgage backed securities. The majority of Australian residential backed mortgages are supported by prime loans and almost all are protected by lender’s mortgage insurance. A revitalised securitisation market emphasising AAA rated residential mortgage backed securities could provide an opportunity for smaller banks, some credit unions and building societies to compete with large banks. Small banks were able to compete with large banks prior to 2007 when liquidity was greater and the cost of funding was lower.
Introducing an Australian covered bond market would provide a source of liquidity for financial institutions. Covered bonds are debt securities endorsed by a pool of banks assets. The cost of raising funds in wholesale markets has increased since the beginning of the international financial crisis and the sovereign debt crisis in Europe. The Banking Act 1959 does not allow Australian banks to issue covered bonds. The legislation intends to protect depositors and avoid customers withdrawing funds in the event of a ‘run’ on banks. An amendment to the Banking Act would be required to permit Australian banks to issue covered bonds. Bank assets would have to be separated. The capital available to depositors would be reduced. The Australian Prudential Regulation Authority would be involved in regulating the covered bond market. It would be responsible for ensuring a degree of protection for depositors and creating a market for investors of high rated debt products.
Increasing household savings would provide banks with a larger source of deposits. The low level of household savings compelled large banks to utilise wholesale debt. Wholesale debt financed the strong demand for business and household lending. Since 2002, the level of household savings has increased. Several factors have contributed to the increase in household savings. A significant increase in income growth accompanying an improvement in the terms of trade, moderation in the growth of capital gain, a sustained increase in the level of real interest rates until 2008 and households are aware of the risk concerning the high level of household debt.
The Henry Review recommended several initiatives to increase household savings. The introduction of a personal savings discount of 40 percent would apply to interest earned from bank deposits. It will also include residential rental income, capital gains and interest expense from listed share investments. Another recommendation involves widening the exemption for interest withholding tax for finance raised by banks operating in Australia from international sources. The recommendations provide incentives for households to increase savings and allow banks to diversify their funding requirements.
A strong corporate bond market could reduce Australian banks dependence on international wholesale debt markets and improve competition. Corporate bonds provide investors with the opportunity to invest in Australia’s public debt rather than bank debt. The Australian Securities Exchange has requested permission to create government and retail corporate bond markets. The retail corporate bond market could utilise superannuation savings to finance investment in the banking sector and reduce Australian banking reliance on international wholesale debt. Government approval to trade Commonwealth Government Securities on the Australian Securities Exchange would provide retail investors with a visible market price for investments issued by Australian corporations and persuade them to diversify savings in the fixed income market.
SOW- Martin Haggas
1. What are the risks and benefits of large bank wholesale debt and how should each be addressed?
The benefits of wholesale funding are quite straightforward: assuming global wholesale debt markets are operating in an efficient manner, they represent an almost endless source of funding for a bank that faces pressure raising sufficient retail funding to satisfy the needs of its loan book. This is particularly important in Australia, where the willingness and desire of people to borrow money far outweighs their ability and desire to save it. Wholesale funding has historically played the role of a ‘plug’ on the balance sheet of banks, filling the shortfall between deposits taken and loans advanced.
The role of wholesale funding has become even more prevalent in recent years, as the focus for both borrowers and lenders shifted to a borrower’s ability to service debt at current and “expected” interest rates, with little consideration given to their overall level of indebtedness (which any self-respecting lender will justify by making reference to the inconsequential levels of loss historically realised on loans advanced to households and lenders mortgage insurance placed on any loan written in excess of an 80% loan to valuation ratio). The result has been an exponential increase in household debt and further challenges for banks wishing to fund their slice of the ever growing household credit cake.
Furthermore, in the post-GFC banking world, wholesale debt represents an attractive funding option as the competition for retail deposits has driven the price of deposit funding up significantly.
The risks of wholesale debt to financial intermediaries are varied, but all tend to stem from the relatively short term of such facilities. 3 and 6 month facilities are common – the latter of which needs to be rolled-over 50 times in the contractual life of a typical mortgage. There are two key categories of risk – or rather, impact, that arise from the use of wholesale borrowings to fund balance sheet growth. Broadly speaking, these impacts arise from the “rollover risk” of wholesale funding – that is, the potential inability to replace maturing wholesale debt with new wholesale debt.
Of course it is rare for any bank to experience a repricing of wholesale funding in isolation, save for a significant downgrade to its external credit rating. Therefore, the overall impact of limited access to wholesale debt markets is a function of the entire sector’s reliance on wholesale debt.
Risks to liquidity
In a fractional reserve banking system, the measure that ensures, to an extent, a bank’s capacity to satisfy the demands of depositors and other creditors is the amount of liquid assets held on the balance sheet. Liquid assets are typically maintained at levels which cover the bank’s day-to-day cash needs and to withstand an ‘adverse’ scenario, in which abnormally high cash demands are placed upon the bank. The threat posed to a bank’s liquid assets by wholesale funding manifests when a piece of debt matures and the bank is unable to secure ‘new’ debt to replace the maturing debt and the maturing liability must be met from the bank’s liquid asset reserves. Considering an Australian bank, on average, maintains around 5% of the liquid assets necessary to satisfy the simultaneous claims of all its creditors, it is clear that the inability to rollover a portion of wholesale debts will soon erode available cash and other liquid assets, rendering it unable to satisfy further claims from creditors i.e. it would be in a state of default.
The obvious mitigant to address this risk is to maintain a higher level of lower-yielding liquid assets, which places a bank in a position to better fund the redemption of maturing liabilities from its own reserves. The reduced interest income from doing so would need to be recouped from the loan book. i.e. interest rates on loan products would need to be higher than they otherwise would.
Risks to capital
In the scenario described above in reference to liquidity risks, it is unlikely that funding will be unavailable in a purse sense of the word. During the GFC, when banks described “difficulty in rolling over their maturing debt financing”, what they were actually experiencing was “difficulty in rolling over their maturing debt financing at suitable price”. Even whilst the walls of the global banking system are crumbling, counterparties in wholesale markets still have their price.
As we have witnessed since the race that stops the nation last stopped the nation, banks are limited in their ability to reprice loan assets. Even attempts to move a further 20bp above what the RBA moves its target cash rate by sees political parties tripping over one another to introduce “reform” in pursuit of the all-important mortgage holder vote. Put simply, if a bank is unable to pass on the increased cost of wholesale debt that prevails in a risk-averse wholesale funding market, it has the potential to lose money on its loan book – and in doing so, erode its capital base. Once a bank’s capital base is eroded, depositor and other creditors’ claims are jeopardised. i.e. it would be in a state of insolvency.
Similar to addressing liquidity risk, the primary method for protecting against this risk would be to maintain a higher portion of its balance sheet as capital in order to be able to withstand a higher level of losses. Again, the increase in latent money would necessitate higher interest rates across the loan book to pick up the earnings slack.
2. Given securitisation was at the centre of the GFC, what role should it play in renewed competition?
Securitisation is a useful and legitimate tool for managing a bank’s balance sheet. Assuming that the bank is satisfied the structure of the transaction leaves no recourse to its own financial well-being (i.e. If securitisation investors, not the bank, wear the loss of defaults in the underlying pool of mortgages), then it is not required to hold regulatory capital against the loans. The inflow of cash from selling these assets is also an attractive funding option. There should be no concerns with securitisation being part of a diversified set of options used by a lender to manage its balance sheet.
Similar to wholesale debt, the pricing of securitisation funding now seems much more attractive following the rapid increase in the cost of retail deposit funding. Greater access to securitisation funding would likely reduce banks’ funding costs and allow for lower lending rates.
However, the panacea which securitisation is spruiked as in the current debate suggests an appetite for this funding to be relied upon as an integral part of lenders’ business models – in particular the smaller participants in the industry. This is a cause for concern. In its extreme, such a strategy was employed by various non-bank lenders, who did not have a license to raise retail deposits, from the period of the late 1990s until the GFC - a period which saw significant contraction of bank lending margins due to the increased competition brought about by these lenders. The banks had the last laugh when securitisation markets froze, choking the funding sources for these lenders, who had little choice but to offer themselves for sale to the very institutions they had spent their lives battling. Smaller deposit taking lenders experienced the same pressures but, as their banking licenses allowed, had the ability to raise funds in the retail deposit market and were able to keep funding their lending activities. If we are to promote a higher degree of reliance on securitisation for smaller deposit taking institutions, we may not be so lucky when the next crisis hits.
3. How can competition be returned to the financial services sector, as well as balanced against the need for stability in the light of the first three questions?
It seems that when phrased in the context of the current debate, the notion of “competition” is a proxy for lower margins on standard variable rate mortgages (it seems unreasonable to suggest that politicians and consumer groups are advocating true competition, where strong and adaptive institutions thrive whilst weak and stagnant ones fail). As highlighted at earlier junctions of this submission, measures taken by the Government to enhance lenders’ access to these streams of funding would indeed allow banks to maintain their interest margins with lower variable mortgage rates.
But if we also consider lower variable mortgage rates in the context of the focus on serviceability referred to earlier, it is unlikely that banks and borrowers will be satisfied to settle on the reduced payments required to service a loan at the lower rate. Borrowers will be buoyed by an increase in the maximum loan amount now offered by their bank and the banks will of course be happy to extend the additional credit. As some of the most indebted households in the developed world, it cannot be argued that further indebtedness at the hands of government is a desirable outcome.
The benefits of wholesale funding are quite straightforward: assuming global wholesale debt markets are operating in an efficient manner, they represent an almost endless source of funding for a bank that faces pressure raising sufficient retail funding to satisfy the needs of its loan book. This is particularly important in Australia, where the willingness and desire of people to borrow money far outweighs their ability and desire to save it. Wholesale funding has historically played the role of a ‘plug’ on the balance sheet of banks, filling the shortfall between deposits taken and loans advanced.
The role of wholesale funding has become even more prevalent in recent years, as the focus for both borrowers and lenders shifted to a borrower’s ability to service debt at current and “expected” interest rates, with little consideration given to their overall level of indebtedness (which any self-respecting lender will justify by making reference to the inconsequential levels of loss historically realised on loans advanced to households and lenders mortgage insurance placed on any loan written in excess of an 80% loan to valuation ratio). The result has been an exponential increase in household debt and further challenges for banks wishing to fund their slice of the ever growing household credit cake.
Furthermore, in the post-GFC banking world, wholesale debt represents an attractive funding option as the competition for retail deposits has driven the price of deposit funding up significantly.
The risks of wholesale debt to financial intermediaries are varied, but all tend to stem from the relatively short term of such facilities. 3 and 6 month facilities are common – the latter of which needs to be rolled-over 50 times in the contractual life of a typical mortgage. There are two key categories of risk – or rather, impact, that arise from the use of wholesale borrowings to fund balance sheet growth. Broadly speaking, these impacts arise from the “rollover risk” of wholesale funding – that is, the potential inability to replace maturing wholesale debt with new wholesale debt.
Of course it is rare for any bank to experience a repricing of wholesale funding in isolation, save for a significant downgrade to its external credit rating. Therefore, the overall impact of limited access to wholesale debt markets is a function of the entire sector’s reliance on wholesale debt.
Risks to liquidity
In a fractional reserve banking system, the measure that ensures, to an extent, a bank’s capacity to satisfy the demands of depositors and other creditors is the amount of liquid assets held on the balance sheet. Liquid assets are typically maintained at levels which cover the bank’s day-to-day cash needs and to withstand an ‘adverse’ scenario, in which abnormally high cash demands are placed upon the bank. The threat posed to a bank’s liquid assets by wholesale funding manifests when a piece of debt matures and the bank is unable to secure ‘new’ debt to replace the maturing debt and the maturing liability must be met from the bank’s liquid asset reserves. Considering an Australian bank, on average, maintains around 5% of the liquid assets necessary to satisfy the simultaneous claims of all its creditors, it is clear that the inability to rollover a portion of wholesale debts will soon erode available cash and other liquid assets, rendering it unable to satisfy further claims from creditors i.e. it would be in a state of default.
The obvious mitigant to address this risk is to maintain a higher level of lower-yielding liquid assets, which places a bank in a position to better fund the redemption of maturing liabilities from its own reserves. The reduced interest income from doing so would need to be recouped from the loan book. i.e. interest rates on loan products would need to be higher than they otherwise would.
Risks to capital
In the scenario described above in reference to liquidity risks, it is unlikely that funding will be unavailable in a purse sense of the word. During the GFC, when banks described “difficulty in rolling over their maturing debt financing”, what they were actually experiencing was “difficulty in rolling over their maturing debt financing at suitable price”. Even whilst the walls of the global banking system are crumbling, counterparties in wholesale markets still have their price.
As we have witnessed since the race that stops the nation last stopped the nation, banks are limited in their ability to reprice loan assets. Even attempts to move a further 20bp above what the RBA moves its target cash rate by sees political parties tripping over one another to introduce “reform” in pursuit of the all-important mortgage holder vote. Put simply, if a bank is unable to pass on the increased cost of wholesale debt that prevails in a risk-averse wholesale funding market, it has the potential to lose money on its loan book – and in doing so, erode its capital base. Once a bank’s capital base is eroded, depositor and other creditors’ claims are jeopardised. i.e. it would be in a state of insolvency.
Similar to addressing liquidity risk, the primary method for protecting against this risk would be to maintain a higher portion of its balance sheet as capital in order to be able to withstand a higher level of losses. Again, the increase in latent money would necessitate higher interest rates across the loan book to pick up the earnings slack.
2. Given securitisation was at the centre of the GFC, what role should it play in renewed competition?
Securitisation is a useful and legitimate tool for managing a bank’s balance sheet. Assuming that the bank is satisfied the structure of the transaction leaves no recourse to its own financial well-being (i.e. If securitisation investors, not the bank, wear the loss of defaults in the underlying pool of mortgages), then it is not required to hold regulatory capital against the loans. The inflow of cash from selling these assets is also an attractive funding option. There should be no concerns with securitisation being part of a diversified set of options used by a lender to manage its balance sheet.
Similar to wholesale debt, the pricing of securitisation funding now seems much more attractive following the rapid increase in the cost of retail deposit funding. Greater access to securitisation funding would likely reduce banks’ funding costs and allow for lower lending rates.
However, the panacea which securitisation is spruiked as in the current debate suggests an appetite for this funding to be relied upon as an integral part of lenders’ business models – in particular the smaller participants in the industry. This is a cause for concern. In its extreme, such a strategy was employed by various non-bank lenders, who did not have a license to raise retail deposits, from the period of the late 1990s until the GFC - a period which saw significant contraction of bank lending margins due to the increased competition brought about by these lenders. The banks had the last laugh when securitisation markets froze, choking the funding sources for these lenders, who had little choice but to offer themselves for sale to the very institutions they had spent their lives battling. Smaller deposit taking lenders experienced the same pressures but, as their banking licenses allowed, had the ability to raise funds in the retail deposit market and were able to keep funding their lending activities. If we are to promote a higher degree of reliance on securitisation for smaller deposit taking institutions, we may not be so lucky when the next crisis hits.
3. How can competition be returned to the financial services sector, as well as balanced against the need for stability in the light of the first three questions?
It seems that when phrased in the context of the current debate, the notion of “competition” is a proxy for lower margins on standard variable rate mortgages (it seems unreasonable to suggest that politicians and consumer groups are advocating true competition, where strong and adaptive institutions thrive whilst weak and stagnant ones fail). As highlighted at earlier junctions of this submission, measures taken by the Government to enhance lenders’ access to these streams of funding would indeed allow banks to maintain their interest margins with lower variable mortgage rates.
But if we also consider lower variable mortgage rates in the context of the focus on serviceability referred to earlier, it is unlikely that banks and borrowers will be satisfied to settle on the reduced payments required to service a loan at the lower rate. Borrowers will be buoyed by an increase in the maximum loan amount now offered by their bank and the banks will of course be happy to extend the additional credit. As some of the most indebted households in the developed world, it cannot be argued that further indebtedness at the hands of government is a desirable outcome.
Son of Wallis Challenge - winner
The Government’s response to the Opposition push for a debate on post-GFC banking reform has been to throw a blanket over the issue. Rather than open up discussion with a wide “Son of Wallis” inquiry leading to ‘root and branch’ reform, Wayne Swan has rushed a minimal package of regulatory changes and corralled debate in a Senate Inquiry that is circumscribed by the very parameters that brought on the GFC - competition.
In an effort to fill the void, five concerned citizens commissioned a private A Son of Wallis Challenge offering a $1000 prize for the best essay addressing the real problem in Australian banking - it’s reliance upon unstable forms of funding and the public risk that that entails. The five include the business bloggers Houses and Holes, Delusional Economics and The Unconventional Economist, as well as David Richardson, banking analyst at The Australia Institute and Deep T., a banking insider that is fed-up with his colleagues’ reliance on public support.
The results are in and they could not be more impressive. In fact, judging the prize was no easy task for the reason that so many good and innovative ideas were forthcoming.
Without further ado, the winner of the prize is Kaon Li. Following is an excerpt from the essay:
The wholesale funding guarantee offered by the Australian government was the ‘least worse’ option during the GFC. The Irish government started off a global bank run when they guaranteed the liabilities of the Irish banks. After that, only government guaranteed banks could borrow.
While giving certainty to foreign investors during a crisis is critical, the current government guarantee is a lousy way of doing it. It is crony capitalism: profit is privatized, risk is socialized. Although the risk does not show up on the balance sheet of the Government, it is there nevertheless and, as Ireland has shown, it can cripple a country.
The guarantee saved the Australian financial system, however it cemented the ‘too big to fail’ status of the Australian banks. The cost paid by the banks to the Australian government for the guarantee did not and does not address ‘moral hazard’. The banks simply pass the cost along to Australian borrowers.
We need a better deterrent mechanism.
With the global economy stablizing, it is time to ask why the Australian government guaranteed wholesale debt at 100% anyway? If the investor wants 100% security, they should be buying Australian Government bonds. We need a scheme that can impose a ‘haircut’ on the bond holders. My proposal is for the Australian government to support the bank wholesale fundings with a variable 3 month bond swap option. Let me explain how it works.
All wholesale funding of Australian financial institutions will now receive a partial government guarantee. The value of the guarantee with depend on the maturity and credit rating of the institution, and it’ll change every day. For example, a ‘AAA’ bond from one of the big 4 will be guaranteed up to 97c, but Bendigo Bank will only be 95c to the dollar.
The guarantee take the form of a swap option with a Government bond in 3 month’s time. If the bond holder chooses to exercise the option, the interest rate for the previous 3 months will be forfeited, and the bonds will be exchanged. The bondholder can also hold onto the bond instead, costing them nothing. In effect, it’s a free insurance policy for the bondholder with an excess of 3 month bond revenue.
However, the guarantee is not costless. If the bond is swapped, the financial institution will automatically issue a preference share to the Government of the same value. If the total value of the preference share exceeds the market capitalization of the bank, it’ll become Government owned.
The judging panel awarded Kaon high scores for her innovative solution to the ongoing dangers of moral hazard without bringing the banks to their knees. Her solution also offers a new long-term mechanism to control wholesale funding.
As mentioned, the competition was very close and the winning entry crossed the line ahead by a nose. Covering similar territory was Andrew Selby Smith who argued that the moral hazard of the government guarantee to wholesale funding could be mitigated by inserting a simple condition, that if it is ever called upon and the Australian government has to pay out creditors of the banks, then automatically “... the shareholders and management must be wiped out and the bank pass to Commonwealth ownership and control.”
Selby Smith also made the point that securitisation - the other from of Australian bank funding that was proven by the crisis to be very unstable - suffers the inherent danger of diffused responsibility because the “... originating bank can pass the risk on to some other party who was not involved in the assessment of the original mortgage loan. The risk should remain with the party who benefits from the taking of that risk, and who is best placed to assess the level of that risk - in this case the originating bank.”
Russell Bradshaw also addressed securitsation, basing his submission around the vital insight that nothing in the process itself offsets this agency problem because “... credit risk can’t be qualitatively transformed (as assumed within the market based competition for lending), instead it just gets absorbed or transferred.” According to Bradshaw, “... banks receive the right to profit from appropriately containing or avoiding risk, not because of their ability to convert the risk to a less hazardous state.” Therefore “... the turning over of banking functions to a seemingly competitive market has at best yielded superficial hopes of improved customer choice but, more importantly, has masked a more serious issue of the mis-selling of credit and gargantuan risk transfer to the public purse”.
In seeking to balance these problems with securitisation against the quest for an efficient financial system that benefits consumers, Sam Birmingham offered the breakthrough conceptual framework of “sustainable competition”:
In response to the Treasurer’s reform package announced over the weekend, Bank of Queensland CEO, Graham Liddy, argued that “...you can access funding today, but it’s still the cost that is the anti-competitive issue”. Similarly, in its submission to the Senate Inquiry into Competition in the Banking Sector, CUA argued that: “(O)ne of the major factors restricting competition within the Australian banking sector is the difficulty CUA and other customer-owned financial institutions have in accessing reasonably priced funding from both domestic and overseas markets.
Sadly, both BOQ and CUA fail to grasp the difference between competition and sustainable competition.
Let us consider for a moment that the levels of competition prior to the GFC were not sustainable – after all, the business models of various non-bank lenders who aggressively drove margins down over the preceding years collapsed as soon as (excessively) cheap money sources dried up.
...Relying on competition to drive down lending margins is not sustainable anyway, because once borrowers expect that the reductions will continue, they feel confident to assume a larger debt and any “savings” are quickly capitalised into higher asset prices… Then we’re back to square one.
Winding up the challenge (but by no means last) was the outstanding contribution of Rory McKeown who attacked the overall “toxic logic” that surrounds modern banking, entrenching perverse incentives. His suggestions are threefold. First, on wholesale funding and other forms of bank interconnectedness:
The banking system is highly connected via the repo and swaps markets. The fall of one institution could mean the fall of all, as the asset book of a bank becomes less determinable as it's counter-parties default. As it becomes less determinable, the reserve ratio requirements and mark to market accounting become even more problematic. The bank is essentially bankrupt. For a small bank, this is a problem for counter-parties, but for a large bank, it is a system threatening collapse.
The author proposes that banks be taxed not in proportion to their size, but in proportion to their connectedness to the market. Each trade entered into must be registered with a central institution, where the deal is valued in terms of risk and size. The total risk to the system of an institution should be composed of it's own outstanding debt, and a proportionate amount of it's nearest neighbours.
Hence as interconnectedness in terms of size and risk increase, the institutions forming this risk nexus should be taxed appropriately more.
Second, on securitisation:
The rating agency model is completely conflicted where an agency is authorized by the government to define the quality of a securitized product. As the rating individuals involved see their year end bonus defined by the quality of the ratings they give, clearly they will always be proposed to “do business”, rather than “do analysis”. As they are government sponsored, a competing independent agency is always considered a lesser value analysis. The author proposes an end to “certified ratings agencies”, and an open platform for securitisation vehicles to present the credit worthiness of their underlying mortgages. Hence independent analysis houses can access this information and provide independent reports to funds and banks who are interested in these products.
And finally on bankers themselves,
The author proposes a stringent set of examinations similar to an actuary or a barrister for any person who wishes to become an executive of a bank. They should include banking history, economic theory and financial mathematics. Qualification should come at only serious personal cost (i.e. many years of personal study), and should be stripped away immediately in the event of failure. Top bankers should by law have undergone a training regime as rigorous as top surgeons or judges. As the recent crisis has shown, their role in society is in many was more powerful than other people in serious positions of responsibility.
There can be no better final word.
I would like to thank all participants in the challenge. The full text of the nine finalists will be on display at Houses and Holes across the Xmas period. I would also like to thank my fellow judges, who underwrote the project.
David Llewellyn-Smith is the founding publisher of The Diplomat magazine. Now Asia’s leading international relations website. He is also the co-author with Ross Garnaut of The Great Crash of 2008.
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