Friday, October 22, 2010

Go Joe

Yesterday, Shadow Treasurer, Joe Hockey, was torn to shreds for making the most sensible suggestion regarding Australian banks that this nation has heard since the global financial crisis.

First on ABC radio and then again in a doorstop interview, Hockey made the case that the government needs to act to rein in unilateral interest rate rises. Hockey called for "...a mature debate about the future of banking here in Australia and the challenges around the world". And although he rejected recent Greens' agitation for legislation on the matter, the Shadow Treasurer rang a clarion opening bell for that debate by welcoming their ideas.

In a parliament defined by conflict this was genuine leadership.

Hockey's argument is as fresh as it is straight forward: "I am calling for a social compact between the banks, the community and the government that focuses on delivering affordable credit to Australians and does not disadvantage unfairly people who are borrowing money to buy their home."

The keystone of Hockey's position is that in its recent statement on monetary policy, the RBA called time on the bank's expanding net interest margins. According to Hockey the banks therefore have no excuse for further unofficial rate rises.

To understand each of these two important and interdependent points we need some history.

Banks are privileged businesses like no other. Their role as mediators of savings and credit give them a virtual license to print money. Yet, this position is also central to the smooth running of every dimension of an economy. There is always therefore a balance to be struck between the banks' profit and its duty of care.

Since the 1997 Wallis Inquiry the monitoring of that duty of care has been split in two. Deposit-taking banks were governed by the Australian Prudential Regulatory Authority (APRA) and its rules that banks keep certain levels of capital in reserve in case of losses, and that they do not over-leverage.

Non-banks also mediate credit but they take savings from investors which they pass onto borrowers via market-based bonds called Residential Mortgage Backed Securities (RMBS). After Wallis, they were left unregulated because investors and the market in which they operated were deemed sophisticated and efficient enough to handle themselves. Listed firms fell under the purview of ASIC like any other company.

What happened next was that the two sides of Australian financial services went to war over customers. The battle lasted ten years and by its conclusion both halves had borrowed enormous amounts of money offshore and poured it into housing mortgages.

Then, when the GFC arrived, both sides of the regulatory structure failed.

Non-banks were found to rely heavily on cheap short-term funding from investors for the long-term loans they provided customers. As the GFC gathered pace, this short-term funding suddenly became very expensive and the interest rate spread that underpinned the non-banks business model collapsed. Most were absorbed for a pittance by the banks.

When the crisis reached fever pitch after Lehman Brothers hurtled off a cliff, the banks were found to have a similar problem. They had borrowed a huge amount of money offshore and much of it was also of the cheap, short-term variety. As global markets froze, neither APRA nor the RBA had the firepower to contain the bank's bleeding.

A government guarantee of $157 billion in offshore borrowings was needed to stave off probable insolvency for all major banks and a calamity for Australia.

So neither APRA's regulations nor the market's discipline sufficed to hold banks and non-banks within the social compact outlined by Wallis.

That brings us to Hockey's second point. Since the GFC, markets have recovered enough that they will now lend Australian banks money at reasonable rates. But those rates are generally still higher than they were pre-GFC. As well, APRA has pushed banks to refinance cheap, short term offshore borrowings to more expensive longer term loans.

The banks are not kidding that their cost of funds has gone up. As each pre-GFC offshore loan becomes due it must be refinanced at a higher rate. The rise in costs is unlikely to have plateaued because APRA is not finished restructuring international bank borrowing. It has yet to impose new international rules called Basel III.

Hockey is right, however, that the banks can pass on these higher costs only because there is no competition. There is nothing to the banks' argument that they must ipso facto pass on their higher funding costs to customers. If there were healthy competition then they would simply have to wear it in lower profits. Sadly, because all of the banks borrowed monstrously offshore there is nobody left to take advantage. This is Australia's version of too-big-to-fail.

But Australia is in a bind. Hockey's suggestion for increased competition is to extend the nation's AAA guarantee to RMBS issues. This is a ludicrous solution for a number of reasons, not the least being it relies on the same Wallis structure that has just proved unacceptably vulnerable.

Unless, of course, the guarantee is permanent. In that event, Australia will have established its own version of Fannie Mae or Freddie Mac, the government sponsored enterprises at the heart of the US mortgage meltdown. That runs the risk of breeding a whole new generation of cowboy lenders sporting the badge of the sovereign.

Besides which, a surfeit of credit has already inflated the great Australian housing bubble, the most stark real economic consequence of the failure of the Wallis structure. We don't need more mortgages, we need more business lending.

A better but more difficult road is to begin the long hard slog of raising more banks. Conservatively run banks that encourage savings and local deposits.

Some hints of how that might be done are already available. A combined AMP/Axa could be encouraged into banking services. Australia Post might begin a people's bank. Perhaps some of the smaller banks can merge. Longer term these options offer greater hope of producing a more competitive banking sector without relying on expanded moral hazards.

To answer these questions, Australia desperately needs a new 'son of Wallis' Inquiry. The first question it should ask is what kind of banking system does Australia want not today but in ten years. The current piecemeal approach will only repeat the failures of history.

Only that way can we answer Hockey's last and most important question. How does Australia deal with "...a new paradigm – I hate to use those terms, but I’m sorry, don’t groan too hard – a new framework, that’s the word – we are facing a new global banking framework. This is a whole new environment we are in."

An environment we haven't even begun to explore. Opening a window on that was Hockey's greatest contribution yesterday.

This article appeared in Crikey.

211010 - Joe Hockey Transcript Doorstop (1)


john said...

great article, thank you

sofar said...

Thanks for the good commentary and explanation of the Wallis structure. I watched Joe's doorstop interview on ABC24, and was wondering when his comments would receive more attention in the blogosphere.

Like you I fully welcome some real discussion on the future of the Australian banking system from our Members Elect.

Hockey is clearly backing the RMBS market as way of opening up competition between lenders. This is now doubt coming from his historical role of the Howard supporter of small businesses. Regardless of ideology, I'm not convinced that more mortgage lenders hawking larger and larger LVR's is what we really need.

Surely some of our politicians are aware of the fraudclosure debacle in the states and what a mess the securitization process can result in. Has anyone yet looked into the structure of RMBS notes here? What are the legal requirements for the transfer of mortgage notes in Australia, and what are the chances that the same shit-show can happen here?

I'm of the belief that Australian housing is in a bubble and that the bursting point is imminent. What I'm trying to get my head around now is what the consequences will be within the financial system, and indeed the big 4 banks we rely so heavily on.

Leith van Onselen said...

Brilliant post, David. The best analysis of Australia's financial system architecture that I have read (the second being your book). Well done. I just hope parliamentary advisers and officers in Treasury read your blog.

mahaish said...

hi david,

i think there are more fundamental issues at stake here than banks gouging interest rate movements.

as far as im concerned, the rba should not be interest rate targeting. that power should be removed from it, and it should only be there to guarantee the integrity of the payment system.

targeting has pervers income distributional impacts, and its a pretty clumsy way to control the money supply and spending in the economy.

the tax system is there if we want to control and direct spending in the economy.

right now under a budget deficit envioronment,official interest rates would be closer to zero than 4 and a half if we let the market decide, since a deficit would create a system wide surplus in the interbank market.

if we are worried about bubbles developing , we can tax the hell out of them,rather than use interest rates .

how on earth would the rba board know what a neutral setting is, as far as interest rates are concerned. there guess is as good as mine, given the lags invloved in monetary flows and changable velocity.

this is just a quick post, when i get the chance ill have more to say, especially re bank inernational wholesale funding.

when i get the chance i will say more on this

David Llewellyn-Smith said...

Thanks Mahaish,

I agree that the issues here are much bigger and deeper than Joe Hockey's comments. Indeed Delusional Economics has sequel piece to my own that captures my thoughts perfectly.

Nor do I think the issue is controlling interest rates.

For me, Hockey's comments were the first that addressed ANY of the structural issues emanating from the GFC. In that vein he should be supported and the debate encouraged and widened wherever possible.

The last thing I wanted to do was shut the debate down in defence of vested interests like most of the media did this week...

Sean Reynolds said...

David Llewellyn-Smith is a little bit wrong here, unfortunately -- as is Joe Hockey -- the Australian housing bubble has been caused by too much easy credit from overseas (read US) being fabricated by Wall St off the back of their own dysfunctional derivative products, and the combination of low interest rates and voluminous credit have created an extremely unhealthy price bubble in Australian housing, that is serving no useful economic purpose and disenfranchising a generation.

The RBA is now reluctantly hiking interest rates to try to calm the property bubble, although they never quite spell it out in those words.

To create another low interest operator as 'competition' would just be to set the conditions to make the current bubble worse and more destructive when it blows. What has to happen is house prices have to come down, and the banks have to be forced to lend less of this speculative overseas money -- although higher interest rates are of course the natural lever to achieve this, so it's kind of working. The other way to do it is simply to use APRA to make a few more regulations of the banks, if they have the teeth and the heart. Decreasing LVRs to 70-80% for instance would do it with a single blunt instrument.

Joe Hockey is just jumping on the simplistic, aspirational, hip pocket nerve 'low interest rates' bandwagon that all recent governments have been doing, which is the first sign that he is incompetent and incapable to ever be Treasurer. Not that Wayne Swan is any more competent, so maybe it's a prerequisite. Both parties have been playing off the RBA as the bad guy for some time now, where in fact the ALP passed legislation in its first couple of months of govt to deliberately distance itself further from the RBA to give it a real bad guy status. Now if you talk to the RBA about social justice concerns (and it's in their charter), they say 'that's political, you need to talk to Treasury about that' -- not that the Treasury beancounters have a clue or are any less psychopathic than the RBA and the banks, notorious for making the worst and cruellest policy suggestions in govt, and are usually roundly ignored.

David Llewellyn-Smith said...

Hi Sean,

I agree with everything you've said.

I would like to see a return to the financial services architecture that is generally associated with Glass-Steagall. All banking on-balance sheet. Separation of deposit-taking banks and securities business, as well as all securities business kept separate from mortgages.

There's a reason the world had no financial crises between WWII and the 1980s.

Of course Hockey's being populist. But he has opened a window on these issues when up until now it's been a brick wall of denial.

That should be encouraged.

Pharos said...

this blog ran a while ago so i'm a bit late on the scene but ultimately the way to create competition is for the government to underwrite the credit ratings of the smaller adi's who in quite a few cases carry more capital and less risk, are more conservatively ans sustainably funded than a major but have lower ratings because of supposeded "concentration" or increasingly the fact that they are not seen as strategically important to the economy. This means the marginal cost of funds for a minnow, even BEN or BOQ, is much higher than a major.
Australia is better off for a strong banking system but the big guys are pushing too far. Like the miners who are distirting resource allocation in the economy the banks should either pay rent on their licence to conduct business and their natural incumbency or the Gopvernment should work on a scheme to wrap qualifying smaller ADI's ratings up to the AA range of the Majors.