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.