Thursday, December 23, 2010

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!

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