Graham Hand is the author of Naked Among Cannibals: What Really Happens Inside Australian Banks, published in 2001 by Allen & Unwin, which looks at changes in Australian banking practices over the last two decades. This excellent article was first published in the fabulous Ian Rogers banking ezine on July 4.

Rarely does a month go by without one of the chief executives of a major Australian bank arguing that the “four pillars” policy should be removed.

In the last month, it was Westpac’s David Morgan banging the drum. Perhaps the bankers agreed over coffee and biscuits at an Australian Bankers Association meeting that they would take turns educating the masses. Eventually, they hope, the rest of the country will see the merits of allowing the major banks to merge. As soon as four becomes three, the remaining two would be forced to match their large rival, and three would become two. But the public is right to worry about what would happen to fees and services with only two dominant players.

The irony of the four pillars policy is that the banks have only themselves to blame for the current intransigence. Their behaviour in the 1990s while rebuilding profits after the recession left millions of customers (read, voters) disillusioned with the banks they once trusted. Increasing fees for declining standards of personal service, closure of branches in country towns, excessive executive remuneration and spectacular profit growth alienated the public. It became politically unacceptable to place further oligopolistic power into two hands when four had shown they did not know how to behave responsibly. Surveys showed banks had become the most disliked of all industries in Australia.

A look at one example of the role banks play in any economic system, the “transmission mechanism”, demonstrate show they abused their power. When central banks wish to stimulate economic activity, they lower cash rates. All other market interest rates derive from cash rate expectations, and cheaper funding costs are supposed to be transmitted quickly by banks into mortgage rates and business overdrafts and onto the real economy. In theory, growth follows. However, although the country was desperate to emerge from the 1990-91 recession, Australian banks deliberately delayed passing rate reductions to borrowers for long periods, in an effort to maintain net interest margins. They compromised the efficient operation of monetary policy and delayed economic recovery.

One consequence of the policy stalemate is that Australia is out of step with many other parts of the world. The German and French governments recently expressed a desire to see banking industry consolidation by the creation of so-called Franco-German “champions”. Merger activity is seen as a way to improve competition and encourage economic growth in Europe. Similarly, the US is experiencing industry consolidation, such as the merger of JP Morgan Chase and Bank One, and in the UK, the combined Royal Bank of Scotland and NatWest is now the world’s fifth biggest bank.

Australia is different. It would be an ACCC struggle for the big four to buy any of the regional banks, and impossible to merge with each other.

What were the major banks supposed to do in the decade of rebuilding? Surely, like any business, banks have a responsibility to maximise profits, and a healthy banking industry is essential for the prosperity of the economy. When David Murray told the National Press Club in 2001 that the Commonwealth Bank was a bank for all Australians, but, “I can tell you, on the current trends, we may have to review that decision in future years if we cannot get a fair price for services”, many bankers agreed with him. All banks have the right to provide services only in those places where they can make sufficient profit. There are no obligations to anyone except the owners of the business. Right?

Wrong. The banking industry is different.

Banks are the medium through which monetary policies are transmitted, and in partnership with government agencies, they operate the payments system used for all transactions. Every employee must have a bank account. In Australia, the banks dominate the market for personal and commercial finance, especially for small businesses, and their subsidiaries manage the majority of superannuation savings. Consequently, the government and industry regulators must create an environment in which systemically important banks are protected.

If a bank experiences a financial crisis, it will be the taxpayer who picks up the burden. It is not possible for regulators to insist that the rest of the banking industry bears the costs, because shareholders of other banks will rightly claim it is an inappropriate use of their equity. The only place to go to pay the bills is the Commonwealth Treasury. Banks are therefore carefully nurtured and monitored by government agencies, and it is not surprising that there is no such thing as an unsuccessful Australian bank.

The privileged position is brought into sharp focus by some surprising revelations by Moody’s Investors Service. In its Banking System Outlook for Australia 2003 (the latest available), Moody’s uses global comparisons to measure the relative liquidity strength of Australian banks. Liquidity is the ability to meet obligations as they fall due, and maintenance of sufficient liquidity protects both individual banks and the economic system as a whole. Yet by international standards, the Australian banks have very poor liquidity characteristics.

Does this thing called liquidity really matter? At the recent annual general meeting of the Bank for International Settlements, Charles Goodhart of the London School of Economics made a fascinating claim. “It is arguable that the case for externally imposed liquid assets ratios is actually much stronger than the case for externally imposed risk-related Capital Adequacy Ratios.” For the best part of two decades, the BIS has been preoccupied by capital adequacy and the Basle I and Basle II Accords which banks around the world agonise over, and here is a policy advisor suggesting something else is probably far more important. Goodhart goes on to write, “It is liquid assets, not capital, that provides time in crises.” And time is the most important factor when dealing with financial difficulties.

The more liquid assets a bank holds, the more it can support itself as other asset values fall or deposits are withdrawn. The Moody’s Outlook claims that liquid assets as a percentage of total assets for the four majors was only seven per cent, compared with an average of 37 per cent for banks from the US, Canada, the UK, Germany and Switzerland. Moreover, Australian banks operate on a loan to deposit ratio of134.7 per cent, versus an average for these other countries of 99.7 per cent. Moody’s could be expected to mark down the credit ratings of Australian banks for holding insufficient liquid reserves, and levels of lending far greater than they can finance from domestic deposits. But the ratings agency gives the four majors its highest short-term rating.

In other words, Australian banks are able to hold low levels of the worst yielding assets on the balance sheet, and they do not need to compete as aggressively for domestic deposits, instead relying on funding by selling bonds overseas. Each of these balance sheet management strategies adds significantly to profits, but involves a riskier approach that would normally lead to caution with the ratings.

The crucial and differentiating factor for Moody’s is the high level of support provided by Australian regulators and the prudential environment created. The major banks do not need to meet global standards for liquidity, because, “We believe that, as one consequence of the politicisation of the Australian banking industry structure, relatively high levels of support may in practice be made available to institutions that require it, if they are significant on either a national or State level.” Moody’s argues that the four pillars policy gives the ratings of the majors an “extra element of stability”, and its removal could cause a significant impact on ratings. All four majors have been rated the same for many years, making it virtually irrelevant what they do in their own activities. No bank has been allowed to fail by any government in Australia, nor will it happen in future.

Moody’s even dismisses the cost of taking more of a social role where, for example, the banks are being forced to reduce interchange fees. Revenues are likely to be “largely recouped through other pricing adjustments”. Not for the banks the fear of cheap imports from China or falling global prices for exports. International markets bring cheaper funding, driven by the Aaa credit rating of Australia. Furthermore, the strength of the local property market, itself created by government policies relating to negative gearing, first homebuyer grants and capital gains concessions, allows banks to have high quality loan portfolios, securitise their mortgages and sell them in international markets.

While Australian bankers like to think their profits are driven by their own management skills, much of the credit for the past success of the banks should go to that much-maligned institution, the Australian Prudential Regulation Authority, and previously, the Reserve Bank. APRA is intimately involved in setting bank-specific policies across a range of risks, including liquidity. It offers its advice and in some cases, insists on changes, and each bank must provide a risk management description to APRA at least annually. An examination of APRA’s prudential standards and guidance notes demonstrates the broad extent to which the regulator is involved in running the banks. APRA also requires the external auditor to provide it with a detailed prudential compliance statement within three months of a bank’s reporting date.

In addition, the Reserve Bank has brokered a deal called the interbank deposit agreement, whereby each of the four majors provides $2 billion of 30-day back-up liquidity support for the three others. That’s $6 billion of liquidity for each major bank, which allows them to run lower levels of liquids on the balance sheet.

This special regulatory support for the four majors is so strong that Moody’s admits it does not give a ratings boost to any regional bank as a result of the government support. Moody’s meets regularly with Australian regulators to ensure there is no reduction in the commitment to the major banks, and has never come away with doubts.

Few other industries have large government entities advising them on the management of their business, and negotiating deals on their behalf to maintain corporate strength and improve profits. The major banks are nurtured and protected because they are too big and important to fail. Little wonder the ASX200 index is becoming more of a banking index than one representative of all industries.

It is therefore appropriate that a country whose governments have created such a favourable regulatory environment should share in the success of the businesses that are able to exploit it. Four companies extract $10 billion a year in profits from such a system, and some form of a social dividend, not only shareholder dividend, should follow.

Michael Chaney was recently appointed as the future Chairman of National Australia Bank. At a “Meet the CEO” seminar given to alumni at the University of New South Wales in June 2004, he was asked about corporate responsibility. He said it is clear from case law and legislation that the duty of directors is to the company, not the shareholders. Part of this responsibility is to ensure the company is a good corporate citizen, and looks after all its stakeholders. While success is primarily measured by returns to shareholders, the company must recognise its role in the broader community and to its customers.

Far from being obliged to maximise the share price at the expense of all other responsibilities, Australia’s major banks have obligations to many stakeholders. The regulatory and economic environment of the past 10 years has ensured their success, but it must be a two-way deal. They should pass on rate reductions to borrowers quickly, maintain a widespread and well-staffed physical branch presence, provide inexpensive banking services to the disadvantaged, pay market rates on deposits and remunerate senior management with more restraint. The banks did not create Australia’s strong economic growth, low unemployment and benign interest rates, nor did they design the tight and favourable prudential environment that underpins their profits. They have simply reaped unprecedented and sustained profit growth. A lucky industry in a lucky country.

And until all the banks show they clearly understand this and can act responsibly, four pillars will remain sacred government policy.

Stuart Mackenzie is editing The Sheet this week and can be reached on stuart if you’ve got a hot banking news tip.

Peter Fray

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