With our banks and other financial institutions now effectively underwritten by the Federal Government and taxpayers, it’s time we started discussion about the regulatory structure needed to oversee financial groups that are too big to fail.

The Federal Government and regulators are still concentrating on getting the guarantee system in place and pricing it, accompanied by the self-satisfied self applause of Nelson Turnbull and Brendan Hockey. But we need discussion to start on a new system of regulating financial groups that can’t fail.

Up to now the banks and financial groups have been regulated so as to force them to maintain liquidity and solvency. That stays, but restrictions on behaviour now have to be devised. Here are some thoughts on which direction they should take.

First off, the banks have to start giving back their higher funding margins, starting with the 0.20% not passed on from last week’s 1% rate cut from the Reserve Bank. The Federal Government guarantee of their wholesale funding will lower their costs: Australia has a triple A rating, the banks AA for the big four and lower for others. There has to be a quid pro quo for the banks. Holding onto higher interest costs to help finance their more expensive fund raisings is no longer an option or an excuse. After last week banks have an extra 0.71% or more (that’s the Commonwealth) in interest margin. Time to give that back to the customers fellers! And time the Federal Goverment told them to do just that!

No more mergers or acquisitions. The big four are big enough. The Four Pillars policy should be reaffirmed. If anything the events of the past year shows that size is no defence from collapse and it seems in many cases, the bigger the bank, the more stupid and culpable the managers and board (UBS, Citigroup, Dexia, Fortis, Hypo Real Estate, RNS, HBOS, Barclays). In Australia the ANZ and NAB made some pretty dopey investments or deals.

There should be no restrictions on what banks can invest or finance, so long as the necessary capital allocations are made.

The adequacy of the Basel 2 regime on capital should be re-examined by regulators as a matter or urgency.

If there is an implicit guarantee for every bank and financial group, should capital adequacy rules apply to all organisations to varying degrees? Do we need a set of rules that were constructed in the easy credit/debt binge days?

No off balance sheet investments or vehicles like conduits or structured investment vehicles at all, with the exception that if they want to do it, they have to allocate larger than needed amounts of capital to the investments (which will force them to bring them assets onto the balance sheets).

Regulators allowed the big four banks to have one or two off balance sheet conduits (Westpac’s was the soundest of all because it contained mostly its owned originated paper), but there was an estimated $25 billion in assets, out of around $30 billion in off balance sheet vehicles as at August last year. The Reserve Bank had to ask all the banks (with APRA) for details of those off balance sheet groups to find out what was in them and their vulnerability.

SIVs and conduits were used to hold more assets than allowed by bank capital ratios off the balance sheet by many foreign banks, they were used to drive earnings, bonuses for executives (because of the positive impact on earnings) and many were highly geared, much more so than the bank was allowed by regulators. The Spanish central Bank told its banks that they could have off balance sheet vehicles so long as they allocated the same level of capital as if they were on balance sheet. it’s why Spain never had a problem sub subprime mortgage exposure directly or indirectly.

In truth Australia was lucky, had the boom gone on for another year or two our banks would have gone deeper into the mess. The NAB has a conduit with $4.5 billion of assets of supposed higher values, but the bank can’t bring it back on balance sheet and has had to pay $500 million over five years for extra credit insurance!

APRA and the RBA should be asked in any public inquiry why the banks were allowed to have conduits and SIVs, without appropriate capital allocations.

Fees should be set now at current levels and then reduced, much in the way regulators cut power charges) by an agreed method over the next five years (for example) by the headline inflation rate. So next year the fee would be say $10 less the CPI of 5%, then in the second year, $9.50 less the CPI. With the CPI falling, the cost of the reductions would ease.

The banks now have 90% of all home lending and a great swag of business and personal non-home lending. Their interest margin should be enough to drive earnings, along with operating efficiencies.

If this proves too much, a one off reduction in all fees and charges should be levied, with bank dishonour and overdrawn fees abolished. They are fiddles and are often charged by the banks when people have money in other accounts.

Bonuses for bank executives at all levels, bar the front line staff, should be banned. Our performance is not a concept that is easy to understand when you control 80%-90% of the total banking services market. Bank executives and boards should not be able to reward themselves at their own behest and with the connivance of complacent institutional investors.

Banks should have to open seven days a week and for longer hours each day: they are not effectively money utilities and should be regulated as such, with the overlay of strengthened prudential requirements. Unions should not have a role in this, but employees should be paid to reflect the greater availability of services.

The banks should be encouraged to sell off, separate in some way their non banking businesses, such as fund management and insurance. They add extra risk to the equation and its doubtful the capital tied up in them, or the amounts originally paid for them, get useful returns for their owners. We will see from next week the damage of having funds management businesses in the balance sheet when the NAB and St George report their 2008 full year results.

Westpac partly sold down its funds management arm into the market, but St George has 100% ownership. The ANZ has a 49% stake in its fund management arm with ING owning the rest.

We have the absurdity of many institutions, supposedly investing super funds for the long term retirement plans of Australians, taking short term decisions to boost profits by lending shares to hedge funds and other speculators. And when the value of their shares fall, the value of the members or customers investment falls. No stock lending and hedge funds and other investors have to reshape their hedging and other investment models, but not off the backs of the value of retirement funds managed by greedy and avaricious managers.

These are not hard and fast ideas, merely thoughts to kick off discussion. But we have now established that every bank and financial group in this country can’t fail, so regulation at all levels has to change.

Peter Fray

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