Joe Hockey may have blundered into the issue of bank regulation, but he is dead right about the need for a fundamental debate about financial regulation. Hockey overplayed his attack on Wayne Swan this morning over bank interest rate rises outside the RBA cash rate when he appeared to suggest legislative measures to curb interest rate rises. He was very quickly under fire from all quarters, particularly from the bankers' cartel, not least for the apparent hypocrisy of the party of small government calling for more regulation of markets. At a press conference this morning he pulled back significantly, and used as his cover a call for a "social compact" and a fundamental debate about the responsibilities of major banks and how they should be regulated. He is not, he made clear, calling for regulation of interest rates. Hockey will doubtless be hammered by the Press Gallery for his clumsy handling but what he had to say about finance regulation was the most sensible thing we've heard from a major party politician on financial regulation since the GFC. The Reserve Bank made it clear this week that the major banks' repeated claims that they are facing higher borrowing costs are, not to put too fine a point on it, rubbish. The RBA minutes from its meeting two weeks ago were extraordinarily blunt for the central bank: "members noted staff estimates that banks’ funding costs had been relatively flat over recent months. While the spread between lending rates and funding costs was below its peak in 2009, it remained well above its pre-crisis level." If anything, that suggests that, in the event of a rate rise by the RBA, there's a case for the Big Four to increase rates by less than the increase in the cash rate, not more. There are two key issues raised by Hockey that should form the basis of the debate he wants to see. One is the need for greater competition for the big banks, which has been seriously impaired since the GFC. Hockey mentioned an idea he raised in 2009, of a government guarantee for Residential Mortgage Backed Securities, to try to breathe further life into the non-bank lending market. That sector has been on government-funded life support ever since, courtesy of $16b worth of funding from Wayne Swan. It has been slowly -- very slowly -- recovering, but is obviously not within cooee of providing the sort of competitive pressure it provided for the banks before the GFC. If Hockey is serious about encouraging more competition for the big banks he should be exploring some of the ideas raised by the Six Economists in July last year, especially around a "people's bank" that could deliver low-cost financial and lending services (I've previously suggested Australia Post could be the delivery mechanism for such a bank, or AP could team up with one of the major regional banks). The ACCC should also be looking a lot more closely at the manner in which the Big Banks appear to be coordinating their interest rate rises by publicly flagging rate increases beyond the cash rate -- behaviour that looks an awful lot like a public kind of collusion between oligopolists. But Hockey raised a more fundamental issue of whether banks should be growth stocks or yield stocks, and in doing so has opened the way to the sort of debate that some economists have been calling for for some time. In the wake of the GFC, there is a basic tension at the heart of our regulation of the big banks. Their core activities of domestic borrowing and lending for households and businesses are never going to grow rapidly. But bank executives are ruthlessly focused on growing their share prices. This is where the dilemma over being growth stocks or yield stocks plays out. Our big banks make excellent yield stocks - they are low-risk, have been tested and proven by the GFC, and produce a steady, strong profit stream. But they're not growth stocks, particularly in a market where the RBA is clearly anxious to limit the growth of credit. The only way the banks will become growth stocks is by expanding into riskier areas of operation. Bear in mind that, by accident and design, it was our banks' non-exposure to riskier activities, unlike their American and European counterparts, that was a key reason why we dodged the GFC bullet. Now our banks are hunting for growth, most obviously in offshore expansion, for example expanding into riskier Asian markets. And they're doing so with an implicit government guarantee. The Government's actions in the GFC signalled that, indeed, our largest banks are too big to be allowed to fail. They are so crucial to Australian economy that they will not be allowed to fail -- no matter how risky their behaviour. It's as good an example of moral hazard as you'll get at the moment. The banks are behaving like private companies but should be regulated like utilities, and compelled to focus on lower-risk, bread-and-butter financial services. They already generate, as Hockey said this morning, "super profits". CEOs' need to pump up their share prices for the sake of a bigger performance bonus shouldn't place at risk the critical economic role played by the banks, nor should it be supported by a de facto government guarantee. These are the issues Hockey has now put on the table, whether by accident or design. It's in contrast to Wayne Swan, who since his (deft) handling of the GFC has been strangely reticent on the issue of banking competition and regulation. If Swan was smart, he'd put aside bagging Hockey -- there'll be lots of other opportunities to do that -- and seize on the chance to pursue them. Oh and one more thing. Hockey is right about the banks earning super profits. Which begs the question -- is a super profits tax on banks worth considering?