Yesterday, Shadow Treasurer Joe Hockey was torn to shreds for making the most sensible suggestion regarding Australian banks that this nation has heard since the global financial crisis.
First on ABC radio and then again in a doorstop interview, Hockey made the case that the government needs to act to rein in unilateral interest rate rises. Hockey called for “… a mature debate about the future of banking here in Australia and the challenges around the world”. And although he rejected recent Greens’ agitation for legislation on the matter, the shadow Treasurer rang a clarion opening bell for that debate by welcoming their ideas.
In a parliament defined by conflict, this was genuine leadership.
Hockey’s argument is as fresh as it is straightforward: “I am calling for a social compact between the banks, the community and the government that focuses on delivering affordable credit to Australians and does not disadvantage unfairly people who are borrowing money to buy their home.”
The keystone of Hockey’s position is that in its recent statement on monetary policy, the RBA called time on the bank’s expanding net interest margins. According to Hockey, the banks therefore have no excuse for further unofficial rate rises.
To understand each of these two important and interdependent points, we need some history.
Banks are privileged businesses like no other. Their role as mediators of savings and credit give them a virtual licence to print money. Yet, this position is also central to the smooth running of every dimension of an economy. There is always, therefore, a balance to be struck between the banks’ profit and its duty of care.
Since the 1997 Wallis Inquiry, the monitoring of that duty of care has been split in two. Deposit-taking banks were governed by the Australian Prudential Regulatory Authority (APRA) and its rules that banks keep certain levels of capital in reserve in case of losses, and that they do not over-leverage.
Non-banks also mediate credit but they take savings from investors, which they pass on to borrowers via market-based bonds called Residential Mortgage Backed Securities (RMBS). After Wallis, they were left unregulated because investors and the market in which they operated, were deemed sophisticated and efficient enough to handle themselves. Listed firms fell under the purview of ASIC, like any other company.
What happened next was that the two sides of Australian financial services went to war over customers. The battle lasted 10 years and by its conclusion both halves had borrowed enormous amounts of money offshore and poured it into housing mortgages.
Then, when the GFC arrived, both halves of the regulatory structure failed.
Non-banks were found to rely heavily on cheap, short-term funding from investors for the long-term loans they provided customers. As the GFC gathered pace, this short-term funding suddenly became very expensive and the interest rate spread that underpinned the non-banks business model collapsed. Most were absorbed for a pittance by the banks.
When the crisis reached fever pitch after Lehman Brothers hurtled off a cliff, the banks were found to have a similar problem. They had borrowed a huge amount of money offshore and much of it was also of the cheap, short-term variety. As global markets froze, neither APRA nor the RBA had the firepower to contain the bank’s bleeding.
A government guarantee of $157 billion in offshore borrowings was needed to stave off probable insolvency for all major banks and a calamity for Australia.
So neither APRA’s regulations nor the market’s discipline sufficed to hold banks and non-banks within the social compact outlined by Wallis.
That brings us to Hockey’s second point. Since the GFC, markets have recovered enough that they will now lend Australian banks money at reasonable rates. But those rates are generally still higher than they were pre-GFC. As well, APRA has pushed banks to refinance cheap, short-term offshore borrowings to more expensive longer-term loans.
The banks are not kidding that their cost of funds has gone up. As each pre-GFC offshore loan becomes due it must be refinanced at a higher rate. The rise in costs is unlikely to have plateaued because APRA is not finished restructuring international bank borrowing. It has yet to impose new international rules called Basel III.
Hockey is right, however, that the banks can pass on these higher costs only because there is no competition. There is nothing to the banks’ argument that they must ipso facto pass on their higher funding costs to customers. If there were healthy competition, then they would simply have to wear it in lower profits. Sadly, because all of the banks borrowed monstrously offshore there is nobody left to take advantage. This is Australia’s version of too-big-to-fail.
But Australia is in a bind. Hockey’s suggestion for increased competition is to extend the nation’s AAA guarantee to RMBS issues. This is a ludicrous solution for several reasons, not the least being it relies on the same Wallis structure that has just proved unacceptably vulnerable.
Unless, of course, the guarantee is permanent. In that event, Australia will have established its own version of Fannie Mae or Freddie Mac, the government-sponsored enterprises at the heart of the US mortgage meltdown. That runs the risk of breeding a whole new generation of cowboy lenders sporting the badge of the sovereign.
Besides which, a surfeit of credit has already inflated the great Australian housing bubble, the most stark real economic consequence of the failure of the Wallis structure. We don’t need more mortgages, we need more business lending.
A better but more difficult road is to begin the long, hard slog of raising more banks. Conservatively run banks that encourage savings and local deposits.
Some hints of how that might be done are already available. A combined AMP/Axa could be encouraged into banking services. Australia Post might begin a people’s bank. Perhaps some of the smaller banks can merge. Longer term, these options offer greater hope of producing a more competitive banking sector without relying on expanded moral hazards.
To answer these questions, Australia desperately needs a new “son of Wallis” inquiry. The first question it should ask is what kind of banking system does Australia want not today but in 10 years. The current piecemeal approach will only repeat the failures of history.
Only that way can we answer Hockey’s last and most important question. How does Australia deal with “… a new paradigm — I hate to use those terms, but I’m sorry, don’t groan too hard — a new framework, that’s the word — we are facing a new global banking framework. This is a whole new environment we are in.”
An environment we haven’t even begun to explore. Opening a window on that was Hockey’s greatest contribution yesterday.
*David Llewellyn-Smith is the co-author of The Great Crash of 2008 with Ross Garnaut and the founding publisher of The Diplomat magazine. He writes daily at his blog Houses and Holes, this post originally appeared there .