Crikey’s Bernard Keane as always produced a fascinating commentary yesterday on banking reform, but while making some prescient observations, Keane committed the all-too common mistake of over-stating the banking sector’s actual importance to the economy. Bernard is hardly alone though — many business and political commentators erroneously point to the so-called heroic role played by Australian banks in steering Australia through the global financial crisis, when in actual fact, it was the Australian taxpayer that saved the banks.

Keane noted:

Governments create all sorts of distortions in banking, nearly all of them aimed at improving the stability of the industry, recognising that the industry is different to others in being critical to the functioning of the entire economy.

There’s a reason big banks are regarded as “too big to fail” — it’s because the damage systemic failure in the banking system would cause wouldn’t be limited to the banking industry, but extend across the entire economy.

The mistake made by Keane (and in fairness, by most commentators) is in assuming that governments have some sort of innate wisdom and banks are critical to the functioning of an economy. In reality, banks perform the reasonably simple task of allocating capital — they do that by raising funds from shareholders and lenders, and redistributing those funds to borrowers. The problem is, as the recession of the early 1990s and the GFC proved, usually, banks do a pretty poor job of allocating capital (the likes of ABC Learning, Babcock and MFS were only able to thrive and then collapse thanks to bank lending). The problem is, when credit is expanding, banks’ mistakes are generally hidden — as Warren Buffett would opine, it is only when the tide goes out do we see who has been swimming n-ked.

Contrary to popular wisdom, banks did not save Australia from the global financial crisis. In fact, during the height of the crisis, Australian retail banks and Macquarie were rushing through the halls of Canberra to ensure that Australian taxpayers were there to save them from their own risk-taking incompetence. Aside from a short-selling ban, the Rudd government created an almighty moral hazard by guaranteeing bank deposits (and lowering banks’ funding costs) as well as guaranteeing billions of dollars in wholesale funding.

At the same time, the Reserve Bank was dramatically cutting interest rates and providing liquidity assistance to banks. It was also revealed last week that the RBA borrowed $US53 million cheaply from US Federal Reserve (and its amazing money printing machine) in late 2008 while NAB took $US4.5 billion and Westpac $US1 billion. So forget the banks saving us, it very much appears that taxpayers (both local and foreign), who saved the Australian banks.

Keane is correct in noting that Australia’s Big Four (and possibly Macquarie) are politically, too big to fail. But to simply brush off such a fact as an unchangeable reality is foolish. Banks are too big to fail because Australia’s incompetent political class (from both sides of politics) has allowed them to grow too large. If the large banks were split up (at least into separate wholesale and retail arms, but probably even to a greater extent), they would not be too big and the explicit taxpayer guarantee would not be required.

Instead, Keane and other commentators suggest another option — instead of splitting the big banks, strengthen the banks’ smaller competitors, Keane suggested:

The extension of government protection to credit unions and smaller banks in a manner that at least reverses the pro-big bank outcome of the wholesale borrowing guarantee indicates that Swan is prepared to beyond pushing consumers to shop around and specifically address the competitive impacts of the government’s role in the industry.

That’s a bit like having two sons, one of whom is a drunk, the other of whom is a teetotaler, and solving the problem of having one drunk son by forcing the non-drinker drink a bottle of Scotch.

Credit unions and building societies have performed well precisely because they haven’t received substantial government assistance. By supporting the residential mortgage backed securities market (as the government did briefly in 2008 and 2009) or issuing “covered” bonds, the government would be encouraging the smaller banks and credit unions to undertake the very risky behaviour currently being exhibited by the big banks (who are backed by government guarantee).

The problem with Australia’s banking sector isn’t a lack of competition at all — in fact, it is the reverse. Over the past 15 years, banks have been too willing to lend money (there has been too much competition). This has led to a massive property boom, with the ratio of mortgage debt to GDP increasing from just over 20% to almost 90% today. The banks have sourced much of this increase from overseas, with most than a third of their funding coming from abroad. Banks lending too much money has created a property bubble, which if history is any guide, will lead to a widespread housing and possible banking collapse (until saved by taxpayers of course).

As Steve Keen points out in Business Spectator:

[It is a mistake to suggest] that the [banking] sector’s ills would be cured by more competition. In fact, we allowed too much competition in the 1980s, and again in the 1990s. The outcome, both times, was too much debt — firstly for businesses, and then for households. That’s the sector’s real problem, and adding a third dose of competition won’t fix it.

One merely needs to look to Ireland to see what happens when banks (supported by naïve governments) lend too much money for speculation on non-income producing assets.

Australian financial institutions are already terribly over-exposed to residential housing — increasing their exposure (through any sort of government-assisted borrowing) would serve to exacerbate the problem and increase an already burgeoning moral hazard. The government should (but almost certainly won’t) step in and ensure that a banking collapse doesn’t take down the entire economy. This is done by splitting the banks, not by giving them more explosive debt.

Peter Fray

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