From crisis to cosy: why banking needs another inquiry

Recent regulator thinking on the financial system has been to favour stability over competition. thehutch/Flickr

Reporting season has delivered another round of record bank profits. Yet, in itself, this is no bad thing.

Former Reserve Bank governor, the late Sir Harold Knight, used to quip that profitable banks don’t fail. Indeed, we should be thankful that our banking system is sound, stable and profitable. No-one wants the opposite, that’s for sure.

But is stability the only thing we seek in a banking system? Profitable banks might be stable but are they innovative? And does the profitability of our big banks indicate that they face too little competition?

It’s been 16 years since the Wallis Committee handed its final report to then Treasurer Peter Costello. It’s time we thought again about the bigger questions surrounding financial system development in this country.

Think how differently the financial system looked in 1997. Banks funded themselves predominantly from wholesale sources, and deposit funding was slowly declining. The household sector was a net borrower and superannuation savings were a mere fraction of the A$1.6 trillion they have since become.

Securitisation revolutionised mortgage lending, pushing down mortgage rates, narrowing bank net interest margins and raising competition for home loans to fever pitch.

Prudential regulation, while acknowledged as important, stood in the shadow of market conduct and disclosure regulation, which those espousing the dominant mantra of market efficiency assured us would suffice. The financial system itself accounted for a steadily rising share of the national economy.

Since the global financial crisis of 2008-09, each of these apparently inexorable trends has stalled or reversed. There has been a flight from capital markets and a retreat to the comparative security of traditional intermediaries like banks and insurance companies. Regulators have worked overtime to sandbag their financial systems against continuing instability in global capital markets.

Competition still missing

Stability now stands at a premium over competition and innovation, as does sheer size. Authorities seem content to allow greater concentration among financial intermediaries in the interests of shoring up their stability. In a world of one-eyed regulators staring down stability, capital on balance sheets is king.

None of this would be especially surprising or worthy of investigation were it not that the Wallis Committee’s regulatory framework, implemented in virtually every detail by the Howard Government in the years following the inquiry, was built on very different assumptions. Chief among these were the assumptions that capital markets would come to dominate intermediaries and that systemic risk was essentially about bank runs.

Confidence in the stability of markets is at a low point. montuschi/Flickr

Capital markets descended into paroxysm during the financial crisis and on some measures have yet to recover. The convulsions originating in capital markets soon engulfed entire financial systems, leaving central banks to resuscitate securities markets as well as banks, something the architects of systemic risk supervision had not envisaged.

For all this, the Wallis framework withstood the onslaught, ably administered by skilful public officials. Australia’s fortunate economic position in relation to China no doubt also played a role. But the fact remains that the financial landscape is very different post the crisis from that envisaged by the Wallis Committee and on which its regulatory framework was based.

Shift in super

Superannuation played a minor role in the Australian financial system at the time of Wallis and must figure prominently in a “Son of Wallis” inquiry. Our defined-contribution superannuation system has been a huge success, with funds under management now equal to the size of the economy itself and ranking fourth in the world behind countries with economies substantially larger than ours.

Yet Wallis recommended that the “best endeavours” nature of defined-contribution superannuation ought to exempt funds from prudential supervision. Events have conspired against this sanguine approach, and public offer superannuation funds are now subject to liquidity controls. The neat separation of responsibility between regulators that flowed from the Wallis vision has blurred after sixteen years, and is yet another ground for rethinking the regulatory blueprint.

Superannuation is now so large that, arguably, it distorts the flow of funds through Australia’s financial system. While it’s true that super funds lend money to banks as well as buying their shares, the objectives of superannuation remain narrowly to fund retirement incomes. Banks exist to finance enterprise, especially small and medium-size enterprise. Can we be confident that the right mix of projects will be financed for the future development of the Australian economy?

The Wallis Committee, and the Campbell Committee before it, recommended against forcing banks and superannuation funds to lend money to governments, even if the funds were earmarked for infrastructure. Has the weight of evidence and logic changed on this front? When so much funding passes through intermediaries rather than markets, and some markets, like the corporate bond market, don’t exist in Australia, can we be confident that the financial system will meet the varied needs of businesses and governments for financial accommodation in the future?

Crucially, the thinking has changed fundamentally since the Campbell and Wallis inquiries. These committees deliberated against an intellectual backdrop of rationalist economics. Markets were assumed to be efficient and the onus of proof lay on those who thought otherwise.

In the wake of the global financial crisis, confidence in the efficiency let alone stability of markets is at a low ebb.

Behavioural finance has become a force to be reckoned with, leading observers to think very differently about the efficacy of market intervention and regulation.

Not only has the practical ground shifted under Wallis, so has the intellectual ground: two fundamental reasons why it’s time for another financial system inquiry.