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A system at risk: the case for regulatory overhaul in Australia’s banking sector

If one of Australia’s big four banks were to fail, it would be disastrous for the economy and the financial system. AAP

The focus of the statement by the Australia-New Zealand Shadow Financial Regulatory Committee asks whether the systemic importance of the big four Australasian banks warrants special regulatory treatment. Firstly, what constitutes a systemically important bank?

One of the issues that came out of the global financial crisis was recognition that there are substantial interrelationships between banks, particularly the large, complex banks, which means that if they fail or get into financial difficulty, it creates spillover effects or what is often referred to as negative social externalities, which impact on the functioning of the economy and financial system.

That has led to concerns in regulatory circles about how we best deal with and regulate what are referred to as systemically important banks (SIBs).

What is the Australian government’s policy on dealing with the prospect of bank failure? Is the system well equipped to handle the possibility of contagion, given the interconnectedness of our main financial institutions?

The Australian regulators have done a lot of work over recent years in putting together better plans and mechanisms for dealing with failures of banks. These are good moves, although we still have some issues on how they would deal with one of the the big four, if they were to get in trouble here or in their New Zealand subsidiaries.

In our statement, we’ve coined the phrase “too big to swallow” as being an issue that distinguishes the big four from the other banks in Australia and New Zealand. Traditionally what happens when an institution gets into trouble in Australia has been that the regulator, APRA, has found some way to induce another institution to take over a bank or institution in difficulty. So, it’s able to make a smooth exit without it really being known that it was in difficulty.

The problem with the big four is that they’re too big to swallow. It’s too hard for another bank to quickly and smoothly take them over.

It’s very hard for anyone to know exactly what the losses are for a bank in difficulty. For a bank to take over a large organisation, it would face very substantial risks that would make it hesitant to do so.

In Australia, the only institutions that could take over one of the big four would be another one of the big four. That would create further concerns about increased concentration in banking.

There is a provision under the Financial System Stability Special Account for a standing budget appropriation of $20 billion to help in a takeover of a troubled institution, but that’s nowhere near enough to cover the potential losses associated with one of the big four.

International regulators have recommended additional capital requirements for 29 international banks, but Australia’s big banks aren’t included. Why is that?

The international body looked at 73 large international banks, which included the major Australian banks, but ultimately it didn’t include them in their final list of global, systemically important banks.

It’s a mixture of several things, I think. Australian banks aren’t global. They are very important regionally, but they’re not systemic in that global sense. Also, their activities are much more focused on plain lending - in particular, housing finance - and they have lower involvement in trading activity. From the perspective of global interdependence, that’s probably the reason they weren’t included.

Let’s discuss the idea of special regulatory treatment. What sort of capital requirements and measures would be adequate?

I don’t want to put a number on an appropriate minimum capital ratio requirement. But a higher requirement, and various other sorts of suggestions you hear around the world for dealing with the large banks, are aimed at trying to reduce the probability that they might fail, and trying to reduce the negative external social costs associated with one of them failing. And its worth remembering that governments tend to bail out systemically important troubled banks creating costs for taxpayers. To the extent that people believe that will happen, monitoring and market discipline by bank stakeholders is reduced and bank management incentives for appropriate prudence can be diminished.

The various ways suggested to try and reduce the negative social externalities associated with SIBs include things like stopping them from being so big and interdependent. There are suggestions for forced restructuring or sell-offs and so on. In the UK, the Vickers report has argued for retail ringfencing - separating retail banking from their other components, so you don’t get spillover effects.

In the US, the Volcker Rule - named after former Fed Governor Paul Volcker and part of the Dodd-Frank Act - requires separation of proprietary trading by banks to try and stop spillovers.

People have also suggested that we impose taxes on large banks, inducing them to become smaller. There have also been suggestions for living wills (recovery and resolution plans), where bankers are required to have in place a living will that outlines what they will do if the bank starts get into trouble.

The Basel committee has put forward the idea of higher minimum capital requirements for globally systemically important banks (G-SIBs). While not necessarily disagreeing with that, we think, slightly differently, that there is merit in requiring systemically important banks to have some minimum level of contingent capital. Contingent capital takes the form of hybrid securities which mandatorily convert into equity on certain triggers being hit when a bank is in trouble. That has two benefits. First additional equity is automatically created when it is needed. Second, holders of those securities will be likely to monitor and exert market discipline over the bank given their exposure to it. Of course, the appropriate design of those securities has to be carefully thought through.

You also mention the importance of leverage ratios. Can you explain their role?

One of things that’s happened with the development of bank regulation over the last 20 years is that the Basel committee has continually increased the complexity and intrusiveness of the financial regulations they propose. And over this period the leverage of banks has increased - reflected in ongoing declines in the ratio of common equity to assets (or exposures).

In particular, the focus has been upon having capital requirements that are risk-adjusted, such that if the bank is engaged in risky activity, the bank is required to have a higher capital ratio to act as a buffer to protect depositors against loss.

The trouble is, how do you actually define risk? What we’ve seen over the past 20 years is that is that it is hard to adequately define risk precisely, and there are all sorts of incentives for banks to engage in activities that are not treated as highly risky by the regulators. Financial innovation continually undermines whatever the requirements are.

So, an alternative approach is to put in place a simple, but higher leverage ratio, where the leverage ratio is defined to be a minimum amount of capital relative to the size of its overall exposures. The risk there, of course, is that banks might respond to that by getting into higher-risk activities. But there’s no reason why the regulators, can’t increase the minimum capital ratio that they require for any individual bank.

Our observation is that there’s no clear evidence that this increasingly complexity and apparent sophistication of the risk-based approach has proved to be particularly successful. A careful review of the relative costs and benefits of the complex risk based regulatory approach of the Basel Committee against simpler approaches (recognising of course that good supervision is the key) is, we believe, warranted.

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