Have Australia’s banks become “too big to fail?” Is Australia’s financial system vulnerable to systematic collapse? These and other questions are at the heart of the financial system inquiry, chaired by David Murray, a former CEO of the Commonwealth Bank of Australia. The panel is tasked with analyzing the myriad ways in which Australia’s financial system has changed since 1997 (when the last inquiry was held) and providing a set of recommendations that, it is hoped, will foster a more “efficient, competitive and flexible financial system.”
The interim report, which was released last month, caused quite a stir. The most contentious aspects undoubtedly have to do with the state of Australia’s “big four” banks: Australia and New Zealand Banking Group, National Australia Bank, Commonwealth Bank and Westpac. The report finds that by international standards, Australia’s banking system is “relatively concentrated” and that this trend has only accelerated since the global financial crisis (GFC). “The major banks have benefited,” it notes, “from better access to funds and lower funding costs than their competitors, allowing them to grow faster.”
The report raises the idea that Australia’s large banks may actually be gaining from perceptions that they’re “too big to fail.” If markets believe the government will provide taxpayer support to one of the big four in order to prevent damage spreading to the rest of the economy, this could lead to moral hazard. In fact, the report finds that creditors may already be willing to lend to at a reduced rate. And the banks themselves are able to exercise far more leverage with home loans and generate far higher returns on equity when compared with their competitors.
So what’s the panel likely to do about it? One of the potential policy responses includes raising capital requirements for “systemically important banks.” Given the considerable damage the Australian economy would face if one of the “big four” banks collapsed, creating a capital buffer is arguably the simplest and most straight-forward solution. The report finds Australia’s current capital requirements to be “at the low end of the international spectrum,” so there’s ample room to maneuver. Profits for the major banks, however, would undoubtedly take a hit. Recent research by UBS, for instance, suggests that simply adopting an extra 3 percent capital buffer could force the banks to raise an additional $23 billion.
Another option follows on from more recent experience in Cyprus with the “bail-in” option. Unlike a traditional bail out in which outside investors (in this case, taxpayers) provide funding to vulnerable banks to help them service their debt and stave off a wider financial collapse, a “bail-in” would involve imposing losses on the borrower’s creditors. The difficulty is whether the government and regulators will be either willing or able to impose losses on creditors without causing wider instability in the financial system.
Similarly, the report considers ring-fencing, in which riskier financial activities are kept separate from more traditional banking and financial activities. In the United States, the “Volcker rule” aims to keep depositor funds separate from proprietary trading and in the United Kingdom, the Vickers Commission is currently considering separating core retail financial services from riskier activities such as securities trading. Although the report finds the “mixture of retail and investment banking” to be less of a problem in Australia, it also notes that in the long term ring-fencing could act as a stabilizing force. “Introducing ring-fencing now,” it notes, “could assist in avoiding future issues if banks were to move more into riskier activities.”
Predicting what recommendations the Murray inquiry will arrive at by its September deadline is proving to be an equally difficult task. Christopher Joye at The Australian Financial Review worries that the “inquiry has carefully hedged itself on the solutions it tenders… So we don’t really know where it will land.” But having shone the spotlight on the implicit advantages the “big four” banks receive as well as the potential systemic threat they pose to the wider economy, the inquiry will make it difficult not to take a tougher stand against the major banks.