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Knowledge@Australian School of Business

Banking Regulation: Protecting the Engine Room of the Economy

Published: April 16, 2010 in Knowledge@Australian School of Business
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In the wake of the global financial crisis, Australian bankers have been singled out as different from their counterparts on other continents. In the US, the government had to bail out Citibank and Bank of America, the German government took action to stop the collapse of the Hypo Real Estate and the British government nationalised Northern Rock Countrywide Financial. But in Australia no taxpayers' money was spent on banks, nor did the federal government have to nationalise any banks. Technically, Australia did not even have a recession. But what exactly did Canberra do better than London, Brussels or Washington?

David Bell, chief executive of the Australian Bankers' Association, tells anyone who will listen that Australian bank boards have done a good job running their institutions. “They have made, and continue to make, prudent lending decisions and have minimised their exposure to toxic debt instruments.” It’s true, but it’s only one side of the story. The other is the regulatory practice in Australia that forced the nation's bankers to manage risk properly. That’s what the London G20 Conference, the International Monetary Fund (IMF) and the World Economic Forum said in unison.

“Australia created what’s now internationally regarded as a model of corporate governance. This model tamed the rise and dominance of the management culture with a culture of risk mitigation and accountability,” says Michael Peters, lecturer in business law and taxation at the Australian School of Business. The backbone of this model, created in 1998,has three parts: the Reserve Bank of Australia (RBA) which defines the monetary policies and guarantees the stability of the system; the Australian Securities and Investments Commission (ASIC) which acts as the “policeman” controlling market integrity and protecting consumers' rights; and, the Australian Prudential Regulation Authority (APRA) which provides the “health service” for all corporations authorised under the Banking Act (1959) to accept deposits from the public.

Strength in Collapse

The biggest bankruptcy in Australia’s history – the 2001 collapse of insurance giant HIH that had some 30% of market share and left a loss of A$5.3 billion – also helped to firm up Australia’s regulatory resilience. The shock led to massive investment into APRA's competencies. A probability and impact rating system was created to measure the potential for failure for the Australian economy, along with the supervisory oversight and response system to measure and determine how to manage risk.

The demise of HIH also opened ears to the recommendations of the Basel Committee on Banking Supervision (Basel II), designedby the Organisation for Economic Co-operation and Development and the IMF in 2004 as a codified legal regime to regulate almost every aspect of the banking business. “Australia was one of the few nations toadopt the guidelines virtually in full,” notes Peters. With Basel II, APRA freed banks to reduce the funds available to meet the demands of deposit holders. It also meant that traditional banking was no longer the obvious business model. Banks could now lend funds to themselves, set up hedge funds and other trading ventures, and become their own customers. Basel II also instigated corporate governance to instill healthy risk management practices. So long as the corporate culture was geared towards containing the risks, such ventures were considered suitable.

In implementing Basel II, the US and the UK focused solely on the libertarian side of the new rules and allowed their banks to start owning and investing in hedge funds and private equity, and to trade through their own accounts. “They ensured their banks'liquidity, but the regulators widely ignored the risk management and the corporate governance side of the matter,” Peters points out.Consequently, while the exposure to toxic investments of US and European financial services companies at the beginning of the financial crisis was up to 15%, the exposure of Australian banks was less than 1%. That was due to good regulation and structural differences: “Australian banks were less conflicted, since the proportion of investment banking in Australia's financial services companies was nowhere near the proportion of their counterparts in the US.,” explains Brian Johnson, bank analyst at Credit Lyonnais Securities Asia.

Still, no system is perfect and when the crisis hit, the Australian government cautiously guaranteed deposits to keep worried citizensfrom a bank run. Fariborz Moshirian, professor of finance at the Australian School of Business, does not believe that the rules of Basel II alone – even if implemented properly worldwide Aussie-style – could have prevented the global financial crisis. “The issue is the new financial instruments. Derivatives are complicated, and many banks did not understand what they were dealing with and did not put aside adequate funds to cater to the risks involved.” What’s needed, according to Moshirian, is a global supervisory board “to measure the risks from the actual products on the banks' balance sheets.”

Not Desperate, but Dateless

The G20 leaders who gathered at the summit in London in April 2009 had similar thoughts.They established the so-called ”Financial Stability Forum” to work with the IMF to ensure wider global co-operation and to provide an early-warning system for future financial crises. This regulatory agency will be able to do what Basel II could not: enforce itsrules through police and penalties. The outcome is supposed to enhance capital requirements, and link the remuneration of bank managers to how well they manage risk and cater to social objectives, since banks are the engine room of any economy. Shortly after the G20 summit, the Basel-based Bank for International Settlements set a revised "Basel II" requiring banks to bolster capital provisioning and remedy flaws in remuneration. Twenty-seven major countries agreed in general to new standards –but no date was set for implementation. If, and when, updated rules will apply remains uncertain, says Moshirian. “As much as I would like to see an international standard and more rules to govern the financial institutions, so far I cannot see the executive power to make it happen. There is no such thing as a world government.”

True, the US has its own agenda. President Barack Obama's proposal, the ”Volcker rule” (named for the former chief of the Federal Reserve, Paul Volcker) aims at separating the ordinary financial activities of the publicly-guaranteed banking system from the speculative ventures of investment banks: Banks that take deposits should not be allowed to trade in stocks or derivatives on their own behalf, the draft says, nor can they invest in hedge funds or private equity funds, to limit the size of their liabilities. Plus, the 50 largest banks have to pay back taxpayers for the bailout. The basic idea is to micro-manage the banks' internal risk mechanisms and remuneration policies – and to re-size them according to the principle that no bank’s failure should be big enough to jeopardize the whole system.

Go with the Flow?

Australia’s big four banks are arguably “too big to fail”. Australia and New Zealand Banking Group Ltd., the Commonwealth Bank of Australia, the National Australia Bank Ltd., and the Westpac Banking Corp. together now represent 76.1% of all banking when measured by assets. The Australia Institute, an independent research body, estimates in a recent paper that the “big four” alone make underlying profits of around A$35 billion before tax –or just under 3% of GDP. But most have no big investment bank operations, which would make “the Volcker rules vastly meaningless for Australia's banks,” suggests Johnson. Moshirian does not believe the Volcker rules would work for Australia either: “Banks need a certain size to compete internationally.” Breaking up the big four or prohibiting further mergers with wealth managers or insurance companies will not necessarily strengthen Australia’s economic well-being: “Banks need to be efficient – and, from a global perspective, it’s clear that all small banks are struggling.”

New regulations, following the G20 initiative, are like an insurance policy and someone will have to pay the premium. Australia's big four “are impregnable and they will use their oligopoly to pass on the ensuing costs to the customer,” suggests Peters. “Australia’s credit rates are already among the most expensive in the world, and new rules will make money more expensive in comparison to the US and UK.” Additional costs will also affect the regional banks and the already slim margins of Australia’s 132 credit unions. “They do not have the market power to just pass costs on to their customers and might find it difficult to remain viable as a business,” he says. “This could weaken competition in Australia even further.”

These are some of the reasons why Moshirian believes that the Reserve Bank is not leaping into new rules. He says there’s a prevalent question: why should we be penalised with new rules just because some 40 foreign banks created problems? David Craig, chief financial officer of the Commonwealth Bank of Australia, also believes local regulators are conscious of the risk of importing blanket regulations.

On the other hand, there’s a hunger for foreign capital because about 62% of all finance stems from domestic savings; the rest is foreign, with the majority of the capital increasingly originating in China. “Chinese state banks are exposed dramatically to the sub-prime derivatives that led to the financial crisis in the first place, and they will join the efforts for new rules to get rid of them,” Peters predicts. Japan will have to join as well, and when Australia's biggest trading partners are subscribing to new standards, Canberra will have to go with the flow. “Some legislative tweaking may be possible but, in the end, Australia is “such a small economy, it will have no choice but to comply, provided others also comply with these new international rules,” says Moshirian. Prime minister Kevin Rudd bowed to the G20 and committed Australia to complying with the new rules.

The experts agree. As for the proposed changes to liquidity, provisioning and industry structure, Australia will be most affected by the question of liquidity. And that's a good thing, according to bank analyst Johnson. The major flaw in Australian banking practices is in their exposure to short-term offshore debts, he says. “What we really need is better liquidity requirements.” The pressure is on for Aussie banks to hold more liquid assets and to use long-term debt to fund balance sheet assets that cannot easily be exchanged for cash.

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