IT WAS perhaps not the question Phil Green expected first up.

Sydney Morning Herald - 21st Jul 2010 - Michael Evans

IT WAS perhaps not the question Phil Green expected first up.

Some fifteen months after the collapse of the Babcock & Brown empire he headed through the boomtime float at $5 a share to a peak of $34 amid billion-dollar deals, no amount of preparation could help Mr Green when asked his current job description.

An uncomfortable pause. A nervous laugh. And then a confession with just the hint of a question mark: "Investment banker?"

What followed was an illuminating glimpse into the world according to Babcock & Brown - a world of avaricious deal doing, a world of staggering bonuses and self-interest with precious little regard for the oncoming global financial storm.

It was a line neatly summed up in the company's email address book: messages to its 1500 staff were addressed to "The World".

"It was the world as we knew it at the time," Mr Green told a liquidators hearing in the Federal Court yesterday. "It's a smaller world now, I'd suggest," replied Peter Wood, counsel for the liquidators.

In a day-long examination, Green was grilled primarily on the period between late 2007 and the middle of 2008 on three key areas - the "wildly optimistic" profit forecast of a $750 million made in February, Babcock's deteriorating liquidity position and the impact of margin calls on Babcock staff of shares held by Tricom that placed further pressure on Babcock's share price.

Green batted away questions about any conflict of interest he may have had as the head of a listed holding company with no assets (Babcock & Brown) and a director of a private company loaded with assets (Babcock & Brown International) that was borrowing money raised on public markets from the The main cause of the 2008 freeze in USand subsequently global credit markets was a collapse of confidence in the shadowbanking system.

Traditional banking is the process through which those with savings are connected with those who wish to borrow. The connection is made by a bank, whotakes the savings as deposits (liabilities) and lends that money on (assets). Importantly, both assets and liabilities are held on the bank balance sheet, and regulators determine howmuch capital the bank must hold in reserve to cover loans that go bad.

Also supporting the system is a central bank, which lends money to banks if too manydeposits are taken out at a time. Any risk arising from the mismatch between the duration and the quality of the assets and liabilities at the bank is managed.

Through the deregulation of the 80s and 90s, however, the mechanism that connected savers and borrowers shifted away frombanks towards credit markets. That is, investors and businesses put their savings directly into floating securities made up of bundled loans.

Banks, especially investment banks, became the middlemen who did the packaging of the securities, often with mortgages bought from new retail players likeMerit Financial.

Neither kept an interest in the securities once theywere in the hands of investors, norwere the assets and liabilities recorded on any balance sheet.

Instead, risk was managed through derivative contracts which effectively insured the securities, and rating agencies which approved the individual risk profile of each investment. Banks had shifted much of their business to the shadows where no capital was required to backstop transactions, nor was there any central bank support in the event that risks became real.

Sadly, in 2007 and 2008, whenUS housing values collapsed, the entire system was exposed as a fraud. The assets (loans) thatmade up the securitieswere replete with the kind of rosy assumptions one might expect froma Friday afternoon loan atMerit Financial. The derivatives that managed the risk had no capital backing them up, and when called upon destroyed such behemoth companies as American InternationalGroup.

Rating agency approvalswere of the rubber-stamp variety.

As it unravelled, investors ran for the hills. The entire system dodged annihilation only by the sudden and near-complete sponsorship of the USTreasury and Federal Reserve to the tune of more than $US2 trillion.

So does the financial regulation bill address the causes?According to specialistUSfinancial sources, the short answer is no.AnewConsumer Protection Agency will have the scope to diagnose abusive lending practices and dodgy shops likeMerit, and offers hope that any future consumer-based bubble will not go undetected.However, as the history ofUSfinance shows, the next bubble is almost certain to be elsewhere.

The bill alsomoves some of the derivatives thatwere designed to insure market-based credit products onto exchanges where they can be monitored, and capital reserves enforced.However, according to Yves Smith, the creator of the expert finance blog naked capitalism, estimates of the percentage of derivatives that will shift to exchanges are as lowas 20 per cent.

The bill also contains a new resolution authority to cover banks or shadowbanks that pose grave risk to the financial system. Knownas the Kanjorski Amendment, after Congressman Paul Kanjorski, it is an attempt to neutralise the power of too-big-to-fail institutions that require bailout. Simon Johnson, the former IMF chief economist and a long-time critic of the power of large Wall Street banks, has celebrated this dimension of the bill because for the first time someone at the federal level must make a determination regarding whether an individual firmposes system risk.

However, the power is governed by a council of 10 seniorUSregulators, who, as the global financial crisis showed, are unlikely tomove on any institution until a crisis is so advanced that bailing out is still the most likely outcome.

Another lesson of the crisis was that regulators themselves are often captured by the interests they seek to constrain. According toMike Konczal of the specialistUSfinance blog Rortybomb, this was obvious even in the passage of the bill as the USTreasury fought against many of its proposed rules.

The most significant of these is the watering downof the Volcker Rule, which sought to ban deposittaking banks fromengaging in shadowbanking activity. In the final days of the bill,Wall Street lobbying opened a loophole that allows 3 per cent of commercial bank capital to be deployed in various formsof proprietary trading.

Above all other failures in the bill, it is this that hasmanyUScommentators saying that the final formof financial regulation offers no structural reformto separate banks from the risky shadow-bank behaviour that caused the crisis.Rather, it is seen as a reformof the regulators.

In Australia, since the crisis of 2008, banks have enjoyed a reputation for being exceptional. While it is true that they did not, for the most part, engage in the same creditmarket chicanery asUS banks, it is not true that Australias big banks avoided all shadowbanking-like activities. Ifwe broaden the definition of shadowbanking to parameters like the mediation of shortterminvestor capital using derivatives to manage risk, then Australian banks addiction to international wholesale funds fits perfectly.

It seems more than fair to do so given that, despite Australian bank liabilities and assets being recorded on balance sheet, the financial crisiss shadow-banking freeze triggered a collapse in Australian bank liquidity that meant the big lenders faced the prospect of being unable to roll over their wholesale debts.

This happened despite the Reserve Bank tearing up its rule book on acceptable collateral for loans to the banks. Fiscal intervention, in the formof the wholesale guarantee, prevented a disastrous credit crunch in Australia and likely insolvency for some, if not all, of the major banks. As muchwas said to the government at the time.

Needless to say, if efforts atUSreregulation have failed, then Australian banks continue to be exposed to the liquidity risk in their international wholesale liabilities, which have grown9 per cent since the crisis to more than $385 billion  some 15 per cent of their total liabilities.

Yet in large measure, Australia has either deluded itself or denied thisweakness. There has been no inquiry, no explicit policy shifts and conflicting responses by regulators with different mandates.

Its no wonder that when the federal government removed the wholesale guarantee earlier this year it said nothing about whether it would return in the event of another crisis.Of course it will. It is our own version of too-big-to-fail and the moral hazard embedded in its idled status guarantees its return.

TheUSmay have failed to address the causes of the crisis but it has at least had the courage to try, and by doing so set in place stronger foundations of public awareness for the next battle to re-regulate banks after the crisis to come.

David Llewellyn-Smith is the former publisher of The Diplomat magazine and co-author of TheGreat Crash of 2008 with Ross Garnaut.