Don't bank on a break-up to solve the financial system's flaws

Former Goldman Sachs co-chairman Alastair Walton got a lot of airplay this morning with his call to break up the four major banks to boost competition and address the 'too big to fail' issue.

There’s an assumption in that call that the system isn’t sufficiently competitive and that more and smaller banks would reduce the risk and/or cost to taxpayers if a bank failed.

That’s not necessarily the case.

In fact, the evidence within the history of the system says that the number of banks or other financial institutions doesn’t necessarily determine the intensity of competition or drive benefits for consumers.

It also says that having too many institutions competing too aggressively can destabilise the system and imperil taxpayers.

One only has to look at the pre-crisis system. St George and BankWest were independent banks, Bendigo Bank hadn’t yet merged with Adelaide Bank, and there were a number of large non-bank lenders like Wizard, Aussie and Rams competing on the major banks’ core home loan turf.

In 2006-07 the major banks’ average return on equity was 21.2 per cent and their average net interest margin was 2.2 per cent in an environment that was, supposedly, far more competitive than it is today.

The most recent half-year bank earnings statements, however, produce an average annualised return on equity of 16.3 per cent and an average net interest margin of 2.08 per cent. If the major banks are operating a profit-maximising oligopoly, they are not doing so very effectively.

In the mid-1980s, of course, we had many more banks. Most states had state-owned and regional banks, along with finance companies, building societies, friendly societies and credit unions. In 1985 Paul Keating opened the system to foreign banks and 16 rushed in. It was a very competitive system.

In fact, it was too competitive. In the early 1990s, state banks, finance companies and building societies collapsed. Most of the foreigners withdrew licking very bloody wounds and three of the four majors went to the brink of collapse. So, too much competition may not be such a good thing. Size, or lack of it, doesn’t correlate with stability.

Australian Prudential Regulation Authority chairman Wayne Byers gave a speech this week in which he said something obvious (but still profound) about the nature of the 'too big to fail' problem.

It was, he said, a long-standing problem and that solving it would undoubtedly be a positive outcome.

It needed to be recognised, however, that "long-standing problems rarely have an easy answer".

The 'too big to fail' challenge posed by the scale of the four major banks can’t be resolved easily or simply.

The odds of a problem arising can be reduced by increasing the amount of capital they have to hold, tinkering with the risk-weightings of the assets they are lending against, requiring them to hold more liquidity and, perhaps, to hold so-called ‘’bail-in’’ capital that would absorb the first layer of any losses. All of those things are on the global bank regulators’ agenda.

They all, however, carry a cost for shareholders or customers or, more likely both.

Banks are intermediaries, so the bulk of the costs of attracting and servicing extra capital and liquidity or attracting bail-in capital with its higher levels of risk for the providers would be borne by customers, unless increased competition from smaller and more lightly-regulated institutions prevented that pass-through from occurring.

In other words, regulators would be promoting arbitraging of their own regulations, handicapping the most strongly capitalised and most closely regulated while encouraging the growth and profitability of the less-regulated and capitalised banks and shadow banks. That’s not necessarily in the long-term interests of the stability of the system.

Byers pointed to the risk of unintended consequences from requiring bail-in capital. Apart from the bigger interest spreads the providers would inevitably demand, in any future systemic crisis the bailing in of creditors in one bank could (and almost certainly would) lead to a run on other banks as their bail-in creditors rushed for the exits.

Whether there were four majors, or eight mini-majors if the majors were broken up, as Walton advocated (which won’t happen, given the millions of voters with direct exposures to bank shares), a system-wide run would force government intervention and taxpayer support.

Breaking up the majors also wouldn’t address the most obvious vulnerability of the Australian system: its reliance on offshore borrowings.

While the extent of that reliance has been significantly reduced post-crisis as the majors have vacuumed up deposits, the Australian system and economy have always had to borrow offshore to maintain a higher standard of living than could be financed domestically.

The banks are simply the conduit for the funds required to meet the demand for credit in the economy. Breaking them up would alter that basic imbalance of domestic supply and demand.

The notion of ridding the system of institutions that are too big to fail is attractive, but the more realistic approach is for the regulators to do what they can do to reduce risk (a financial system doesn’t function without some level of risk-taking by the lending institutions) without unduly increasing the costs of intermediation while also increasing the intensity and quality of their own prudential supervision.

The international regulators are doing the former, while APRA actually has a very good and stress-tested record of strong prudential supervision.