Locals unsuited by 'one size fits all' banking rules

Two decades on, management from one of the country's failing state banks still remember the moment when customers lost confidence. As reports spread the bank was struggling under the weight of losses from commercial property loans, a smattering of unusually large withdrawals started appearing across branches. This pattern accelerated in just a matter of days, until suddenly millions of dollars were flying out the bank's door.

This forced managers to take extraordinary measures to win back trust and the deposits before the cash ran out.

A bank run is a death spiral that even the world's biggest institutions struggle to snap out of before regulators step in. In most countries, few banks suffering a run will survive more than five days.

At the state bank's head office, four senior staffers drove up to the loading dock, and their cars were filled with bulging bags of cash. They were dispatched across the suburbs with instructions to top up the funds of the branches suffering the heaviest withdrawals. It was a war of attrition, in the hope that customers would be convinced there was enough money to go around.

"You would just drive around until you got the message with the name of the branch where to go," said one person involved in the emergency deliveries.

All this was done in secrecy, and just a handful of the bank's managers knew of the rescue operation. If word got out, it threatened to shatter the confidence it was trying to restore. Even regulators were not told about the cash dumps.

"We drove back into head office several times a day and we'd just load up the boot with hundreds of thousands of dollars," said the person, who declined to be named but is now a senior executive at a big four bank. "It was real; we were right in the middle of it."

And it was a story being played out across several states. For Australia, a banking crisis came early. The scars of that crisis have been critical in shaping a deeply conservative culture among Australian regulators and some senior bankers over the past two decades.

At the time the state banks of NSW, South Australia and Victoria, and two of the big four - ANZ and Westpac - were all teetering under heavy losses of soured commercial property loans and wayward subsidiaries. It threatened to paralyse an economy already in the throes of recession.

And so two years to the week since the spectacular collapse of Lehman Brothers, the world's top banks regulators, including Australia's, finally agreed on new rules intended to shield the global banking industry from financial disasters.

Bearing the name of the Swiss border town where the rules were thrashed out, the Basel Committee of Banking Supervision signed off on a package of reforms that place banks on more conservative settings and forces them to hold a larger cushion of funds to protect against future losses.

The measures, to be introduced over the next few years, are aimed at rebuilding global confidence in the banking system.

Banks are unlike most other businesses. Even the way they report their balance sheet is all upside down. In a bankers' view of the world deposits are called liabilities, while the mortgages or business loans sitting in their balance sheets are assets.

Banks are ultra highly geared businesses that rely on funding well in excess of what shareholders have put into the business for the bulk of their financing requirements. This funding, needed to lend out to borrowers, is made up of a combination of deposits or wholesale borrowings.

Some liken banks to inverted pyramids - giant stores of borrowed funds supported by just a slither of real money. Indeed, shareholder equity or retained profits - the safest form of cash - rarely account for more than 5 to 10 per cent of total liabilities.

This leaves banks with little margin for error. As one banker puts it: "We're that leveraged, we wouldn't want to be in the business of lending money to a bank."

And as Lehman Brothers showed, when things do go wrong in a bank that has borrowed money from many other banks, it is usually with spectacular consequences.

A lesson of the global financial crisis is any bank that tries to support a massive lending book with a just a drop of shareholder capital has a bleak future.

Lehman, which was not even the most highly geared of the global banks, had just one dollar of equity for every $30 it lent out. Likewise Northern Rock, the British mortgage bank that was the first to be rescued by its government, had a stated aim to grow its mortgage book faster than profits. At its peak Northern Rock was lending out the equivalent of $50 to just one dollar of equity. At these ratios it only requires a small number of loans to turn bad before shareholder equity is wiped out.

In Australia the ratio is closer to one dollar of equity for every $10 in lending. Reserve Bank figures show our banks are holding $131 billion of tier one capital against $1.39 trillion worth of loans (measured by their relative risk).

But in the global push to make banks safe, do the rules threaten to curb the very activity that banks are in the business of doing: lending money?

Australia's big banks campaigned hard against being subject to new rules, and at the very least called for some watering down of the proposals to recognise they did not take excessive risks. The big four Australian banks are just a handful to carry a credit rating of "AA", ranking them among the world's safest.

Yesterday the new chairman of the Commonwealth Bank, David Turner, again argued Australia should be cautious about signing up to a "global solution" on regulation, warning high capital and liquidity levels would reduce the availability of credit.

"While regulators in some jurisdictions clearly need to address the adequacy of their regulatory regime post the global financial crisis, it is important that we, in Australia, think carefully before adopting a 'one size fits all' approach," Mr Turner said.

The new Basel rules require banks to boost the level of safe capital.

For Australian banks, their so-called tier one ratio will rise from a minimum of 4 per cent to 6 per cent. In addition they must also include a 2.5 per cent buffer that banks can draw down in times of strain, lifting the tier one to 8.5 per cent. Australian banks have already been sitting at or above these levels for the past year.

But the biggest worry for local banks is a requirement they must have enough government bonds to make sure they can support 30 days' worth of lending without any new funds coming in the door.

The assumption is that banks should be self-funding for a month in the event of another freeze on global markets. Known as the liquidity coverage ratio, this represents a fourfold increase over the present five-business-days funding rule.

The chief economist at National Australia Bank, Alan Oster, said many underestimate what the rules mean for Australia.

"The financial crisis was a really good stress test and Australian banks were fine. Now they might implement rules that are going to cause problems for Australia," he says.

Meanwhile, Australia's relatively small level of government debt mean banks will be unable to get their hands on enough government bonds to fulfil the requirements. At present banks have enough cash to support lending. But this is going to be put into government bonds. If banks intend to continue lending at the same rate, they will need to borrow even more funds from wholesale markets.

Ratings agencies have little tolerance for Australian banks to increase their borrowings and would be expected to react with a ratings downgrade. None of the big banks would be prepared to give up their prized AA-ratings, meaning the only option is to curb lending.

Local banks, via the Australian Bankers Association, continue to argue for leeway on requirements that banks increase their holdings of top-rated government bonds.

"Australia faces a problem, given the lack of government debt, and we still have a task ahead of us to demonstrate how we're going to meet the liquidity coverage ratio in a way that others are meeting it overseas," says the chief executive of the Australian Bankers Association, Steven Munchenberg.

For all their strengths, Australia's banks also have a glaring structural weakness. They do not have enough deposits, so they rely on wholesale borrowings, much of it from overseas, to fund their lending activity.

This is fine in normal times, but as the financial crisis accelerated through 2008 it became apparent that wholesale borrowing markets were shutting down. On a much grander scale of the state bank run, no one wanted to lend to a bank as confidence levels plummeted.

Officials of the Australian Prudential Regulatory Authority have said it is "pointless and unhelpful" to stand against the tide of international reform, but they also say there is still some way to go before we know the shape of the final rules. The measures need to be approved a meeting of Group of 20 leaders in November. A further two years' consultation with industry will follow.

But as human behaviour is the driver of much of the financial system, Charles Littrell, a general manager at the Australian Prudential Regulatory Authority, acknowledges the new rules will not prevent another Lehman-style event, or possibly an Australian bank run. "None of the changes, either individually or in aggregate, will guarantee we will never have another financial crisis or we'll have an institution that won't fail.In fact, I'm perfectly comfortable we'll have both."