Murray has got it wrong on bank capital

Despite the noble rhetoric surrounding recommendations on bank capital, the Murray inquiry has failed to make a convincing case for change.

The Murray inquiry’s final report failed to make the case that Australian banks need to hold more capital. Indeed, it’s quite obvious from the report that there really is no case to be made. The concerns are baseless and symptomatic of the inability of many to disassociate themselves from crisis events abroad.

Consequently, the government has no option but to reject the recommendations on bank capital made by the FSI.

It’s not that the rhetoric surrounding the inquiry’s view is unattractive. It entreats to a noble purpose: to prudently shore up the nation’s defences against crisis, especially given that “Australia’s financial sector is not invulnerable to risks to stability, and the costs of crises can be wide-ranging and severe. Financial crises can deeply damage an economy and have a lasting impact on people’s lives.”

Amen. No one would disagree with that or the comment “Australia can draw lessons from other countries’ GFC experiences, which highlighted that financial systems are vulnerable to low-probability, high-impact ‘tail events’, which can be caused by large external shocks or be generated domestically. An asset value shock of similar magnitude to those experienced by overseas banks during the GFC would cause Australian banks significant distress".

Yet rhetoric aside, there is little to suggest this outcome hasn’t already been achieved. The evidence shows that it has: the nation escaped unscathed (comparatively) from the GFC, the worst crisis since the Great Depression.

Given that fact, the bar for change should be quite high. Yet what is noticeable from the FSI report is the lack of any compelling argument for any adjustment. “In the inquiry’s view, although Australian ADIs are generally well capitalised, further strengthening would assist in ensuring capital levels are, and are seen to be, unquestionably strong”.

Unfortunately this idea of unquestionable strength is a rather vague notion. 

Many would argue that the financial system is already unquestionably strong. We survived the GFC and Australia’s banks are already ranked among the world’s safest. Yet members of the FSI disagreed, for the simple reason that capital ratios were not in the top quartile of globally active banks. It should be noted, however, that no attempt was made to find out what the capital position of the banks actually was -- instead members relied on a ‘plausible range’. “The Inquiry has not sought to determine the exact capital position of Australian banks on a consistent basis compared with banks in other countries”. It’s a fairly serious oversight, especially when a report from PwC found that the nation’s banks were already in the top quartile.

Either way, Murray failed to make the case that Australia’s banks, assuming they weren’t in the top quartile, should be. It was simply assumed that the failure to reach this benchmark posed risks, given our nation’s reliance on foreign savings.

That’s a fairly sizable value judgment, however, and a potentially worthless one.

For a start, the FSI already recognised that "Australian banks have built a reputation for prudent risk management, with low levels of proprietary trading and sound management".

Moreover, many of the other banks that are listed for comparison, are banks with large global operations -- banks with, in many cases, large investment banking operations. They are systematically important banks, not just to their own jurisdiction, but to global financial markets. They should hold high capital and our domestic banks cannot be compared to them.

That our banks already do better than most in regards to capital suggests that the Inquiry’s concern that "the relative strength of Australian ADI capital ratios may therefore decline as banks in other jurisdictions continue to increase capital" isn’t based on logic. Global systematically important banks should lift their capital holdings sharply. And if and when they continue to do so, that doesn’t mean that our bank’s capital ratios are somehow insufficient, it’s not a relative proposition. Capital is either sufficient to withstand a dire outcome or it isn’t. Care needs to be taken then, especially when none of the conditions that caused the GFC are present in Australia.

For example:

  • There is no housing glut;
  • There is no housing bubble;
  • The non-recourse lending that acted as a catalyst to crisis doesn’t exist in Australia. That is, mortgage holders cannot simply walk away from their loan if it exceeds their home value;
  • There has been no explosion domestically in the financial wizardry (like CDOs) that saw a stock standard housing recession morph into a global financial crisis.

The absence of those conditions means that the likelihood of "an overall asset value shock…which was within the range of shocks experienced overseas during the GFC” is negligible. 

The probability of such dire, extreme events need to be put into perspective “even though it would be sufficient to render Australia’s major banks insolvent in the absence of further capital raising".The inquiry did not provide evidence that this was unquestionably the case. 

If and when those conditions develop, then maybe regulators can reassess. For now, the case for change has not been made, and Australian policymakers (and leaders elsewhere) need to calm down.