Murray spots a tripwire in a dark financial forest

David Murray isn’t one to pull his punches and he let a few fly at governments, central bankers and bank regulators at an event organised by The Economist in Sydney today. There were some underlying truths to his comments.

It is hard to argue with his statement that the massive quantitative easing programs being run by central banks in the US, Europe and Japan are creating "significant distortions" in the global economy and asset markets.

It’s equally hard to refute his view that governments prefer to "issue bonds" – run deficits – to buy votes and promise entitlements to avoid having to embark on unpopular structural changes within the new 24-7 media and communications environment.

There will be some who might disagree with the former Commonwealth Bank chief executive and Future Fund chairman’s view that the international banking regulator, the Basel Committee, had responded too aggressively to the financial crisis with its raft of tougher prudential rules, although there is some legitimacy to his view that the impact of the new capital and liquidity regimes on already weak economies has been contractionary.

"If the banking system is the gear box of the economy, then Basel III stripped out over-drive and top gear at the wrong moment," he said.

The quantitative easing programs have encouraged sometimes extreme volatility in financial markets as investors with access to extremely low-cost funding have elevated return over risk.

It won’t be clear until those programs are wound back whether that has created new asset price bubbles and threats to the underlying stability of the global financial system but there is some risk that it has.

The recent turmoil ignited by the 'will they, won’t they' debates about the start of a tapering of the US QE III bond and mortgage buying program underscores how sensitive investors and markets are to these programs, which suggests there is some potential for unpleasant outcomes when the program is eventually withdrawn.

It is probably too big a call to say that central banks have resorted to these massive and open-ended and potentially harmful programs because governments had failed to confront their debt and deficits – there are counter arguments about the impact of austerity programs on recessed economies.

It is true, however, that some governments, have been slow to do anything meaningful to address the structural issues in their economies and banking systems (other than shift profits from savers to banks) and that the eurozone in particular (other than in applying real austerity on southern Europe) has done nothing to address the fundamental structural flaws in the eurozone itself that were laid bare by the crisis.

The Basel Committee’s prescription for the global banking system of more and higher quality capital, more and higher quality liquidity, leverage caps and more consistency in regulation and disclosure will have an impact on the capacity of banks to fund growth when growth returns.

There is a debate here, with a much stronger banking system than most economies, about the ability of the Australian banks to fund business lending when demand picks up now that it is clear that they can’t and won’t return – and wouldn’t be allowed – to their pre-crisis levels of reliance on offshore wholesale debt markets.

If alternative and competitive sources of debt aren’t developed that will act as a limiter of economic growth.

There is an alternate source of funding within the superannuation system but the super funds don’t have the infrastructure or credit evaluation skills to provide funding to small and medium-sized businesses.

It may require a massive reinvigoration of domestic securitised debt markets and the development of a functioning corporate bond market for the banks and larger companies to get funds to flow out of the super system and into markets that have in the past been funded off bank balance sheets.

The impact of tighter prudential regulation on the real economy, or at least on the extent to which regulation should be tightened, is an issue worthy of discussion – but the post-crisis reality is that much tighter and internationally harmonised regulation has been inevitable and necessary regardless of the economic impacts.

A legitimate concern is that by limiting the capacity of banks to lend profitably, regulators will drive activity off their balance sheets and into the shadow banking system.

If there are likely to be unintended consequences from tougher regulation of banks it is even more likely that there will be unintended consequences from the easy money policies of central banks.

The prolonged period of quantitative easings and the impact on banking systems of the host of restrictive new regulations (not just from the Basel Committee but some very heavy-handed proposed new country-specific overlays that could have international implications) will inevitably have repercussions at some point that are uncertain but likely to be unpleasant.