Murray’s glaring omission

The Murray inquiry could have gone harder by recommending restrictions on bank lending to take the heat out of housing.

The Financial System Inquiry report proposes a range of measured but sensible reforms to the Australian financial system. It covers most of the important issues -- proposing 44 recommendations on such issues as capital requirements, tax concessions and the superannuation industry -- but there was one glaring omission. What happened to macroprudential policies?

According to the Murray inquiry, our financial system has a number of weaknesses, including: "taxation and regulatory settings distort the flow of funding to the real economy; it remains susceptible to financial shocks; superannuation is not delivering retirement incomes efficiently; unfair consumer outcomes remain prevalent; and policy settings do not focus on the benefits of competition and innovation".

Such weaknesses undermine the view that Australia’s financial system is well-functioning or allocates capital efficiently. To some extent Australia’s economic success has come in spite of a financial system that continues to operate on distorted incentives; it’s a system that favours unproductive investment over entrepreneurialism and innovation.

The poster child of this distortion has been Australia’s property market. The narrative is well-known: prices are among the highest in the world and so are our debt levels. A less well-known part of that narrative is that the incentives favouring mortgage lending have crowded out the business sector and increased business costs (due to both higher lending costs and land prices).

The Murray inquiry recognises this distortion and has recommended changes to help fix the problem. As it stands, Australia’s property market presents an ongoing systemic risk to the financial system and potentially an impediment to economic growth.

The report notes that the Australian financial system needs to reduce both the probability and cost of failure. According to the report, Australian banks’ capital ratios are inadequate and Australian banks are “not in the top quartile of internationally active banks when it comes to capital strength.”

Due to the low-risk weight associated with mortgage lending -- regardless of the level of mortgage lending -- Australian banks actually hold much less capital than most other international banks. The report recommends that the risk weight on mortgages should rise to between 25 and 30 per cent -- well above the current level of around 18 per cent. Banks are holding a few cents for each dollar of mortgage assets they have on their books.

According to the report, a financial shock to asset prices well within the range of shocks experienced during the global financial crisis, “would be sufficient to render Australia’s major banks insolvent in the absence of further capital raising.”

The experience of the global financial crisis highlights the potential risks Australia faces. According to the report, financial crises are historically associated with “an average rise in unemployment of seven percentage points, which in 2014 would be almost 900,000 additional Australian workers.”

International estimates of the cost of financial crises are between “19 – 158 per cent of one year’s GDP -- which for Australia would have equated to $300 billion to $2.4 trillion in 2013.” Even the low-end estimates would prove devastating.

As it stands our banks survived the global financial crisis due, in part, to the implicit government guarantee put in place shortly after the Lehman Brothers collapse. With debt levels now higher -- and the economy in a weaker state -- taxpayers are poorly placed to foot the bill.  

Our major banks will argue that they have sufficient capital. Given each of the major four banks are ‘too big to fail’ their capital position cannot be open to debate: they have to be strong and there has to be no doubt about that strength.

It’s also worth noting that there is no existing scenario in which just one major bank fails. If one fails then the other major banks will join them; "the majority of Australian banks pursue similar business models, with broadly similar balance sheets compositions that can be expected to have a high correlation during a crisis".

Each of them is systemically important, each of them is too big to fail; together they are too big to save.

Taxpayers cannot foot a bill worth a trillion dollars. They never should be asked to, and for that reason the Australian public should support moves to increase the capital ratio of our major banks. They should also support any move to remove the government guarantee that underpins the major banks business model.

The implicit government guarantee "reduces banks’ funding costs by moving risk from private investors onto the Government balance sheet". It gives large banks a significant advantage over smaller rivals, eroding competition, and weakens market discipline. The end result is moral hazard and excessive risk-taking.

The report stops short of recommending that major banks pay for the right to have access to a government guarantee. In its view increasing capital requirements should act as a sufficient buffer to reduce the need for such a guarantee.

The banks also will argue that higher capital requirements will increase lending costs, but that argument is nonsense. Any increase in lending spreads can be easily offset by the RBA lowering interest rates. The end result is that lending rates are unchanged, but systemic risk is lower.

The best part is that banks can increase their capital ratios at very little cost to the broader economy. Estimates suggest that increasing the banks’ capital ratio by 1 percentage point would cost between $150,000 to $1.5 billion in 2013 prices – roughly between 0.01 to 0.1 per cent of GDP. That’s a steal.

The one glaring problem with the Financial System Inquiry is that it didn’t push hard for the introduction of macroprudential policies. That takes the heat off both the RBA and APRA.

The truth is that higher capital requirements -- combined with higher risk weighting on mortgages and tax reform -- would have a similar (potentially larger) effect as macroprudential policies. In the long term financial system and tax reform is clearly the better approach to creating an efficient and sustainable housing and financial sector, but these reforms will take longer to implement.

Finally, the report recommends significant tax reform. It notes that reducing concessions for negative gearing and the capital gains tax "would lead to a more efficient allocation of funding in the economy". Winding back these policies, while potentially unpopular, would lead to a more equitable property market and would support the business sector by boosting business lending and lowering land prices.

The Murray inquiry nails most of the big issues. It could have gone harder on the implicit government guarantee and macroprudential policies but its recommendations, if implemented, would greatly diminish both these issues.

The banks are going to fight tooth and nail to ensure that these reforms never see the light of day. They’ll cite lower profitability, higher lending costs and lower house prices -- we should ignore their complaints. The reality is that Australian banks are undercapitalised and the risk weight applied to mortgages does not correspond with the systemic risk created by Australia’s $5 trillion property market.

The federal government now has the opportunity to usher in a new age for the financial system, where allocative efficiency and equity is favoured over short-term profits. After a forgettable year I hope it grabs this opportunity and runs with it.