Murray's modesty highlights the financial system's virtues

Anyone looking for big and bold proposals for reform to emanate from the Financial System Inquiry would have been disappointed by its relatively low-key reality. Apart from the well-flagged punishment of the major banks for being too big and an interesting idea for driving down superannuation costs, it is, despite its 320 pages, a report full of modest and largely platitudinous recommendations.

That's not a bad thing. The Australian financial system has proven itself more stable and efficient than most similar systems elsewhere in the globe, with both the major institutions and regulators generally performing well. (The exception would be the Australian Securities and Investments Commission's oversight of financial advisers.)

Unlike the Wallis inquiry, which was conducted in the aftermath of the very large, institution-destroying losses of the early 1990s, there were no obvious and compelling structural deficiencies in the system or its regulation to address. The FSI, therefore, was destined to be a relatively modest document full of quite modest recommendations.

The exception -- the treatment of the major banks -- was expected. Joe Hockey, in opposition, foreshadowed the inquiry during a period when both he and Wayne Swan were bashing the banks for their tardiness in lowering mortgage rates exactly in tandem with the Reserve Bank's official rate movements.

The increased dominance of the system by the majors post-crisis also made them a soft target for those smaller banks and non-bank lenders complaining about the lack of competitiveness in the system and the unlevel nature of the playing field.

The FSI, chaired by former Commonwealth Bank chief executive and Future Fund chairman David Murray, has determined that despite considerable debate about how to compare the capital adequacy of one system with another's, the Australian system held levels of capital below the international median and well below the global top quartiles.  The majors have and will continue to dispute that.

Nevertheless, the FSI has recommended the majors should hold sufficient common equity tier one capital to be within the top quartile of "internationally active" banks, even though those tend to be the "global systemically important banks"(G-SIBs) rather than D-SIBs (domestic systemically important banks), like our majors.

The inquiry panel took the view that other countries will adopt the G-SIB standards for their D-SIBs, even though the international regulatory environment specifically distinguishes between the two classes of institution.

With the FSI saying the Australian banks' core capital ratio averages 9.1 per cent and the top quartile of international banks 12.2 per cent, that would imply the banks will have to raise a significant amount of new equity, with a cost to bank shareholders, bank customers or both.

Apart from simply holding more core capital, the FSI also wants the banks to hold more "loss-absorbing" capital -- debt that gets bailed-in and either converts to equity or gets written off in a crisis.

That would come at a cost, although it might lower the cost of secured debt for the banks. The distancing of the implicit taxpayer guarantee for institutions deemed too big to fail, however, probably means that a requirement to hold debt designated as loss-absorbing would lift the banks' overall cost of funds.

The FSI has also been won over by the arguments of the smaller banks and non-banks competing with the majors in home lending that the risk-weighting regime for bank assets adversely impacts the ability of the smaller players to compete.

The major banks are allowed by the Australian Prudential Regulation Authority to use their own internal models to calculate the risk weights for their credit exposures. Institutions without the systems to develop credible models use a standardised approach. The average mortgage risk-weight for the majors is 18 per cent while for those using the standardised model, it is 39 per cent.

While comparing the risk weights is something of an apples and oranges comparison -- the big banks are more sophisticated, more diversified and face other capital imposts -- the difference between the two means the majors generate double the return on capital of the smaller institutions.

The FSI wants to put a floor under the majors' risk-weights of between 25 per cent and 30 per cent, severely narrowing the gap. It says the cost of meeting the higher risk weights would be roughly equivalent to a one percentage point increase in the majors' common equity tier one capital ratio. Competition would limit the extent to which this could be passed onto customers, with shareholders likely to bear some of the cost.

The major banks are, of course, so dominant and most of their customers so reluctant to shift their accounts that the notion that shareholders will bear most of the cost of the increased capital the banks would have to hold if the all FSI recommendations are implemented is questionable.

The majors would be slightly safer if they hold more capital, but given that they would remain highly leveraged institutions and remain exposed to offshore wholesale debt markets, the amounts of extra capital envisaged wouldn't and couldn't make them completely safe.

The final report may disappoint some (other than the majors) because of the absence of radical measures or changes to the architecture of the system. But the reality is that while there are some obvious corners of the system that need some attention -- like superannuation, where scale and supposed competition hasn't driven down costs -- the system is actually quite robust and progressive. 

With nothing absolutely broken, there was nothing of substance to fix.