Neutralising banking's new moral hazard

Asset-backed securities have been given short shrift by Australian regulators, but they remain the single best hope of boosting competitive neutrality in our banking system.

There are solutions to Australia’s banking competition crisis. But they will require our policymakers and politicians to boldly minimise moral hazard and embrace global best practice.

Late last year the International Monetary Fund published a thorough review of the Australian banking system after extensive consultation with domestic regulators. Among many findings, it arrived at two key conclusions.

First, that Australia had ended up with one of the most concentrated banking systems in the world following the global financial crisis.

The four majors are now among the 20 largest on earth ranked by the value of their shares, notwithstanding their small customer base of 22 million people.

Some experts have highlighted the oddity whereby Australia’s biggest bank, which has a market capitalisation of around $100 billion, is now larger than iconic global brands like American Express and McDonalds, and the same size as the leading chip manufacturer, Intel.

The second important IMF finding was that this "oligopoly” – fancy economists’ jargon for multiple monopolies – was a raw deal for taxpayers.

In particular, the IMF concluded that taxpayers were directly subsidising the costs, profits (and pay packets) of the majors because they have become "too big to fail”.

Combined with the fact that taxpayers are also guaranteeing the banks’ deposits for free, which it said was unusual by international standards, the IMF argued that Australia’s financial system had embedded significant "moral hazard”.

That’s another technical term for the dynamic known as "heads bankers win, tails taxpayers lose”.

Imagine if the government always insured your car for free with no strings attached: many people would become more reckless. The same principle applies to the banking system. In fact, it was moral hazard that experts claim was the original cause of the GFC.

Most banking is actually a very simple, commodity-like business. In the long-run, the institution with the lowest funding costs normally prevails either through more market share and/or profits.

If you tilt the playing field in favour of a select few by giving them cheaper funding, like the IMF says we have with the majors, smaller players will struggle to compete.

This is exactly why the returns on equity of all smaller banks are lower than the majors.

As experts have pointed out, Australian banks’ profits invert a fundamental maxim that normally exists in all properly functioning markets: a trade-off between risk and return.

Ordinarily, as a company’s risk declines, it offers investors lower returns to reflect the lower chance of loss. A government bond pays the lowest possible coupon in recognition of this.

Yet despite the fact the majors are perceived to have the lowest risks, they have actually generated the highest returns on equity.

You don’t need to be a university medalist to work out why. The IMF published the answer: the majors’ superior returns on equity are partly attributable to the funding cost benefits their "too big to fail” taxpayer-backed status affords.

It is also a function of the fact that they don’t hold especially high levels of "tier one” or "first-loss” equity capital when normalised against other big banks around the world, the IMF found. On average, the majors are more than twenty times leveraged, although this is rarely highlighted. (The trick to understand here is that the tier one capital ratio is not worked out against actual asset values, but so-called "risk-weighted” assets.) This is why the IMF called for the majors to hold more capital.

One of the most interesting policy issues in 2013 will be how we minimise the moral hazards the IMF has identified, and establish more competitive neutrality.

And do not doubt the challenge: neither APRA nor the Reserve Bank normally consider "competition" consequences in their policymaking. They are focused primarily on "system stability”.

The irony is that we would probably have a more stable banking system with eight mid-sized banks that were not individually systematically important than a small number of too-big-to-fail goliaths.

The good news is that the global "regulator of banking regulators”, the Basel Committee, has unwittingly offered a solution.

In the ashes of the GFC and the unprecedented measures governments and taxpayers were forced to introduce to save the system, regulators have sensibly determined they want to prevent these problems arising again.

There are two main mitigants that are being championed. First, that banks should have more first-loss capital and less leverage. The second is that they should hold minimum amounts of so-called "liquid assets” that can be called on to meet the demands of creditors – be they depositors or wholesale funders – when they ask for their money back.

On the capital front our sound banks are ahead of the game and should have no trouble complying with the new Basel III rules.

It is on the subject of liquidity that we have work to do. The Basel Committee has advocated two types of liquid assets: so-called 'level 1' and 'level 2'. Level 1 assets are limited to high-quality government bonds. Around the world, level 2 assets include asset-backed securities and corporate bonds, amongst others.

Yet Australian regulators have to date decided not to permit any level 2 assets at all. And because the pool of government bonds is small, they have uniquely created a direct loan from government (ie, taxpayers) to the banking sector to allow banks to satisfy the new liquidity tests. We were the only country in the world to do this.

The obvious problem with this solution is that it permanently embeds a taxpayer loan at the heart of Australia's banking system. Every year the banks figure out how much money they need in a crisis. They then go to the RBA and get a 'line of credit' equal to this crisis funding. They pay just 0.15 per cent per annum for this extremely valuable line of credit, which basically means they will never likely face an insolvency event.

It would be preferable if taxpayer bailouts were an absolute last, as opposed to a first, resort. Glenn Stevens understands this. He has observed that, "..enormous moral hazard, perhaps greater than ever before, exists in the global financial system as a result of the actions – albeit essential ones in the circumstances – of 2008.”

Stevens worries that when the next banking storms begin brewing, policymakers will be called on to allow private players to tap the public purse.

"My very firm view is that…whenever that day comes our government will be in a position to say, ‘No, we are not going to give a guarantee and the system can cope with that'", Stevens says.

Given Stevens’ views, APRA and the Reserve Bank should be promoting the liquidity of private asset solutions, such as corporate bonds and highly-rated asset-backed securities, as taxpayers’ first line of defence against a banking collapse.

An explanation offered by APRA as to why it has not included asset-backed securities in the level 2 liquid assets category in line with the Basel Committee’s recommendations is because they are not liquid enough.

But the liquidity of any asset class is a reflection of institutional design. By unusually excluding AAA-rated asset-backed securities from level 2 assets, Australian regulators are only undermining demand for these assets while forcing banks to lean more heavily on taxpayer loans.

And as the Reserve Bank itself has noted, Australian asset-backed securities have proven to be exceptionally safe and resilient throughout the recent ructions.

Beyond the Basel Committee’s advice, there are two precedents for this move.

The Reserve Bank fosters general system liquidity by acting as a counterparty that is prepared to purchase (and later sell back) select assets from participants that need short-term cash.

The 'repurchase eligible' assets the RBA will acquire include government bonds, senior-ranking bonds issued by banks down to a BBB rating, and AAA-rated asset-backed securities.

A second precedent is the fact that the direct taxpayer loan the banks are being asked to use to satisfy Basel III is 'secured' by bank assets. These are exactly the same assets that are the collateral in asset-backed securities!

It is surely inconsistent to propose they are fine to back taxpayer loans, but not good enough to be used as private market liquidity protection.

Unlike government, bank or corporate bonds, asset-backed securities have three advantages.

The first is that they are secured credit as opposed to being unsecured. A clearly identifiable pool of assets serves as 'collateral' protecting the loans.

The second is that they are 'institutionally independent' insofar as investors are mainly taking credit risk on the diversified pool of assets, rather than the institution and its management.

Importantly, this also means asset-backed securities offer a funding channel to institutions that is independent of their size or credit rating. They are our single best hope of introducing more competitive neutrality into our telescoped banking system.

Finally, they are the only AAA-rated assets other than government bonds that are available as a buffer.

Since the GFC, the Reserve Bank, Treasury and APRA have worked hard to improve the design of this market. Issuers of asset-backed securities now regularly retain the first-loss equity pieces to align interests with investors. The Reserve Bank is insisting on a raft of standardised disclosure requirements while APRA has offered guidance on superior structures. And the Treasury has invested directly in these assets at prices much lower than current levels as an emergency liquidity injection.

It would be a tragedy to needlessly discriminate against this asset class by avoiding global best-practice and first-round private market solutions in favour of moral hazard-inducing taxpayer loans.

Mark Bouris is executive chairman of Yellow Brick Road.

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