The financial inquiry's competing interests

Improving competitiveness in the financial system won't be achieved by simply making the Big Four less competitive. Such a move will risk their credit ratings and the sector's stability.

Standard & Poor’s rating of the Australian banking system as one of the five strongest in the world isn’t exactly new news. Nor is it a revelation that a credit ratings agency regards the level of government support and the creditworthiness of the government itself as a factor in its conclusions. But as the financial system inquiry looms, the S&P analysis provides a useful reminder of the strengths of the domestic system and the potential threats to its stability.

S&P rates Australian banks as among the least risky in the world, just behind Hong Kong and alongside Switzerland, Canada, Singapore and Saudi Arabia.

That assessment is a function of two factors. One is the profitability and balance sheet strength of the sector and the other is the AAA-rated status of the Australian Government. Government ratings influence the agencies’ views of the ultimate riskiness of systemically important institutions, like the four major Australia n banks.

As we’ve seen from the recent Commonwealth Bank half yearly profit announcement and the quarterly updates from other major banks, the big end of the Australian banking system is in very good shape. Profits are up strongly, bad debts are at historically low levels and balance sheets are strongly capitalised and highly liquid.

Bendigo and Adelaide Bank today provided an insight into the second-tier of the sector, with a 9.5 per cent increase in cash earnings on a solid increase in revenue and a modest bad debt experience.

Bendigo’s Mike Hirst referred to the subdued conditions and the low-growth environment for banks, but made the point that it was being driven by customers focusing on reducing their debt. The post-financial crisis period has seen Australian households lifting their savings and focusing on their own balance sheets.

At a fundamental level, the Australian banks are highly profitable, conservatively funded and have significantly improved their efficiency. They are operating within a subdued economic environment within which households are behaving more conservatively and governments are focused on improving their own financial positions.

Given that the Australian Prudential Regulation Authority has been ratcheting up prudential requirements and implementing them on a timetable that is faster that that required by the Basel Committee, the S&P conclusion is supported by the evidence.

It is no surprise that the ratings of the major banks are influenced by the Australian Government’s rating – that’s true of every banking system after the experiences of the crisis. Although the government’s financial position has been deteriorating, it remains far stronger than that of most other developed economies.

It is often forgotten – sometimes conveniently by critics of the dominance of the majors – that the only reason the Rudd Government guaranteed (for a fee) the wholesale borrowings of the majors and introduced an explicit guarantee of bank deposits was that governments offshore had done so first, which undermined the advantage and the access to wholesale debt markets that the Australian banks had previously enjoyed because of their stronger fundamentals.

There are obviously threats to the profitability of the major banks, which S&P noted – a severe downturn in the housing market or a hard landing in China or another global financial crisis – but it would take something quite dramatic to have a truly material impact on the banks and their stability.

The absolute value of that stability is no doubt something that will be debated within the Australian financial system inquiry. The inquiry’s chair, David Murray, said last week that it would explore the extent to which stability objectives hindered competition.

Murray said that regulation for stability inevitably created a cost to the economy and the inquiry would welcome views on the trade-offs between the objectives of stability and competition.

The majors, of course, do face some costs and challenges – like the capital surcharge for domestically systemically important banks, or the continuing (albeit reduced) need to access offshore wholesale debt markets – that are peculiar to them. Once the new regulatory regime is phased in, these challenges could help make smaller institutions more competitive.

The inquiry does face a challenge in trying to determine the right balance between competitiveness within the system and its overall stability. The experience of the GFC period has highlighted the value of a strong, profitable and stable banking system and its importance to the stability of the overall economy.

Ideally, the priority of the inquiry should be to tackle any specific structural disadvantages faced by the smaller banks and non-banks.

Improving competitiveness in the system by making the majors less competitive – simply handicapping them via extra imposts as some would like to see – would risk undermining their profitability, their credit ratings and the perceived strength and stability of the wider system.

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