The majors can bank on being bashed by Murray

Pleas for policymakers to take a considered approach to whatever the financial system inquiry recommends make sense. But there’s no political downside in bank-bashing.

Ian Narev’s weekend plea for policymakers to hasten slowly in considering imposing tougher regulation on the Australian banks is obviously self-serving. That doesn’t mean he’s wrong.

There has been an extraordinary focus on one aspect of the financial system in the discussion surrounding the likely recommendations of the financial system inquiry in the final report it handed to Joe Hockey last Friday.

The report, likely to be released publicly next weekend, is expected to recommend significantly higher capital requirements on the major banks, flowing from their “too big to fail” status.

The various estimates of how much extra capital the majors might have to raise/generate range from about $25 billion to $53 billion, depending on what the David Murray-chaired panel recommend in terms of the capital surcharge for domestic systemically important institutions and the floor they propose for the risk-weighting of residential mortgages.

It does seem odd that, in an inquiry that is looking at the entire financial system, the issue of major bank capital adequacy should be such a dominant topic.

Apart from the majors’ key roles in system stability and the contentious issue of whether or not they should pay a price for the taxpayer exposure that flows from being too big to fail, however, there is the underlying issue of their dominance of the system and the implications of that dominance for its competitiveness.

It’s not surprising that the majors’ competitors and critics see changes to their capital ratios as an opportunity to put some lead in their saddlebags.

It also isn’t surprising, given the heightened focus on the state of the housing market, that others see the reduction in the appeal of mortgage lending that would flow from raising the floor under the risk-weightings of housing loans as a macro-prudential tool for taking some of the heat out of the housing market.

Narev, the Commonwealth Bank chief executive, argued at the weekend that there shouldn’t be a rush to impose new rules on the Australian banks until the new global prudential regime, with its tougher capital and liquidity requirements, capital surcharges for systemically important banks and simple leverage ratios are in place.

The Basel Committee’s financial reforms are an evolving regime, with various jurisdictions -- notably the US and UK -- also adding their own variations.

It is obviously desirable that the Australian prudential regime retains its reputation as one of the globe’s more conservative and better-regulated regimes. It is, however, unclear whether the financial system inquiry should dictate what that regime should look like.

In the Australian Prudential Regulation Authority we have one of the world’s most respected financial regulators. It regulates intrusively and dynamically and is regarded as a very sophisticated regulator.

The chair of APRA, Wayne Byers, has been intimately involved in the wave of global re-regulation of banks. Before being appointed chairman of APRA he was Secretary-General of the Basel Committee and therefore played a pivotal role in the development of the new Basel regime.

Byers has expressed some concern about the risks within the housing market and the implications for the major banks of a serious problem in that market, as well as questioning whether the amount of capital within the system would enable it to recover quickly from shocks. He has said that APRA is “dialling up the intensity” of its supervision to improve the resilience of the system.

It isn’t obvious why a credible regulator should be second-guessed by a panel of experts that, while highly-respected for their achievements, have no experience as prudential regulators.

A concern about any proposals to make the system “bullet proof”, if indeed it is possible to make the system invulnerable to external shocks (it isn’t), is that there hasn’t been much discussion at all about the trade-off that entails in terms of the efficiency of the system, nor of the potential unexpected consequences of significant shifts in the incentive framework for institutions.

More capital and liquidity within the bank system will mean a higher-cost system. Given that financial institutions are intermediaries, that means customers – depositors and borrowers -- and shareholders will have to absorb those higher costs. Essentially, raising the amount of capital and liquidity required equates to a tax on financial transactions.

In terms of the unexpected consequences, the reason banks are fixated on mortgage lending dates back to the original Basel requirements, dating back to the late 1980s, when the committee introduced the capital adequacy and risk-weighting frameworks.

Given their perceived -- and proven -- lower risk than commercial lending, the amount of capital required to support mortgages was originally about half that of a commercial loan. Over time the Basel regime has become more sophisticated and granular but that rational bias towards lending against residential mortgages has remained and, indeed, has been increased.

Reducing the appeal of lending for housing by playing with the risk-weightings would increase the relative appeal of commercial lending, which has been the source of almost all the previous episodes of stress and distress within the Australian system.

Shifting the dials and balances within the system ought to require a delicate, dynamic and cautious touch overseen by an intelligent and sophisticated regulator.

It’s not obvious that a panel of outsiders, no matter how well-credentialed, is better-equipped to decide the appropriate core prudential framework than a specialist regulator like APRA.

That does, nevertheless, appear to be the likely outcome from the inquiry and one that Joe Hockey and his cabinet colleagues are likely to endorse. There’s no political downside in appearing to bash the major banks.