The risky business of financial sector reform

Australian banks' disproportionate exposure to home loans is a source of weakness for the sector, but any changes to the system must account for the trade-offs between risk, competitiveness and efficiency.

One of the key insights provided by this week’s tabling of the Financial System Inquiry’s interim report is how inter-connected the system is and therefore how sensitive it is to any change.

Nowhere was that more evident than in the related discussions about competition within the system and the vexed issue of banks -- four of them in our system -- that are 'too big to fail'.

It was obvious, even before the financial crisis, that the four major banks are too big to be allowed to fail. The crisis, the government guarantees of funding and deposits, simply reinforced what was previously known: the increased concentration within the banking system that occurred during the crisis has amplified both that conclusion and its implications.

While the inquiry, headed by former Commonwealth Bank chief executive David Murray, canvassed a number of options for reducing the risk to taxpayers created by having too-big-to-fail institutions -- including bail-ins of creditors, ring-fencing of core activities, higher capital charges and charging up-front for the government guarantee of deposits -- the difficult truth is that none of those would do much more than marginally reducing the risk to taxpayers. What's more, all would come at a cost to efficiency and competition.

In the event of a crisis that threatened one of the major banks -- which have combined total assets of more than $3 trillion -- all would be threatened. Ultimately only the Commonwealth government has the balance sheet to respond to that magnitude of risk.

Which is why the inquiry also made the point that the Commonwealth should maintain a strong balance sheet both to support the economy and the financial system in the event of another significant disruption and to maintain the confidence of the foreign investors who fund a significant proportion of the system and economy’s needs.

The chaos in Canberra that is frustrating the Abbott government’s attempts to bring the burgeoning federal government’s deficit and debts under control, unless resolved, won’t help create the capacity for the government to respond to another major financial crisis.

Within the system, higher capital requirements could both dial down the levels of risk at the margin while also impacting the competitiveness of institutions.

There’s a significant discussion within the interim report of the unlevel playing field for residential mortgage lending, with major banks having to hold significantly less capital against mortgage lending than their smaller competitors because they have achieved advanced accreditation status under the Basel Committee’s regulatory framework.

The playing field could be levelled by either allowing the smaller banks to hold less capital against mortgage loans or by requiring the bigger banks to hold more. If there is to be a change, one suspects that it will probably be to change the risk-weightings for home loans for the bigger banks.

That’s because the inquiry is clearly concerned about the explosion in home lending that has occurred over the past couple of decades -- two-thirds of bank balance sheets are now devoted to home loans -- and the steep increase in households’ mortgage indebtedness associated with that shift in demand and lending.

At a prosaic level, the Basel Committee’s risk-weighting of loans has diverted funding from business to mortgages, which isn’t necessarily in the best interests of the economy. Tweaking the risk-weightings to reduce the returns on equity from mortgage lending might see more funds devoted to business credit.

Of perhaps greater significance is the potential threat the exposure to housing loans poses for the system. In the event of a sharp and prolonged fall in house prices, the banks would clearly be impacted adversely, their ability to lend to business would be affected, and their access to funding would also be hit. Even if there were no institutional failure, the wider economy would be hurt.

While there are some differences between the banks, they all have disproportionate exposures to home loans. Given the correlations of risk within the system, the potential for something very unpleasant occurring if home lending and house prices continue to rise at the rates of recent years will increase.

It is this mix of systemic risks and the competition issues that have led analysts to conclude that the inquiry will advocate an increase in the risk-weighting of mortgage lending for the bigger banks in its final report, causing them to have to raise/create sizeable amounts of new capital.

The major banks already face a one percentage point capital surcharge because of their importance to the domestic system; a change to their risk-weightings would force a further de-leveraging of their balance sheets. That could have an impact of their capacity to lend and their pricing of home loans, as well as for their returns on equity and returns to shareholders.

Even though there might be some unintended consequences flowing from more conservative domestic banking settings, there is an argument that the system should be shored up against the threat of another crisis -- as should the nation’s balance sheet.

The US Federal Reserve bond and asset-buying program is scheduled to end in October. There is an expectation that US interest rates will start rising somewhere between the middle and end of next year, ending the extraordinary period of unconventional monetary policies that has seen the Fed’s balance sheet expand from about $US900 billion to about $US4.4 trillion and official real interest rates in negative territory. Similarly expansive and unconventional policies have also been deployed in Europe and Japan.

It is conceivable that as access to ultra-cheap credit begins to shrink and interest rate start to rise – or their rise is anticipated by markets – there could be another global financial market 'event'.  Last year, when then-Fed chairman Ben Bernanke began talking about an eventual tapering of the Fed’s asset-purchasing program, there was a massive sell-off of risk assets.

There has been a lot of discussion about the impact of the central banks’ policies on the pricing of risk -- it would appear risk premia have essentially been discounted to zero -- and how that could create the foundations for another crisis when risk is rediscovered and funds begin fleeing riskier assets and jurisdictions.

The impositions of new capital and liquidity requirements after the 2008 crisis and, in the US, the Volker Rule’s impact on principal trading, introduces some new 'known unknowns' to how financial systems, markets and institutions might respond to and absorb any new significant bouts of stress.

There is a sense within the interim report that the committee members are still trying to assess the level of vulnerability within a financial system and economy that weathered the 2008 crisis far better than most, as well as trying to better understand the trade-offs between risk, competitiveness and efficiency that will have to be made in any recommendation for change.