So It's ... Banks For The Memory

The Age

Friday October 17, 2008

Tony Cole - Tony Cole is a former chief of the federal Treasury and the Industry Commission, and is now worldwide partner and business leader, Asia Pacific, of Mercer's investment consulting business.

The regulatory regime is only a small part of why our financial system is robust, writes Tony Cole.

THE IMF has confirmed that Australia's financial system and economy are better placed than those of other developed countries to withstand "the most dangerous shock in mature financial markets since the 1930s".

But will the soundness of our regulatory and banking system, and links to Asia, protect us from a global recession?

The financial soundness indicators (profitability, capital adequacy, asset quality and provisioning) for the Big Four are all strong and the smaller banks are also financially sound as a group. Australian banks have minimal exposure to US subprime assets, the securitisation of domestic mortgages is limited and, in any event, defaults and arrears on domestic mortgages are low by international standards. And banks have made provisions for their limited exposures to impaired assets.

Politicians and our financial regulators credit the strength of our banking system to the best regulatory system in the world. While our regulatory system is pretty good, it is not in a class of its own. Governments around the world appreciate the vital role of banks in their economies and generally strive for best practice regulatory oversight. Regulators worldwide actively share ideas and information. We do have the advantage that our smaller economy with fewer players makes our regulators' jobs easier, but that advantage is shared with lots of other countries - some of which have banking systems in dire distress.

The major source of the strength of the Australian financial system at present is the behaviour of the banks themselves - not the regulatory regime under which they live.

The disappearance of two state banks and the near-death experiences of some of the commercial banks in Australia's last major financial crisis in the early 1990s have made them more cautious. This is reflected not only in their balance sheets but also in their attitudes to non-traditional activities and to offshore operations.

Similar lessons from history explain why Asian banks have generally avoided the worst of the current crisis. In their case the Asian crisis of the late 1990s is even fresher in memories.

Australia and Asia's banking histories share other similarities. The Australian crisis was preceded by financial deregulation and the opening of markets to what was expected to be fierce competition from international banks. At the same time, as banks were given unprecedented freedom to run their own businesses, they believed they were under threat from powerful new competitors with years of experience in competitive markets. In their scramble to make the most of their new opportunities they took their eyes off risk and the cycle. When asset prices unravelled, so did some of the banks.

The Asian banking sector's period of heady growth came with the Asian economic miracle. As huge foreign capital inflows fuelled an investment boom across the region, banks found themselves competing in unfamiliar activities and on a scale vastly beyond their experience. When the boom ended, capital flows reversed, sweeping a large part of the banking system away.

Banks get into trouble when they aggressively compete in business areas with which they are not familiar - such as entering a foreign market for the first time or moving from corporate banking into retail.

In this sense regulatory change is a contributor to the problems of the US banking system. The Glass-Steagall legislation in the US set limits on what different financial institutions could do and where. Its repeal allowed banks to undertake activities that were new to them and intensified competition in the broader financial services market. It allowed the big banks to create and distribute the mortgage-backed securities that are now such a problem.

Australia has enjoyed a long expansion, avoiding recession after the dotcom bust and slowing down rather than dipping during the Asian crisis. Can we withstand the sharp global contraction that looks inevitable unless governments and central banks stumble on to a successful strategy to unfreeze financial markets?

The Government's decision last weekend on guarantees for deposits in financial institutions was arguably unnecessary given the financial strength of the Australian financial system. However, it does pre-empt the risk that a spooked public will behave irrationally and create a run on one or more deposit takers. It may also avert the nuisance factor of wealthier individuals opening numerous small accounts, all under the protected level.

The guarantee on banks' borrowings in wholesale markets is a substantial matter. Almost 60% of Australian bank lending is funded by borrowings from the domestic and international wholesale money markets. The IMF highlighted this as the one key vulnerability of our financial system.

The government guarantee removes that vulnerability. It should improve access to funds and reduce the cost of such borrowing. The price issue will probably be neutral for banks after they pay a guarantee fee. My reservations to this proposal relate to how it will eventually be unwound and whether it will lead to questioning of the Commonwealth's own rating, but that can be worked out later.

Through these measures the Government has greatly reduced the risk that the domestic financial system will freeze, taking the economy with it. But we could still be affected by declining demand for our commodity and other exports from a recessed world. If a deepish global recession occurs, it is highly likely that demand for and the prices of Australia's commodity exports will fall away, while new capacity for some key commodities comes on stream.

Broadly these measures seem to have been designed to generate a quick demand response to bridge the gap before the monetary easing has an impact. -- Tony Cole is a former chief of the federal Treasury and the Industry Commission, and is now worldwide partner and business leader, Asia Pacific, of Mercer's investment consulting business.

© 2008 The Age

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