Wednesday, October 01, 2008
"Australia's big four are among a handful of the most profitable banks in the world. Unlike America, the problem here is not that our banks might collapse. It is that the credit crunch may result in them becoming too powerful."
That's my colleague Jessica Irvine in today's SMH. She digs well and reveals the background behind Swan's decision to buy $4 billion worth of mortgages.
And she includes a lovely tounge-in-cheek homage to the forces of nature that are Australia's four biggest banks:
"Amid the global crisis now is the time to congratulate ourselves on how lucky we are to have such well capitalised and profitable banks. How prescient to have been paying a premium all this time so that our banks could weather this international financial storm."
Below the fold, one of the thinkers behind the $4 billion bail out proposal, Chris Joye, outlines his thinking. It was in a comment, but it deserves a full airing:
chris joye said...
In our paper we argued that when critical economic markets fail because of the absence of the ‘public goods’ of liquidity and price discovery, governments have a responsibility to (temporarily) intervene to assist in restoring normalised activity. We were careful to note that the government should intervene--not a subsidised private corporation such as Fannie Mae or Freddie Mac--and that such injections of liquidity should be justified only by extreme emergencies. In particular, we proposed that the government capitalise on its AAA credit rating to issue bonds and use these funds to acquire very high quality, low risk ‘prime’ mortgage backed securities in order to staunch the severe illiquidity that had resulted in the securitisation markets effectively closing in November 2007. We were also at pains to state that we were agnostic as to how our idea was operationalised, but did, for the record, advise the government to use the Treasury’s Australian Office of Financial Management (AOFM).
Despite the predictions of many, Australia’s mortgage securitisation market, which has served as such an important source of funding for non-bank lenders, building societies and smaller banks, has not yet recovered and remains economically shut to this day. By this we mean that the pricing available in the market is not sufficiently low to enable lenders to source capital to underwrite home loans on an economically viable basis. Even the RBA agrees with this point.
The closure of the securitisation markets has--according to Fujitsu Consulting--resulted in the big 5 (now 4) major banks’ market share of new home loans increasing from around 75% prior to the sub-prime crisis to circa 90% today. At the same time, many non-bank lenders have fallen by the wayside while the smaller banks and building societies have struggled to compete. As we anticipated, the illiquidity in this market has had other consequences, such as contributing to the severe credit rationing seen in the corporate and small business lending markets, and wreaking havoc on the conduct of monetary policy with a deterioration in the linkage between the RBA’s cash rate and actual lending rates.
We pointed out that market failures of the kind can occur because of information asymmetries, such as we have seen in the US with the non-transparent AAA-rated investment structures that held sub-prime securities, and because investors have a tendency to over- and under-react to events that can in turn trigger protracted asset-price booms and busts. George Akerlof won the Nobel prize in economics for showing that while markets are ordinarily the best means to allocate goods and services, when you have imbalances in the information that people possess when engaging in transactions--like an understanding of the true risks underpinning complex financial market securities--markets can fail with catastrophic consequences. The introduction of ‘mark-to-market’ accounting practices has only served to reinforce these distortions.
We also argued that that in today’s highly interconnected world global financial crises are being transmitted with ever greater frequency. In just the last decade we have been rocked by the Russian debt crisis and consequent LTCM collapse, the tech boom and subsequent wreck, and now the credit boom and bust. The point is that notwithstanding the intrinsic strength of Australia’s economy and financial system, we can be adversely affected by events that are seemingly far removed from our shores.
Despite some of the protestations to our proposal, the notion that governments have a critical role preventing financial market crises is, in fact, a cornerstone of our capitalist system. One of the main reasons central banks were established is to serve as a lender of last resort and prevent bank runs. Bank panics in the US led to the establishment of its centralised banking system in 1913. The stability of the financial system has also been a long-standing responsibility of the Reserve Bank, which “focuses on the prevention of financial disturbances with potentially systemic consequences.” The Reserve Bank also regularly intervenes in the currency market in order to stabilise our exchange rate on the basis of its belief that currency values have a tendency to deviate significantly away from fair value.
Another less noted, but equally important, issue we raised was that when Australia’s central banking system was set up in 1959, home loans were funded almost exclusively through deposits. That is, securitisation markets and non-bank lenders did not exist. So while today banks and building societies are regulated by APRA and have their liquidity needs protected by the RBA, the securitisation market that has grown to provide nearly a quarter of all the funding for home loans, and which was a key source of funding for so many non-banks lenders, building societies and smaller banks, benefits from no government infrastructure to protect it during times of crisis.
This speaks to going back to first-principles and thinking about how we can improve the current regulatory regime in order to accommodate recent capital market innovations such as the emergence of securitisation. As the RBA and Treasury have noted over the years, there is a fundamentally sound economic basis as to why securitisation should exist. But we currently have an asymmetrical regulatory system that disproportionately favours deposit-taking institutions—indeed, it barely acknowledges these new markets. The system should, therefore, evolve to accommodate these changes.