Back in March 2009, former Reserve Bank Governor Ian Macfarlane gave a now famous speech in which he outlined why Australian banks had avoided the worst consequences of the GFC, because of dumb luck. One of his principle insights in drawing this conclusion was that the banks had benefited from the ebbing of competitive pressures owing to the four pillar system. He argued at the time that the mad scramble to expand and retain control had created an:
… equity culture instead of a banking culture . You had to get big, or be taken over, and that meant taking on more and more risk. Why didn’t that happen here? Because there has been no competition for corporate control. That curious creature, the four pillars prevented it.
Two years on and the RBA of today has released its Financial Stability Review chock full of warnings that the banks are now poised to expand risk-taking, both domestically and internationally.
The RBA begins by noting the same thing several analysts on this site have described, that the spectacular system growth of yesterday is gone:
A challenge for the industry in coming years will be adjusting to a likely slower pace of credit growth compared with the previous few decades, which will limit its growth opportunities.
It appears unlikely that credit growth will return to the very high rates that were sustained in the precrisis period, since credit expansion during that period was significantly boosted by the one-time adjustment to financial deregulation and the shift to low inflation. This suggests banks’ domestic growth opportunities are likely to be more limited in the future. If industry participants were to attempt to sustain earlier rates of domestic credit growth, they could be induced to take risks that may subsequently be difficult to manage. As yet, there is little sign that banks have been significantly relaxing their lending standards in a bid to stimulate credit growth. However, increasing competition in housing loans is starting to put pressure on lending standards. Some banks raised their maximum loan-to-valuation ratios in the second half of 2010 and early 2011, though this followed a period in late 2008 and early 2009 when many banks were tightening these criteria. The share of non-standard and line-of-credit loans declined as a share of new mortgage lending in late 2010 for some major banks, although this could partly reflect weaker demand for such loans.The responsible lending requirements of the National Consumer Credit Protection regime, which came into effect for authorised deposit-taking institutions (ADIs) on 1 January 2011, should help limit any undue loosening in household lending standards.
And then, they also warn on international expansion:
In an environment of slower domestic credit growth, banks may look to expand overseas. Recently, for example, some banks have been looking to increase their presence in the fast-growing Asian region, where there is a large pool of savings and relatively rapid credit growth in some countries. Currently, exposures to Asia (excluding Japan) account for a small share of the major banks’ total offshore exposures, at around $50 billion, compared with total offshore exposures of around $650 billion. Offshore operations can offer growth and diversification opportunities, but they also raise a number of risk management and other challenges that need to be carefully handled. For example, there are challenges associated with being a new entrant to a market and having less familiarity with local market structures. The way in which banks structure their offshore investments can also have implications for how insulated the Australian operations would be from any problems emanating from overseas operations, and vice versa.
And so the RBA should be cautious. Any business person in Australia that has half a brain and is still breathing can recall that in the GFC, banks from small nations (and large) that grew their asset bases aggressively in foreign countries left their home markets deep in the shit when the risk-taking backfired. The examples are too numerous to bother repeating and, as mentioned, was one of the key reasons cited by Ian Macfarlane for the banks’ survival of the GFC.
Neither is it a stretch to recall that Australian banks have a poor record when it comes to oversees expansion. The NAB Homeside debacle, and even its pre-GFC foray into elaborate international instruments, cost the bank roughly $4 billion apiece.
NAB’s other global ventures, into the UK, haven’t performed very well either, failing to grow any faster than the market in general.
And that’s the nub of the issue. The Australian banks are used to growing with the system. They have no management insights that enable them to take market share in new markets.
The one bank we did have that was an exception to this rule was Macquarie, and sadly, after a decade of world-blazing growth, it’s business model proved to be nothing more than a bubble in the general froth of the times.
But the RBA is offering the banks a ray of light. In couching its resistance as looming risks, a shot across the bow as it were, the RBA offers the impression that sensible expansion might be tolerated. This sense is enhanced by a speech delivered today by Assistant Governor of the RBA, Malcolm Edey, at CEDA:
So far, I’ve spoken about things that are already reasonably well advanced on the international regulatory agenda. One big question that I think hasn’t got the attention it deserves is: Is there too much internationalisation in the banking industry?
When we talk about banks being too interconnected to fail, an important dimension of that is international interconnectedness. It’s reasonable to ask the question: if banks are too interconnected in that sense, should they be made less interconnected? One way that that might be done is through greater use of subsidiary structures by banks that operate across borders.
I don’t want to overstate the case for this because I recognise it’s a complex issue. But I can think of a number of advantages for that kind of model from the point of view of financial stability. In particular, all of the key policy tools for managing financial distress are located at the domestic level. Liquidity provision to banks is a currency-specific tool, and is the preserve of the national central bank that issues the currency. Bankruptcy laws, resolution powers, bank regulatory regimes, and the fiscal powers that might be needed in a crisis all operate at the domestic level.
The effect of subsidiarisation, at least in principle, would be to ring-fence the national operations of cross-border banks within separate legal entities in the countries where they operate. There’s a good argument that that kind of structure would simplify the management of financial stress events. It might also reduce concerns about cross-border arbitrage of differences in capital regulation.
I am aware that there are also arguments on the other side. In some instances, ring-fencing might not be a realistic option, or host countries might prefer foreign banks to enter as branches in order to benefit from the full support of the parent. Some would argue that concerns about cross-border resolution could be better addressed in other ways.
Another point is that the subsidiary structure is likely to be more expensive to operate. But I’m not sure we should view that on its own as a decisive argument against it. A lot of the post-crisis regulatory changes will add to the cost of financial intermediation, but they are being done anyway to reduce systemic risk. The point is that the costs and benefits need to be carefully weighed.
Hmmm … ring-fenced foreign subsidiaries. I’m up for Australian companies taking over the world but this gives me the heebie jeebies. Banks have a long history of hiding and shifting risks that look safe enough, until the tide goes out, and suddenly, parental liability reappears. The RBA has recently demonstrated a healthy skepticism of bank culture. This is no time to be backing away from that. The halting tone of Eadie’s speech should be replaced by something more strident.
The alternative to these musings of expansion is that the banks just settle down and live with being effective private utilities. Which is my preference. Admittedly that comes with its own price tag, a downgrade to growth prospects and equity values. Given the size of the sector and its widespread shareholder base, that’s a blow to our wealth. But in my book it’s the price of reality.