Accounting for the rentier

My post last week on APRA’s Discussion Paper on the new Basel III Capital requirements, created a few ripples around what APRA did not address in the discussion paper. Perhaps I can turn these ripples into waves by providing more detail on why APRA’s failure to address these issues will eventually lead to systemic failure which will cost every Australian dearly. Please take note!

Whilst I complemented APRA on a number of initiatives in the paper, I pointed to a few fundamental deficiencies.

  • Failure to acknowledge the 4 TBTF Australian Banks and the implicit government guarantees these institutions receive at no cost.
  • Failure to enforce the Pillar 3 requirements of Basel II for those same banks to disclose the details of the advanced methodologies used under Basel II to calculate risk weighted assets (“RWA”) and minimum capital requirements (“MCR”).
  • No requirement on APRA to publicly disclose the details of any decision or imposition on an ADI when enforcing regulation eg details of an ADI’s Prudential Capital Requirement (“PCR”)

Before outlining more detailed reasons for stating that failure to address the above issues is a very large systemic risk, I think I need to outline my views and experience on, how corporations act, and system risk.

Corporations although made up of individuals, are not individuals and behave completely differently from individuals. To reduce the arguments on this point, let’s assume I’m referring only to financial corporations.

Individuals can be loyal, trustworthy, altruistic and act for the greater good. Corporate structure and rules do not allow it to act in any of those ways as an individual. If an individual tries to impose those actions within a corporation they will be ostracized. Individuals can see and understand rules or laws and will chose to follow those rules both explicitly and as intended. Corporations see rules or laws as impositions to be gamed. It cannot act in any other way as the collective mind of a corporation can only reach the consensus, that a rule must be followed or the rule can be circumvented. It cannot reach a conclusion that a rule should be followed or there is some other greater good reason for continuing to follow a rule. Therefore you cannot legislate rules for corporations in the same way as for individuals.

Bloggers on MB, particularly SoN have recently compared the quality of money with trust. Well maybe for individuals but for corporations its accountability. Corporations work well in a managed low risk environment when accountability is transparent and balanced. Lack of accountability increases risk and the longer it continues the greater the risk of failure. Lack of accountability is born out of a lack of transparency of possible or unexpected risks to the risk takers by the beneficiaries.

A corporation or any closed financial system has a risk of failure or success related to known net returns, expected losses, unexpected or unknown losses and accountability. What is not well understood in this simple relationship is the effect of time and accountability on the risk. If we express accountability as the capital formally allocated to protect against the unknown, then the probability of success or failure of a closed financial system at a point in time is the sum of net returns, expected losses, capital and unexpected losses multiplied by the square of the time since commencement. A positive result reinforces success, whilst a negative result unless rectified leads to an almost certain failure over time.

With these risk relationships in mind, let’s return to the issues I have highlighted that APRA has not addressed.

The lack of formal acknowledgement as allowed under Basel III by APRA that Australia has not 1 but 4 TBTF banks is a mind blowingly huge risk to the system and the longer it goes on the greater the risk becomes. Despite the three main US credit rating agencies increasing their ratings in acknowledgement of the implied guarantee and acknowledgement of wholesale lenders in market pricing that the guarantee is real, APRA has refused any acknowledgement.

Of course the banks through CEOs and other top managers of the banks follow suit and deny that its real and that large profits from greater risk taking and cheaper funding are not available because of taxpayer support but from their skill and they therefore qualify for large remuneration packages. It is impossible though for the banks to operate or respond in any other way and as time goes on the risks and the remuneration will just grow to the point of ensuring that the guarantee is called. APRA and/or the Government must acknowledge the implicit guarantee and ensure there is accountability by guarantor and recipient.

Basel II requirements clearly state that there must be transparency when using an IRB approach for calculating RWAs and MCR. This makes perfect sense when we realize that in our risk equations that transparency is key to accountability and therefore risk management. The lack of compliance with Pillar 3 requirements by the banks and the lack of enforcement by APRA should cause all taxpayers great concern. Lenders to the banks have their implicit guarantee which is provided free by the taxpayer. Shouldn’t APRA be enforcing the taxpayer’s right to be provided with thePillar 3  information so that we can have a proper assessment of how banks are calculating their risks and capital related to residential mortgages and other assets? The lack of transparency and accountability to the Australian taxpayer for information on RWA by the 4 major banks and APRA is a formula for gaming the system. Methodologies will be used to ensure that minimal capital and therefore accountability will result regardless of the real risk. Nothing else results from using a black box because the corporations cannot act in any other way.  It will be gamed until the undisclosed and unexpected risks cause the system to fail.

Finally, APRA must be accountable for its regulation and the enforcement thereof. Under current law, APRA does not have to report publicly on how it’s enforcing regulation or its requirements of ADIs. Under this system, accountability only occurs if there is a failure of or within the system. This should not be acceptable to any Australian taxpayer in light of their support through the implicit guarantee. The lack of transparency of action is the bureaucrat’s friend. It allows for little scrutiny and THE attitude that everything is under control with the best regulated financial system in the world with no problems. Until of course failure occurs for whatever reason, and whatever that reason, it allows the regulators and the government to blame someone else. There is no accountability even though the existence of the implicit guarantee is explicit evidence of an unhealthy system as was the explicit government guarantee of retail and wholesale debt that was applied in October 2008. But of course, that was someone else’s fault.

Anyone of the above could lead to system failure but collectively and unless changed, system failure will occur and a government rescue will be required to the further cost of the taxpayer.


  1. Deep T .

    I am not sure if anyone from the Australia media will recognise how significantly important this post is, but I hope FT pick it up once again.

    You continue to highlight the major failings of our banking regulators to provide a framework for true financial stability, and unless I am mistaken are the only voice from inside the industry who is actually doing that.

    I hope one day to see you at the helm of APRA so the rest of us can sleep a little more easily.

    Thanks again for your fine work.

  2. Exactly. Top work, Deep T.

    I particularly like your explanation of the difference in behavior between corporations and individuals. Identical institutional attitudes as corporates apply in government departments and agencies.

    Australia’s four TBTF banks pocket very substantial economic rents – peeled off borrowers, depositors and the government. From the banks’ perspective, this is merely good practice. Meanwhile, the economy as a whole must work that much harder to carry this deadweight loss.

    Having four banks of global standing is a source of much national pride, but Australia pays a very heavy price for the right to strut.

  3. In order to go forward and act as a catalyst for the MSM to take this up, we need to understand why APRA is not following the right course. Assuming they must be aware of the risks, where is the undue influence coming from? Obviously they will have been subjected to banking propaganda, but surely that’s what one would expect?

    • Rob, the MSM is an enabler. I can practically close my eyes and tell you that every article that covered this story will have a quote from Munchenberry or whatever his name is, a couple of quotes from market analysts on what this will mean for short-term bank profits and nothing else.

  4. Great post Deep T. I meet an big four ex manager at a recent meeting and he said his bank was overweight in housing, and their is concern, but concern and not nothing more; as you say we’ll bail them out so why should they worry. It goes back to the way Invisipower occurs without real transparency, and we find out from FOI’s or other US FED inquiries. Our regulators don’t think it’s important to tell us.

  5. When you have financial newspapers telling people that a “safer banking system” is a bad thing because it will constrain economic growth and lending then you know why they dont enforce it. Saw an article in yesterday’s AFR stating exactly the same thing. No one wants anything to do with a credit crunch right now; the banks have us right where they want us.

    Its amazing that by your post (and the previous MB post on the financial claims scheme and the moral hazard it brings) that people can still say we are better regulated than the US. It seems that we have regulations that more often benefit the banks than the US or other countries have. Maybe this is what helped us in the GFC; not that we were better regulated because it sure doesn’t sound like it but because in this regulatory environment housing lending is a huge cash cow and the banks dont need to take huge risks.

  6. Deep T, I continue to have issues with your disclosure points. I dont see that you have addressed any of the comments that i have made to you on this point. So i’ll make a few more in the hope that you do.

    Firstly, on the disclosure of the PCR, i have previously made the point that disclosing the supervisory adjustment and overall PCR will result in a market perception of risk that is not necessarily in line with that of the regulator. The risk considerations used by APRA will be different those used by the market, the market will have incomplete information about any changes, and changes up or down in the PCR have the serious risk of being misinterpreted. Further you have the prospect of companies competing on the basis of their PCR, which produces a further incentive to conceal information which may be detrimental to their risk ratings.

    Secondly, many US jurisdictions have complete disclosure of regulatory activity. This includes formal public release of regulatory review reports etc. This process results in watered-down review reports, and its hard to argue that financial regulation in the US has been effective. Its therefore difficult to argue that this transparency has actually resulted in better regulatory outcomes.

    The current structure around secrecy means that a company cannot hide behind information being commercial in confidence or sensitive, as APRA cannot disclose such information. It means that the regulator has greater ability to fully examine the corporation. The key issue is, therefore, having the right governance structure around and within APRA to ensure that APRA is effectively operating and discharging its duties.

    If you move to a model of great transparency of actions you run the risk of the information being available to the regulator being severely limited. No company will want to take the chance, for example, their information contained in their Board packs is leaked or finds its way into a publicly available report.

    The focus should therefore be on ensuring that APRA operates within the best possible governance framework to ensure the best regulatory outcomes.

    • I should add that i think regulations on the whole are overdone and help the big end of town. the barriers for entry are too high. this plays a big role in helping the big 4 become so big, and restricts competition in a big way. i’d be all for reducing regulatory power significantly; but this doesnt change my view on transparency.

      if anything, the regulator is there to see what we cant see from public information.

    • The current structure around secrecy means that a company cannot hide behind information being commercial in confidence or sensitive, as APRA cannot disclose such information.
      You are basically saying that the APRA can judge in secrecy, better than even the market can, on whether a bank is solvent or not!! Why, you must be a pinko commie!!
      Screw the market..what about the depositors? Aren’t they supposed to know if the bank is solvent enough to pay back their deposits?
      For a depositor, the suggestion that the information on whether an ADI can meet any prudential capital requirement, should be commercial in confidence, is just insane.

    • Pete

      My post is about addressing very specific issues of transparency. I am neither advocating nor do I believe that transparency involves releasing all information.

      I do not agree with your reasoning in relation to PCR. The same argument is used by credit rating agencies when giving opinions. CRA’s lack of transaprency in RMBS built up systemic risk. Whilst APRA disclosing how and why it is enforcing specific regulations against an ADI may cause risk issues to arise for that ADI or indeed APRA, such disclosure reduces systemic risk which builds in an opaque environment.

      No comment on that swipe at the US regulators.

      How can you ensure that APRA acts in in accordance with proper governance without a level of transparency especially on the issues I have outlined?

    • Pete
      Though I’m not a banker, the gist of what you are saying was that APRA needs to be trusted because:

      a) banks will otherwise hide behind confidentiality
      b) In the US where full disclosure is compulsory, the response is to water down reports.
      c) The market may misinterpret the risk they are exposed to.

      Point c) would surely also apply to European banks who have to comply with Pillar 3. It’s a level playing field if you all have to comply.

      Points a) & b) are actually the reason APRA and other bodies are necessary. Secrecy. If you have it, you abuse it. However, If APRA insist on secrecy all you are doing is removing the risk of misgovernance by one level. Think ‘rating agencies’, think FAA and air crashes. The fact that US banks water down reports as some sort of response to disclosure is a result of shortcomings in the disclosure legislation, not a reason for not having it.
      The big 4 have multi trillion $ exposure to derivatives, I’m sure the vast majority of this is hedged, however, it won’t hurt me to know how much.

  7. “Unfortunately it seems to me that understanding risk is an old persons game. Is it a cross that many of us grow to bare?”


  8. Deep T.

    Brilliant work.

    Thankyou SO MUCH for taking the time to bring these incredibly important issues to a wider audience.

    I hope these points get picked up widely.


  9. Deep T.

    + 10

    I’m a shadow reader and have been blown away buy all the great articles and generosity of the Macrobusiness Team.

    I’m seriously thinking about placing most of my cash in Govt. bonds and steering clear of the TBTF Oz Banks until after the housing market stabilizes.

    Invaluable reading, we regular people desperately need access to this type of open, intelligent and well researched economic commentary that courageously speaks truth and offers ongoing concrete critique of the real issues & risks potentially affecting us all.

    Thanks for the life line through all the regular dross and froth.


  10. Excellent DT. You have pointed out many risks above both in the system and to the taxpayer.

    The risks to the taxpayer needs to be explained to the taxpayer. (If you don’t know who the patsy in the poker game is, it’s you).

    Risk vs reward. Risk vs trust.

    The public- to paraphrase G.leBon (I think): “The real and unreal, are just as real to the crowd”. A good example of this was years ago in the early noughties, a Fed Gov. USA stated: I’m amazed that the majority of people don’t understand that a currency is not money. Apply this with the broad brush of the Pareto Principle-80/20 and risks abound for the taxpayer.

    “Ignorance is not bliss. It is the food of slaves, and the tyrant’s money”. Uknown

    Older people and risk: As parents we get a triple A rating embedded counterparty request-DAAAD. No return on money, of money and if your lucky the cab fare as well.

    Thank you DT. Your vigilance is both admirable and appreciated.