Bank Regulation


With the election campaign now on, it will be interesting to see the policies of the major parties on banking, particularly bank regulation. Just because China saved Australia from the worst effects of the GFC does not mean that our system is all fine and dandy. We have learnt some lessons about banking from the GFC and we need to see how the parties are going to deal with these lessons.

I have touched on these lessons before.

Lesson 1: The Government WILL underwrite financial institutions – whether it wants to or not. This is the big lesson. The federal government currently implicitly insures the banking system. It is politically impossible for the government to do anything else.  This lesson is the starting point for thinking about bank regulation.

Lesson 2: The banks should pay an insurance premium: The government’s insurance of the banks needs to be made explicit and the government needs to act as an insurer through its regulation of the banks. We do not need a new ‘bank tax’ but the banks should pay an insurance premium to the government. The premium should be based on the actuarial risk associated with the allowed bank activities.

Lesson 3: The banks should only engage in a more limited set of activities to avoid moral hazard: The government must police the activities of the banks like an insurer. This means restricting the activities that insured banks can undertake and splitting off some of their current activities. For example, Christopher Joye in a recent speech suggested that banks should be required to divest their funds management activities. From an insurance perspective this sort of separation will be necessary to avoid the banks raising risk at taxpayers’ (i.e. their insurer’s) expense.

Lesson 4: Design financial regulation carefully:We have a lot of experience of industry regulation. Apply it to the banks. We will not get perfect regulation but we can design clear regulation that is not subject to gaming.

The banks will not like these changes. After all, they have been getting free insurance for years. Why would they now want to pay for it?

They have had an insurer who has placed little restriction on their activities. Why would they want to face (actuarially sensible) restrictions now?

The banks will argue that the rules will make them worse off. Yes! They will. The banks have had a free ride through the government underwriting, so obviously they will be worse off by having to pay for an insurance service that they previously got for free. The banks will argue that ‘others’ will be able to compete in markets that they cannot compete in. Of course. But the others better not have an implicit (or explicit) government guarantee.  The banks will argue that money will flow to these ‘others’ to avoid the regulations. Yes – if people wish to place their money in a riskier, non-insured option then that will occur. The government needs to make sure it can credibly commit NOT to underwrite these ‘others’. But given that commitment , if consumers want to take the risky alternative they can do so. But the banks cannot – because the government cannot credibly let the banks go bust.

Which brings me to my final lesson.

Lesson 5: Regulated banks will lobby to remove regulation. Don’t!

5 Responses to "Bank Regulation"
  1. How about: that bailouts above and beyond the insurance in your (2) should take the form of equity investment at the current market rate. This should be a) sufficiently horrific for boards and shareholders that they would be desperate to avoid it and b) likely be a reasonable deal for the government, since a bank in dire need of funding should be trading at a substantial discount. If they can be turned around, or brought through difficult external circumstances then the government could stand to make a good return on such investments. IIRC this has been the case for some equity stakes that the US government has taken as part of various bailouts (but I don’t have any good references handy, sorry).

  2. I’m sure a complex yet sensible reform like that would be well within the capabilities of a Government that successfully implemented similar visionary schemes like an ETS and a Resource Rent tax.
    Now, if only we had a Government like that…

  3. The government needs to make sure it can credibly commit NOT to underwrite these ‘others’.
    That could be done if such “others” were required to include a prominent bold warning in all advertising and promotional material: THIS INVESTMENT CARRIES NO GOVERNMENT FINANCIAL INSURANCE, similar to the health warnings on cigarette packs.
    Might help get the banks on side, too.

  4. In line with kme above, I think an issue has to be that consumers are more informed. Sonray and Storm investors clearly did not know what they were really in for. Those investors should have been walked through a prospectus by the sellers, in the same way that we have mortgagees walked through their mortgages and signing off that they understand their mortgages. This would reduce demand for some of the garbage products out there, but that is the point. And it would also help in making sellers liable where prospectuses and information sessions were misleading, as was allegedly the case with Sonray. Consumer protection laws won’t protect everyone against everything, but they should protect consumers from inadvertedly investing in highly risky products that they are assuming are low risk.

  5. but do not forget that these regulations do come at a cost

    yes regulate but there is a tradeoff between growth and system instability – so bad regulation does cost

    let systematically unimportant banks fail….and make sure they are not selling their “dumb” customers nightmares rather than dreams! its up to banks and their shareholders to manage the adverse selection of customersthat turn out bad risks

    make systemically large banks pay the insurance premium for their contribution to systemic risk that is not able to be isolated and causes contagion and procyclical behaviour towards good customers that then may get squeezed

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