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!