Here is an extended version of my opinion piece on bank reciprocal obligations for government support which appeared in the AFR on 18 August.
The GFC has been a train wreck for the world’s commercial banks. Large banks which were travelling in the ‘too big to fail’ carriage lay beside the wreckage for many months, sustained only by the life giving infusion of equity from central Governments. Hundreds of smaller banks lie dead in the field. But Australia’s four major banks emerged from the still burning wreckage with hardly a scratch, swiping dust from their shoulders and striding confidently into the future with record profits in hand and a field cleared of competition before them.
A combination of good management, good regulation and good luck helped bring them through. But Government support of the banks was crucial. The Government gave banks everything they needed in the GFC to survive and thrive. Only banks were given that special support; cash management trusts, property trusts, investment banks, and others were not.
Special treatment of banks is sound policy in a crisis because banks have a pivotal role in monetary policy and the transmission of liquidity that other financial firms do not. But for all of the Government’s support of banks what has been received in return? With the special treatment of banks goes reciprocal obligations, but so far the Government has not held Australia’s major banks to those obligations.
Before discussing the reciprocal obligations let’s be clear on just how much support the banks have received. After September 2008, the Government took a textbook three pronged approach to protecting the banking system: identify every threat to the banks and neutralise them; merge the weak into the strong; and ignore cries for help from the non-banks.
The threat of a run on bank deposits was ended with the introduction of the deposit guarantee. Banks’ inability to issue bonds overseas elicited the wholesale funding guarantee. A ban on short selling ended the threat of coordinated hedge fund attacks on bank share prices. The Australian Business Investment Partnership (RuddBank) was conceived to inject $30 billion into the commercial bank lending syndicates if needed, and the list goes on.
In the second prong of the bank protection strategy , the Government allowed Westpac to takeover St George, which was experiencing funding difficulties after the securitisation channel closed. Shortly after, CBA was allowed to buy BankWest from its moribund parent HBOS.
In its third prong, the Government ignored the pleas for help from the cash management trusts (CMTs) and mortgage trusts as money flowed out of them into the newly guaranteed banks. The Government did provide securitisation organisers with $16 billion of funding support to keep them alive, but over the same period banks raised ten times as much, more than $160 billion, with Government support.
In some areas Australian Government support was more generous than the support provided by other Governments to their banks. For instance, the wholesale bank guarantee was less expensive to Australian banks and went on for longer than the same guarantees in the US, UK or nearly any other country. The ban on short selling of bank shares went on longer in Australia than in the US or UK. Moreover, the support was in some areas more exclusive to banks. The US Government extended its deposit guarantee to cash management trusts and also provided massive support to keep the securitisation channel open.
The special treatment of banks by the Government comes with four reciprocal obligations on the banks. The first is to maintain high levels of bank capital, which banks have done by increasing average Tier 1 capital to over 9 percent. The second is to keep credit flowing to all parts of the economy under all circumstances. The banks have certainly gorged themselves on mortgages since September 2008. However, small businesses have experienced substantial credit rationing, and some large corporates were forced to issue equity at steep discounts because of banks’ refusal to roll over loans.
The third obligation on banks is to constrain interest rate rises to no more than increases in bank funding costs. Banks have widened spreads on mortgages and small business loans substantially since the beginning of the GFC. The average spread of variable rate mortgages over the cash rate has risen from 1.20 percent in July 2007 to 2.20% today. Banks complain that their funding costs have grown by even more than credit spreads. If that was true then bank net interest margins would be below their July 2007 levels, which they are not.
The final obligation on banks, in return for their extraordinary level of government support, is to restrict takeover activity. Banks must not use the financial muscle and low cost of capital that comes from government support to takeover other parts of the financial system that are not supported. The NAB bid for Axa AP is the current example of banks not meeting this obligation.
After the collapse of Lehman Brothers the Government implemented a plan for protecting Australia’s banks that was comprehensive, coherent and well executed. But the Government has not been sufficiently forceful with the big banks in insisting that they meet their reciprocal obligations.
Even this year the Government has given more to the banks by cutting income tax on deposits, just as other countries are doing the opposite by imposing levies on bank liabilities. What was asked for in return for the deposit tax break? Moreover, the GFC is not finished, which means that more Government support may be required over the next few years.
Whichever party forms the next Government the banks must be told publically that if they do not meet their reciprocal obligations in terms of credit flow, credit spreads and takeover activity, then the Government will take substantial action to assist the competitors of banks, especially the mortgage securitisation channel.