The spectre of re-regulation

[This post appeared in Crikey, 15th July, 2008] It has only been a few decades since interest rates were pretty much regulated and there were a raft of controls on banks. That ended with the Wallis Inquiry of the late 1990s. And since then, political-economic equilibrium on banking control has held because of the twin gifts of loose monetary policy and competition against the major banks. Those gifts have now been returned.

Yet, in the wake of the US government making its implicit guarantee of Fannie Mae and Feddie Mac explicit, there are numerous calls for Australia to leave the market to itself (e.g., in today’s AFR editorial). I believe this is the wrong call economically because there is ample evidence that the market does not provide a sufficient level of liquidity on its own. But it is also a poor political strategy as well.

Consider this: over the next year we have tighter monetary policy at the same time as the real competition in home lending has dried up. We have already been seeing the result of this: interest rates rising faster than the RBA targets and credit rationing of small business lending. And all awhile that major banks keep telling everyone that things are just fine.

That will last until the first profit statements from those banks appear. I predict they will be a bumper year for Australian majors. And then the politics will shift and we will see a raft (yes, a raft as per The Hollowmen) of measures to claw that back. Most of these will just tie banks’ hands and not truely deal with structural competitive issues.

This is a solid reason, apart from hedging the economic risks, that banks, the Treasury and the RBA need to seriously consider structural options. Christopher Joye and I have been suggesting a structural solution to this for sometime. Along with the Australian Securitisation Forum, we see a role in Australia for a government-sponsored enterprise like Fannie and Freddie (well, at least what they were before privatisation, political capture, and slack over-sight). Put those in place as a backstop for the bad times and banks and other financial institutions can make the case for continued de-regulation and a light hand in the good times. The alternative is a heavy hand at all times. Banks playing the political game here have to consider just what they are risking.

[Update: Daniel Gross on the economic risks. Bottom line: relatively small and a good public bargain.]

2 thoughts on “The spectre of re-regulation”

  1. Joshua

    I’m not sure that an article in Slate is the most credible source for defending the optimality of an AussieMac.

    Seeing as you have linked to other Mankiw pieces, perhaps you could respond to the points made in this speech:

    http://www.whitehouse.gov/cea/gsemankiw_speech_nov_6_2003.pdf

    In particular, I’m interested in how you would set up the institution to avoid this:

    “the larger issue for the policymaking and regulatory community is that the subsidy creates a source of systemic risk for our financial system. This risk arises because the subsidy has allowed the GSEs to become gigantic. From 1995 to 2002, the debt issued by the housing GSEs more than tripled. As of the end of 2002, their total reported debt was $2.2 trillion. To put this in perspective, the privately held debt of the federal government is $3.2 trillion. If recent trends continue, GSE debt will soon exceed the privately held debt of the federal government.”

    Given also the difficulties Australian governments had with monitoring the activities of government owned banks during the 1980s (the state bank of SA for example) I wonder whether we would be subsituting one problem (insufficient competition) for another (excessive risk for the public sector).

    Cheers

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  2. This is a real mixing of issues, and the use of a straw-man that has limited relevance to our AussieMac proposal. First, since we published the original paper on the 26th of March (you can download a copy off Joshua’s website), we have made it clear that—unlike Fannie and Freddie—AussieMac would have a singular focus of providing *emergency* liquidity to the “lending system” (NOTE: not just deposit taking institutions, as the RBA currently does) when the securitized markets that provide funding to these lenders (NOTE: including the banks) “fail”. So it would not be an institution—like Fannie and Freddie—that aggressively competed against the private sector. On the contrary, we proposed limiting the amount of funding it could provide to the market during normal operations to say 10%. Over the last 5-10 years, securitization—or third party funding—has been responsible for underwriting 23% plus of all Australian home loans. By market “failure”, we mean the effective collapse of liquidity and price discovery in a market for unlisted securities (ie, residential mortgage-backed securities) as irregularly happens every decade or so. This is why the central banking system was established—to protect the liquidity of our deposit-taking institutions. The problem is that when we established the central banking system securitization did not exist—it was an important innovation that emerged in the early to mid 1990s. Now if you listen to some of the major banks or even the RBA/Treasury, you may get the impression that securitization markets are okay. But this is so far from the truth it is not funny. The major banks in particular would hate to see an AussieMac established as it would ensure competition in the home loan market—which is why smaller lenders such as David Liddy, the CEO of Bank of Queensland, or John Symond, CEO of Aussie, support it. However, the fact is that there has not been a single securitization on what would be considered “economically viable” terms since Nov 2007. By economically viable, I mean pricing that would support new home loan origination. The only securitizations to date have been by distressed sellers who are being forced to sell loans. So by definition, AussieMac would only be a limited liquidity provider during extreme market stress. But unlike the RBA it could actually acquire AAA-rated prime home loans and offer this liquidity service to all lenders, not just the banks and other deposit-taking institutions. One key policy issue here is competition: the market share of the banks is now at its highest level since 1994 while the non-bank lending market has virtually disappeared. And yet it was the RBA and Treasury who proclaimed loudest the benefits of securitization and the advent of heightened competition in the home loan market during the pre-sub prime days. Now as lenders are forced to withdraw from the home loan market or severely ration credit, the bureaucrats are basically saying tough luck—our only interest is in protecting “system stability”, which means the major banks.

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