Small banks are also too-big-to-fail

Australian Financial Review May 26 2017 10:25 AM

Christopher Joye

If Australia's beloved banks were implicitly government guaranteed before the global financial crisis (aka "too-big-to-fail"), they are far more so today. You cannot minimise these guarantees given they cornerstone the entire financial system (nor pretend they don't exist).

All the prudent policymaker can do is mitigate them via recognising the subsidies, pricing them, and minimising the probability they are called upon through, among other things, ensuring our banks retain world-class equity buffers.

Before the GFC we never had an explicit government guarantee of deposits. We had never seen taxpayers insure the banks' wholesale bonds, as they did (and NAB's learnt chair Ken Henry says they will do again).

We did not have a permanent bank bail-out fund via the Reserve Bank's globally unique Committed Liquidity Facility, which is designed to furnish banks with $200 billion in emergency cash at a cost of just 1.9 per cent annually to eliminate threats to their solvency when funding markets sour.

And we did not have a tax on the major banks and Macquarie's too-big-to-fail subsidy care of the 0.06 per cent annual levy on their wholesale debts, which, by definition, makes the implicit guarantee more explicit, ironically only further reducing funding costs.

In 2015 the RBA's research showed that the major banks profit from a 20 basis point to 40 basis point annual funding subsidy vis-à-vis smaller peers because their credit ratings are lifted several notches above what they would otherwise deserve on the presumption we will bail them out.

It was, therefore, no surprise to hear Treasurer Scott Morrison cite this same 20 basis point to 40 basis point range twice on national television when outlining the rationale for his levy.

The levy's cost need not be borne by shareholders, depositors, or borrowers. The banks can fully neutralise it by shrinking their notoriously flabby operating costs by 5 per cent through economies of scale, automation, and slimmer remuneration regimes.

Of course in practice these rational price-setters will chisel deposit rates, expand loan costs, and compress costs, which at the margin will incent more competition. The levy should not, as a consequence, affect their world-beating returns on equity, though the inevitability of stronger capital buffers will do so (with the important offset of less downside risk).

Smart operators

The one thing the big banks are not is systematically stupid or misanthropic. CBA's Ian Narev is a truly outstanding chief executive and very generous private philanthropist, supported by what is probably the best retail banking team in the world.

Westpac's Brian Hartzer is no less capable and years ago personally mentored me through a career transition when he had no good reason to do so. ANZ's Shayne Elliot has thus far displayed tremendous judgement—arguably superior to his peers—under the guidance of Gonski. And Macquarie's Nicholas Moore is the finest financier this country has ever known. (I have yet to meet NAB's Kiwi import.)

Setting aside the hyperbole whipped up by gullible hedge fund shorts, the major banks are materially less risky concerns than they were only a few years ago. Under the terrific leadership of Wayne Byres, the Australian Prudential Regulation Authority has been relentless in repeatedly forcing them to boost the austerity of their lending standards. APRA has also been unwavering in its mission to deleverage the big banks' highly geared balance-sheets.

The final chapter in this journey should be unveiled when APRA releases its long overdue report defining what robust capital ratios are required to meet the government's objective of bequeathing us "unquestionably strong" banks.

Morgan Stanley's Richard Wiles says that even if this hikes the minimum common equity tier one capital ratio to 11 per cent, which would be wise, the "pro forma capital deficit would be $26 billion". Some non-core asset sales and a few years of organic capital generation will do the trick.

S&P's odd move

Which brings me to Standard & Poor's decision this week to elevate Australia's Banking Industry Country Risk Assessment (BICRA) score, which automatically downgraded the credit ratings of all non-major banks while increasing the four majors' too-big-to-fail subsidy from two notches to three.

Blame for this downgrade can be sheeted home to the RBA's August and May rate cuts, in the absence of which house price growth would not have reaccelerated, compelling S&P to sound the alarm.

I will leave you with the wise words of Ian Macfarlane, the former RBA governor: "By designating four banks as being systemically important, it implies that the other banks…are not important.

It is therefore not surprising that the public (and the ratings agencies) assume that the important ones will receive more official support in a crisis than the unimportant ones.

It is just not credible for a government…to promise not to step in and prevent large scale bank failure [of big and small institutions] in a financial crisis. The public know they will, and no amount of words will dispel this expectation."