How have Australia’s banks coped?

But before I do that I need to start with a commentary on the state of Australia’s banking system, which, like other banking systems around the world, has been under a lot of pressure in these recent months.

In a nutshell, Australia’s banks have coped very well, and as a result, our banking system, quite possibly, is the envy of the rest of the world.

Australia’s banking system remains strong and secure, and our banks are well capitalized, profitable, and have low levels of defaults.  These are not just my possibly biased observations, but those of the Reserve Bank, APRA, the IMF and the World Economic Forum.

Indeed the Reserve Bank’s Deputy Governor, Ric Battelino, drew the important link between profitability and strength in his opening comments to the House of Representative Competition inquiry, in August, when he said:

“… that an important reason for the high profitability of Australian banks is their unusually low bad debt experience.”

No taxpayer money has been spent on bailing out the banks - a consistent theme since the 1890s.

Banks have not closed.

The Government has not had to nationalize banks as has occurred elsewhere.

… and there have been no depositor runs like those that have occurred overseas.

Some or all of these things have happened in countries we often compare our banking system to, like the US and Britain.  So why hasn’t it happened here?

There are a number of reasons.

Our bank Boards and executives have done a good job running their institutions.  They have made, and continue to make, prudent lending decisions and have minimized their exposure to toxic debt instruments.

We have also been the beneficiary of good regulation and regulators, good economic management from successive Federal Governments (especially in generating surpluses for the tough times), and a sound economy (compared to the US and Britain), linked to the fortunes of China.

Again I believe we can take comfort from John Laker, the Chairman of APRA, who said in his opening statement to the Senate Estimates Committee on 23 October:

“Australia has a financial system of undoubted strength and Australians can be confident in the financial system that APRA regulates.  This judgment is fully consistent with the Reserve Bank of Australia’s assessment in its latest Financial Stability Review.”

Stresses & Strains

Having said this there have been a significant number of stresses and strains, which are likely to continue working their way through the market.    I will highlight three of these to show you the intersection of politics, regulation and banking which is part of our day to day existence at the ABA and of the banks.

Interest rate cuts

First we had the pressure on banks to pass on the entire amount of the Reserve Bank cash rate cuts.  The ABA mounted a defence against populist attacks (including disappointingly from the Federal Opposition) contending that banks should pass on immediately the entirety of any Reserve Bank interest rate cuts, regardless of the cost of funds in wholesale markets both here and overseas.

As a matter of fact, banks in Australia, on average, source half their funds that they lend from depositors.  The other half comes from the wholesale market, of which half comes from international markets.  The price of these wholesale funds has been under upwards pressure as a result of the credit squeeze.

We made the point that since August 2007 when the credit crisis started, changes in the Reserve Bank's cash rate have not been a good proxy for changes in banks’ actual cost of funds. Even though the cost of short-term funding is usually heavily influenced by the Reserve Bank’s cash rate changes, other long-term funding sources are not.

Thankfully some good policy sense has prevailed in this debate, and the Government has acknowledged these arguments in the wake of the Reserve Bank’s most recent decision to cut interest rates by 1%.
 
Of course most banks have now fully passed on the full 1% cut with some even exceeding the official rate cut.

Bank Bail out myth?

Second, we have to now deal with the damaging myth that the Government has “bailed out” banks with its moves to guarantee deposits, underwrite overseas borrowing, and provide liquidity in the market.

My view is that the Government arrived at its decision on depositor guarantees in an attempt to instill greater confidence in the community, not to head off potential losses.

No bank deposits have been at risk. In any event bank deposits were safe – with or without the Government’s new guarantee.  There is already in place a depositor priority scheme under the Banking Act which gives depositors first claim on the assets of a bank.  This same law requires banks to hold assets in excess of their deposit liabilities.

The wholesale funding guarantee was announced to remove the competitive distortion created by similar guarantees announced by other governments.

The liquidity measures were built on the already active management of this by the Reserve Bank in concert with banks.
Now I don’t want to sound ungrateful but while the announcements were timely, it was not done to bail out the banks as has been reported in short-hand by some media.

This is a critical point because as the world moves into a phase of revising the policy framework for bank supervision, it needs to be recognized that Australian banks performed exceptionally well and insulated Australia against the full impact of the credit crisis which originated in the United States.

I will talk more about this later.
 
Alleged corporate greed

Third, we had the image of the Gordon Gecko “greed is good” aspersion cast over us, especially regarding bank executive salaries, in the wake of the Prime Minister’s speech in mid October.

Our response has been that there is no evidence that Australian banks’ salaries packages have weakened our banks. In fact, the opposite is true because our banks are strong.

The point of these three examples is that they show that rational public policy making in the banking sector can be heavily influenced by populist views on banks.  This is not a good way to influence the rules about banking, and should be resisted by policy makers.

The ABA and our banks have had to constantly reject poorly informed views on our sector, which while superficially appealing, would in the long run if adopted, be to the detriment of our customers, shareholders and the economy.

Domestic regulation

This is the theme I would like to carry forward to the next part of what I am going to say.

I don’t want to go through the usual list of potentially burdensome regulation that we are trying to forestall, and ameliorate.  It is a common theme of every industry in Australia, and in that sense life goes on.

What I do want to do is talk about is the potential far reaching implications of the Government’s intervention in the financial markets, and why at some point, it will be deserving of review.

We are all familiar with the concept of moral hazard which is the notion that an individual or organisation that is insulated from risk may behave differently than if they are fully exposed to that risk.
 
In banking terms we saw the full force of this during the 1980s Savings and Loans collapses in the US where a large portion of depositors funds were guaranteed.  This, in turn, encouraged the S&Ls to take their eye off the ball when it came to risk management and making risky loans seeking higher returns, safe in the knowledge that the loan was underpinned by a legislated deposit insurance scheme.

It can be argued that the seeds of the US sub prime disaster in the US (and possibly other countries) were sown as a result of deposit insurance.   Risky loans were made, with little thought as to their consequence, in the full knowledge that depositor’s funds could never be lost.

The ABA has consistently argued that an explicit deposit insurance scheme in Australia is not only unnecessary (because we already have a depositor priority scheme enshrined in legislation) but could lead to the problems we have seen develop in the US and elsewhere, with poor lending practices, which have thus far not been a feature of our system in recent times.

This remains our view, and while we understand the Government’s recent decision to offer an unlimited three year guarantee from the point of view of boosting confidence in the financial system, we also believe that the decision should be reviewed when the world’s financial markets settle.

Intervention in the credit markets – market distortion

There are also implications for the Government intervening in the credit markets by offering a wholesale funding guarantee on debt securities issued by, amongst others, Australian banks.

Again while it could be argued that these measures were timely and appropriate given the extraordinary circumstances facing some lenders, these too should be the subject of review down the track, and possibly before the three year deadline is up.

Government purchase of housing loan assets

At the time the Government announced it was financially supporting non-bank (securitized lenders) by purchasing Residential Mortgage Backed Securities (RMBS), the ABA said that the Government should not attempt to ‘pick winners’ i.e. fund individual businesses in preference to others – this is a widely accepted principle of sound public policy.

We also said that the Government intervention should not support the supply of high risk loans. This can be a complex issue because even AAA rated securities can be derived from pools of housing loans that include high credit risk loans, known generally as non-conforming loans, or sub-prime loans in the US.

For years now we have heard the calls of Governments, both State and Federal, that we all must be responsible lenders (and banks are given all the evidence).  It would be an unfortunate side effect - particularly in light of the US sub prime crisis - that the intervention was to encourage some non-prudentially regulated institutions, with poorer lending standards than banks, to continue with their lending practices, with the backing of a Government scheme.

Institutions like banks work hard to earn their credit rating.  They do this by demonstrating consistent sound management practices which result in prudent lending behaviour.

Incentives are important

The Government is also facing other downstream consequences of these decisions, on the financial markets.  Inevitably if you make rules - for all the best reasons in the world - which change market dynamics, there will be unintended consequences.
 
The Government of course will need to deal swiftly with each of these because at times like this the market craves certainty.  A good example of this was the hiatus period between when the Government announced the unlimited deposit guarantee in early October, and the October 24 announcement that confirmed more details of the scheme.  During that time we had to deal with the speculation that there might be a “cap” on the guarantee.  That of course would have had major implications for non AA rated institutions.

As you can see the ABA’s view is that while we understand and support the short term objectives of the Government’s intervention, we also think there is a case for commencing a review as soon as markets stabilize.

The fear is that if we don’t we may be sowing the seeds of our own Australian sub prime lending crisis in years to come.

International regulation

One of my other roles is the Chairman of the International Banking Federation (IBFed) which is the representative body for banking associations of Europe, North America, Japan, India, China and Australia.

In this role it is easy to witness the unprecedented cooperation of the world’s Governments and regulators, of the so-called developed world, as they seek to deal with the aftermath of what has occurred.

And make no mistake the world’s financial markets, and their regulation, will be a changed place.  The consequences of capital shortfalls, frozen credit markets, the likely end of massive leveraging rations employed by some US Investment banks, changes to lending models built entirely on securitization, the questioning of the fair-value accounting model, and the moves to curtail (perhaps temporarily) short-selling, to name but a few items, are all matters that will need to be dealt with, or adjusted to, in time.

As you are aware Australia’s banks are already the subject of some global regulation, including capital adequacy standards (through the Basel accord), international accounting standards, as well as anti money laundering standards translated into local law.

Emerging from this crisis there are regulator clubs, who you may not have heard of, that will become far more influential, including:

• IOSCO (securities regulators)
• the Financial Stability Forum (FSF); and
• the Basel Committee (prudential regulators)

It also seems to be the case that the narrower club of the G7 is being broadened to include the G20 which of course Australia participates in.  Our Prime Minister and Treasurer have been at the forefront to lead this effort, which can only be good for Australia.

I don’t want to give you chapter and verse about what’s coming down the track, but if I single out the FSF as an example (which our Reserve Bank participates on), they have on their agenda the following items:

• Strengthened prudential oversight of capital, liquidity and risk management;
• Enhancing transparency and valuation;
• Changes in the role and uses of credit ratings;
• Strengthening the authorities' responsiveness to risks; and
• Robust arrangements for dealing with stress in the financial system.

Expect more in this space.  Our regulators and Government are going to be interested in working with these groups in the future to make certain that there is a global approach to dealing with the financial system.

As an aside it will be interesting to see how commentators react to these developments.  Inevitably this will mean Canberra surrendering some of its powers to the regulatory power houses in the US, and the EU in particular where these organizations are based.

Some final observations

Believe it or not, these tumultuous times have not all been bad.

Whilst our industry is unlikely to be the flavour of the month, we can justifiably say that we have weathered the storm better than most in the world, and I hope this message has begun to get through.

More so, it has become clear that banks are a very efficient way to distribute capital into an economy.  It is no coincidence that in the developed world, there is a strong correlation between those economies that are doing well, and those which have a healthy banking system.  Australia, is possibly a good example of this where, despite the freezing of the world’s credit markets, and the subsequent slow down in the activity of the non deposit taking lending institutions, the good state of our banking sector has contributed to the strength of our economy.  I also accept that the strength of our economy is a positive for the health of our banks!

Let me conclude by saying that in the space of a few weeks this year we have seen views on banks ranging from being branded as greedy for not handing on the RBA interest rate cuts in full, to a grudging acknowledgement that our banks are remarkably strong and secure, and that the country is the better for it.  Doubtless when things stabilize again it will be a case of normal service resumed, with the usual suspects again saying the usual things about banks.

If I had a wish out of all this, it would be that that the wider commentariat, which includes politicians, develops a consistent, responsible and informed view on us.

Let’s see how we go.

Thank you for opportunity to speak to you.

I look forward to any questions you might have.