Published 24 November 2010
Australian economic reformist Dr Nicholas Gruen has set out a way to improve banking across the Tasman without wholesale change in the latest Whitlam Institute Perspectives paper, released on Monday. The institute’s director, Eric Sidoti, said Dr Gruen had produced the paper quickly in response to a symposium held by the institute and the University of Western Sydney’s School of Economics & Finance in July, Delivering a 21st century economy for a fair Australia.
Mr Sidoti said: “Australian banks’ profitable navigation of the global financial crisis may be pleasing shareholders, but the political & community reception has been hostile. Dr Gruen proposes a viable, low-risk policy reform which would address the current inequity in the structure of the Australian banking system.
“Dr Gruen’s insight is that the Canadian arrangements enabled the major elements of the mortgage market (including the market for securitisation) to continue to function throughout the global financial crisis, and in that sense performed better than the Australian market. The proposal that follows takes that experience and applies it in a prudent manner to the Australian conditions.”
Dr Gruen said in his introduction: “While the financial crisis cut swathes through the financial sector & real economics of developed countries generally, its effect in Australia was to illustrate a grand paradox. Our banks were revealed to be amongst the strongest in the world, profitable beyond the wildest dreams of the pre-deregulation era. At the same time they were dangerously fragile, requiring unprecedented guarantees not just on deposits but also for wholesale creditors. If the analysis offered in this paper is sound, the policies it proposes will make our financial system not just less fragile, but also substantially more competitive.
“There has been no shortage of proposals for comprehensive re-regulation of finance. Yet even relatively like-minded experts who can often broadly agree on the causes of the crisis still disagree on the correct solution. Thus for instance John Kay, Paul Volcker, or even the Bank of England governor, Mervyn King, appear to back strong action to return the core banking systemto ‘narrow banking’ and avoiding the problem that some banks are ‘too big to fail’, whilst Nobel laureate Paul Krugman is not so sure.
“Many prescribe substantial increases in capital adequacy by banks. But while this may improve the robustness of our banks, it would do little to improve competition between them and nothing for the competitiveness & stability of alternative sources of finance such as securitisation.
“The approach in this paper is slightly different. It does not propose a new regulatory regime arising from a comprehensive view of finance. Instead we go looking for hundred dollar bills on the pavement: That is, areas of inefficiency whose source can be easily seen in both theory & empirically and which can be improved by the application of simple principles & procedures of micro-economic reform…..
“The paper focuses on lending to households in Australia, and particularly on the largest household debt market – the $A1 trillion home loan market, which constitutes around 60% of Australian banks’ assets. However, the principles articulated here would apply to any area of banking which is susceptible to disintermediation through market-traded portfolio funding (also known as ‘securitisation’).
“The central motivating concerns of the paper are these:
Most finance is ‘commoditised’. Yet in contrast to an industry like IT, where a service being ‘commoditised’ leads to dramatic price falls, in finance this has not happenedAs the crisis demonstrated, banking is a public-private partnership. Banks risk capital to earn profits. But given their capital adequacy will always be limited, catastrophic downside risks are assumed by governments. No amount of denial or policy ambition will remove the government’s guarantee. And even if it were possible to remove it, it is not possible to prevent depositors & money markets from perceiving it as likely that bank guarantees would be activated in a crisisWhile the dilemmas of banking will always involve difficult tradeoffs, the current architecture of banking is inefficient, inequitable & fragile. The real economic payoff is in finessing the contours of the private-public partnership that is banking. The assignment of roles should be the product of careful, practical & principled thought, rather than ideological predisposition which privileges the role of either public or private sectorsGiven the complexity, importance & politically contentious nature of finance, there is a premium on evolving industry structure through choices in the presence of competitionCrucially, competitive neutrality is invoked not just to protect private competitors from subsidised competition from the public sector, but also to ensure that the contribution public-sector assets & capabilities can make to productivity are not artificially withheldTo prevent moral hazard and to manage its own exposure, governments heavily regulate banks. There have been similar calls for governments to regulate shadow banking built on securitisation. However given the advantages of limiting regulation to where its benefits outweigh its costs, an alternative is to allow those in the shadow banking sector to purchase the liquidity-provision & risk-bearing services of governments. Thus ‘regulation’ occurs, but on an opt-in basis and only on products that a government agency considers appropriate risksNew technological possibilities, particularly on the internet, have powerful implications for the way this public-private partnership of finance should be crafted. This point will only live in the background in the analysis here but will come to the fore in a subsequent companion paper.”
Dr Gruen has advised 2 Labour cabinet ministers and sat on the Productivity Commission He’s chief executive of Lateral Economics, a regular columnist & prolific blogger. He chaired the Federal Government’s 2.0 Taskforce in 2009 and is a strong public advocate for economic reform & innovation.
The Whitlam Institute, within the University of Western Sydney at Parramatta, commemorates the life and work of 1970s Labour prime minister Gough Whitlam and pursues the causes he championed.
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Attribution: Whitlam Institute, paper, story written by Bob Dey for the Bob Dey Property Report.