Ten years on from the Global Financial Crisis and the threat of another financial crisis in the medium term is now a solid possibility. There are signs of weakening economic growth in China and the US, with Europe and Japan showing no signs of getting out of their long term economic funks. Global debt levels are well above where they were before the last crisis with dumb lending prominent across government, corporate and consumer debt sectors. Elevated asset prices corrected somewhat in 2018, but many asset classes are still priced well above historical average levels. These indicators don’t guarantee another financial crisis (e.g. late 2015/early 2016), but they do point to the risk being higher than normal.
In light of this increased risk, it is worth considering how prepared Australia is for a potential financial crisis. Has Australia become complacent after escaping largely unscathed from the last one? Have governments and regulators acted to lessen the likelihood and severity of a potential downturn? This article considers these questions for the banking/financial system, monetary policy, fiscal policy, taxation policy and competition policy.
The Banking/Financial System
Australia’s banking system proved more resilient in the last financial crisis that many of its peers from a combination of good luck and good management. Australia’s banking regulator, APRA, is widely regarded as amongst the most conservative regulators and this definitely played a part in dampening risk taking. It also helped that Australian banks are themselves fairly risk adverse, with limited pockets of dumb lending emerging in the 2004-2007 period. The near death experiences were contained to the regional banks and foreign entrants, with timely government/regulator intervention ensuring that no collapses occurred.
The shallower downturn that Australia experienced in 2008-2010 was partly due to these factors and partly due to the economy generally suffering less than other countries did. These two reasons are intertwined in that a well regulated financial system leads to fewer and shallower crises. Higher risk financial systems can experience long and deep periods of economic underperformance, as Europe and Japan have demonstrated. Cutting off dumb lending before it becomes a bubble is paramount.
In this regard, Australia currently finds itself reasonably well placed. Corporate lending, which typically is the cause of the largest losses for banks in a downturn, has few sectors of dumb lending. Australian leveraged loan and high yield bond markets have grown but remain a small part of overall credit provision. There are few large Australian corporates that carry deep sub-investment grade ratings (or would qualify for those if rated) and these companies are typically funded by US loan and bond markets. Arguably the worst placed corporate sector is infrastructure debt, with very high levels of leverage and limited covenants present on some recent transactions.
The primary concern for Australian banks is their exposure to residential property. Fortunately, this has not escaped APRA’s attention with a crackdown on lax lending practices beginning in 2014. It is rare that a banking regulator has the foresight to lean against riskier lending before a downturn but APRA has achieved this feat. Increasing risk weights for riskier loans and increasing bank capital levels as part of the global total loss absorbing capital (TLAC) reforms are also very helpful in building buffers against a potential future downturn.
I argued that APRA should have taken action on these areas back in 2016. APRA has now announced polices on these areas, but the implementation period stretches to 2023. Should the next financial crisis begin in 2019 or 2020, the delays in implementing these reforms will be lamented. Overall, Australia’s banking and financial system is reasonably well prepared for the next financial crisis with the position improving steadily as TLAC reforms are implemented.
Monetary Policy
Unlike APRA, the Reserve Bank of Australia (RBA) has completely misunderstood the impact of its decisions on the residential property market and financial system stability. Like many other central banks, the RBA has taken far too long to recognise that ultra-low interest rates create debt and asset price bubbles but do very little to encourage sustainable economic growth. At the time when APRA was working to reduce the building risks in residential property lending in early 2015, the RBA chose to pour fuel on the fire with interest rate cuts totalling 1% over 18 months.
Those who listened to lenders and real estate agents as these cuts occurred know that each 0.25% rate cut stimulated additional demand to purchase residential property, mostly from investors. Had the RBA kept the overnight rate unchanged in 2015 and 2016, house prices would have stopped increasing much earlier and the price falls seen in the last year may not have occurred.
The RBA now finds itself in a position of negative real interest rates, a position made worse when tax rates are included in the calculations. Whilst never publicly acknowledged, the RBA has a strong academic position that savers should be punished and borrowers should be rewarded. It believes that implementing this position encourages productive investment, despite substantial evidence that almost all it does is encourage speculative investing and asset price bubbles. The foolishness of this academic position has been exposed many times in history, with the 2004-2007 bubble in US residential lending the most obvious example.
At a time of reasonable economic growth and low unemployment, overnight interest rates in Australia should be at or at least moving towards a neutral level, just as they are in the US. The lack of discussion and debate over this bizarre position indicates that the management and board of the RBA is captured by groupthink. Correcting this would require an injection of people with expertise in the functioning of credit provision and debt markets, something clearly lacking in backgrounds of existing senior management and board membership. The failure to normalise interest rates at the appropriate time has made Australia significantly more financially unstable. It also leaves the RBA with little room to respond to the next financial crisis.
Fiscal Policy
The outlook of a small federal government surplus for the 2019/2020 year is a positive development. However, it has come far too late with Australian government debt allowed to escalate over a decade with little regard for the consequences of increased debt levels. The federal politicians of the past decade have been far too keen to play Santa and have mostly been unwilling to cut unnecessary and wasteful government spending.
Traditional Keynesian policy advocates for deficits in the bad times and surpluses in the good times, something Australia did very well on in the late 1990’s and first half of the 2000’s. Peter Costello’s legacy of no net debt gave the Rudd government the ability to stimulate the economy when the last financial crisis began. It should be remembered that this spending was mostly wasteful and short term, with little infrastructure developed. Should a financial crisis begin in the medium term, Australia’s budget position will offer limited ability to stimulate and certainly far less than was possible in 2008/9.
Taxation Policy
The repeated inquiries into taxation settings in Australia (Henry 2010, Tax White Paper 2015) shows that politicians understand that we have a sub-optimal tax system. The lack of courage to implement anything more than piecemeal reform has held back economic growth, increasing the problems discussed above with monetary and fiscal policy.
The good news on tax reform is that if implemented properly it would provide a meaningful and compounding boost to Australia’s economy. The bad news is that polls have a Labor government likely to take over in 2019, with their stated policies including anti-business and anti-wealth tax changes. Encouraging businesses and individuals to take their capital (and therefore job creation) elsewhere is an unwise policy position in a world where governments are increasingly competing to attract capital and jobs.
Competition Policy
Australians have long been well served by the recommendations and actions of the Australian Competition and Consumer Commission (ACCC) and the Productivity Commission. Both bodies have consistently recommended to the Federal Government policies that would enhance competition and economic growth, often recommending action that goes against long standing government policy and vocal vested interests. The major economic reforms of the 1980’s and 1990’s created a foundation for Australia’s record run of positive GDP outcomes.
Unfortunately, the last decade’s crop of Federal politicians has largely given up on economic and competition reform. Vested interests have gained power, with the silent majority of Australians that are looking for better and cheaper, goods and services being neglected. It is often said “never let a good crisis go to waste”; perhaps the next crisis will provide some political cover to re-embark on overdue competition and productivity reforms.
APRA Should Ignore the Big Banks on Tier 3 Capital
APRA’s discussion paper dated 8 November 2018 has laid out the strong reasoning for requiring domestically systemically important banks (D-SIBs) to hold additional subordinated capital. In short, taxpayers should never be asked to foot the bill for a failing financial institution. Higher capital levels and detailed macro-prudential oversight are the key pillars to avoiding disorderly failures of authorised deposit taking institutions (ADIs).
As per the Murray inquiry, Australia’s banks are partially dependent upon offshore funding and therefore must be “unquestionably strong”. By requiring ADIs to hold more subordinated capital the likelihood of one becoming distressed greatly decreases. By having a larger capital buffer protecting senior creditors, the likelihood of a distressed ADI failing in a disorderly fashion is also greatly reduced. APRA’s proposed method of reducing these risks is pragmatic and entirely appropriate for the Australian banking context.
This submission answers several of the questions posed by APRA in its discussion paper. It argues for (i) faster implementation of higher capital levels, (ii) the necessity of using tier 2 capital, (iii) the implementation of a total capital leverage ratio in conjunction with a total capital risk weighted ratio and (iv) for additional macro-prudential oversight of D-SIBs. This submission does not repeat the key reasons for the necessity of the changes. Narrow Road Capital laid out the key arguments for these changes in 2016 and APRA has made similar arguments in its discussion paper.
Timing for Implementation of Higher Capital Levels
The global economy is now ten years on from the global financial crisis and is exhibiting many late cycle characteristics. With good reasons, many experts are concerned about Australia’s record high levels of household debt. These two factors combined point to the need for APRA to lift the countercyclical capital buffer from its current zero setting to at least the middle of the 0 to 2.5% band. An alternative to this would be for APRA to order D-SIBs to implement at least a 2% (risk weighted) increase in subordinated capital levels by the end of 2019, front loading the implementation of the TLAC reforms.
It is also worth noting that APRA has unnecessarily delayed the release of its discussion paper. By 2016 it was clear that TLAC reforms would require banks to substantially increase their subordinated capital levels, with some regulators having announced their positions. Instead of being on the front foot and potentially adjusting the final capital levels over time, APRA has chosen to delay until almost all other banking regulators have announced their positions. This is not a hindsight criticism, Narrow Road Capital publicly argued the case for action in 2016 including sending a copy of its work to APRA. Asking D-SIBs to take substantial action in 2019 would go some way to correcting the delay.
Necessity of Using Tier 2 Capital
In the discussion paper APRA has argued strongly that the best form of additional subordinated capital, which balances both risk reduction and cost efficiency, is tier 2 (subordinated debt) capital. Immediately upon the release of the discussion paper vested interests began campaigning for Australia to introduce tier 3 (senior subordinated) capital. APRA should stand fast in its position, giving greater weight to (i) financial stability and (ii) the interests of taxpayers rather than the vested interests of banks seeking to lower their cost of funding.
Tier 3 debt is a wolf in sheep’s clothing. It may seem more innocuous than tier 2 debt, but if a bank becomes distressed it will have a very similar outcome. Tier 3 debt can have a shorter maturity period than tier 2 debt, but it is subject to the same regulatory approval for principal and interest payments. If a bank is distressed, its regulator would lock-up its tier 2 and tier 3 debt, delivering the same outcome to holders of both. If a bank becomes insolvent both tiers are likely to be facing haircuts or wipe-out, though tier 3 may receive a better recovery rate. Markets have yet to accept this reality, but once the first test case occurs markets will correct, and the margin gap will narrow.
The main (false) concern raised by proponents of tier 3 debt is that they don’t believe capital markets can digest the increase in tier 2 debt that is implied by APRA’s discussion paper. Estimates are that the four major banks will, as a group, need to issue approximately $20 billion of tier 2 debt per annum. There are several reasons markets are well placed to handle this level of supply.
First, as tier 2 margins are now higher following the release of the discussion paper, the incentive for investors to switch from senior debt to subordinated debt has been sweetened. Second, investors will recognise over time that Australian tier 2 debt represents very good value as it has substantial equity and preference share capital providing protection and doesn’t have tier 3 debt diluting its position. Third, increasing the amount of tier 2 capital is likely to see margins on senior debt reduced, offsetting a material portion of the increased cost of funding. Fourth, capital markets have a long history of finding solutions to business capital requirements. If the price is right, the demand will be there for it. The combination of offshore demand, local institutional demand and local listed note (ASX) demand should comfortably cover the forecast supply at a reasonable margin. APRA should ignore the vested interests and prioritise financial stability, requiring the additional capital to be tier 2 debt.
Requirements for Increased Capital and the Impact on Regional Banks/Smaller ADIs
APRA has left open what it will require from regional banks and smaller ADIs. It has been noted that non-D-SIBs may not be required to hold similarly high levels of capital. This may be due to some non-D-SIBs having a lower risk profile or it may reflect concerns relating to competitive positioning.
For non-D-SIBs, APRA should encourage the use of securitisation to reduce on-balance sheet risk. Where ADIs selldown the entire capital structure in a securitisation transaction, full capital relief should be granted. This would allow these institutions to recycle their capital, instead of looking to create exotic subordinated capital instruments that align with their not for profit ownership structures.
Necessity of Having a Leverage Ratio as well as a Risk Weighted Ratio
The current position of Deutsche Bank (DE:DBKGn) is the perfect example of why a risk weighted ratio alone is insufficient. Deutsche Bank’s heavy use of low and zero risk weighted transactions means that it can argue it is well capitalised on a risk weighted basis. However, its miserly market capitalisation to book value ratio shows that the equity markets see its position as mildly distressed. Whilst Australia doesn’t have any banks that are gaming their ratios to the extent that Deutsche Bank is, APRA should specify a leverage ratio to ensure that this doesn’t occur.
The discussion paper points to D-SIBs being required to have a total capital to risk weighted assets ratio of 18.5% to 19.5%. This should be supplemented with a minimum total capital leverage ratio of 8%.
Macro-Prudential Oversight
As noted earlier, higher capital levels and detailed macro-prudential oversight are the key pillars to avoiding disorderly failures of ADIs. Regulators should regularly visit banks and review a sample of their loan books to ensure that lending standards are maintained. In crisis after crisis, banks have shown they cannot be trusted to maintain conservative lending standards through a credit cycle without such oversight.
The best example of a regulator reviewing loan quality is the US Shared National Credit program, run by the Office of the Comptroller of the Currency (OCC). This program focusses on corporate and institutional lending, the area that most frequently leads to bank failures. Each year the OCC inspectors review large loans and assign each loan a risk grade. For higher risk and defaulted credits, the regulator specifies the minimum amount of capital the bank must hold against the loan.
By reviewing the same loans and lenders year after year, the OCC gains enormous insight into whether lending standards are improving or deteriorating. When they are deteriorating, the regulator can take action including increasing the amount of capital held against high risk loans or stopping banks from lending to high risk borrowers altogether. The 2014 guidance to banks to limit the total debt to EBITDA ratio at 6.0 times is an example of an appropriate response to deteriorating lending standards.