The True Cost Of Supporting Banks That Are Too Big To Fail

Mark Carney and Joe Hockey at the G20 meeting In Sydney

While it is the finance ministers and Christine Lagarde of the IMF who are the rock stars of the G20, it is the central bankers who attend that constitute arguably the most influential group among the attendees and hangers-on.

So over the past few days RBA Governor Glenn Stevens has been able to sit down with new Fed Chair Janet Yellen, Chinese Central Bank Governor Zhou Xiaochuan, and Bank of England Governor Mark Carney, to name just a few of the members of the Central banking Pantheon who were here in Sydney.

On their agenda was not just the economic growth that the politicians seemed to be focussed on, but economic and financial market stability too.

In an interview with Fairfax, newly installed Bank of England Governor Mark Carney – who as well as being Chair of the Financial Stability Board, is widely credited with changing the way central banks communicated their intentions during the GFC with his “forward guidance” – gave a frank interview on regulatory requirements for banks to hold more capital and less leverage.

Discussing the move toward bond holders being bailed in, debt converts to equity or they take a loss on the debt, which many banks have resisted, Carney told the AFR: “There’s a process that’s under way right now to answer that precise question, so we will work together and figure out the answer for that. And that’s one of the things that we have to come back to Brisbane with.”

Specifically though Carney pointed to the fact that banks use leverage to make more money than would otherwise be the case, and when it comes to Global and Domestic Systemically Important Banks (G-SIB’s and D-SIB’S respectively) they effectively carried a government guarantee because of their too-big-to-fail status, either in individual economies or globally.

Carney told the Sydney Morning Herald:

Banks went into the financial crisis carrying de minimis levels of capital – for example, less than 2 percentage points relative to their risk-weighted assets, let alone their actual assets. They carried basically no liquidity protection and they were reliant on the state to insure.

The consequence was that we had a crisis where even countries that did the right thing in advance, such as my native Canada and here in Australia, had to take extraordinary measures to support the banks.

We can’t have a system – and G20 leaders have made that clear here – we can’t have a system where some of those institutions that are pushing back on this are still reliant ultimately on the state and are getting a massive subsidy from the taxpayer.

For clarity, Carney added:

If you look at a major mining company in Australia or around the world they will run with let’s say 50 per cent equity to total capital. It depends slightly on the industry, slightly on where they are in the cycle, but let’s say the average leverage ratio is two to one. The leverage ratio for banks, this ‘big blunt horrible blunt instrument’, is 33 to one.

So why aren’t global banks or indeed Australia’s too-big-to-fail majors paying a higher fee for their implicit government guarantee, a guarantee which the Credit Rating agancies say give them a ratings uplift and thus a lower cost of funds than would be otherwise the case.

It’s a question asked by Morgij Analytics in a paper commissioned to better assess “the costs and risks of both implied and explicit government guarantees that Australia’s D-SIBs enjoy”.

The research found:

  • The Government’s deposit guarantee for amounts under $250,000 “is distorting the structure of household financial decision-making in regard to the relative competitive position of authorised deposit-taking institutions versus other financial market participants in the savings, lending and investment markets.”
  • The RBA’s new emergency liquidity facility for the banking sector, for which a fee of 0.15% is to be paid, underprices the true cost to banks by up to 150 basis points or “$4.5 billion”
  • The “too big to fail” implicit government guarantee lowered the cost of borrowing by $2.5 billion (a loss to taxpayers of that amount)
  • A further $3.6 billion of costs accrued from the big bank competitive advantage and lower capital requirement in Australia than other jurisdictions.

If that’s right then $11.1 billion is a whopping subsidy from taxpayers to the big banks per annum. Now Morgij Ananlytics says this is an estimate, so it is prone to some error, but it does “highlight the significant annual dollar benefits enjoyed by D-SIBs over their smaller rivals, organisations which may provide equal services and have high quality loan books.”

But the major banks are resisting change and see APRA’s approach as heavy handed.

The Commonwealth Bank chief executive Ian Narev recently argued against the Big Bank Levy proposed by COBA, the industry body for Credit Unions, Building Societies and Mutual Banks while at the same time criticising former major banker and now Bank Of Queensland CEO Stuart Grimshaw for asking why the majors have to hold less capital against home loans than the rest of the Australian financial sector.

But perhaps deep down Mr Narev agrees with BoQ’s Grimshaw because he recently said about the Government’s message to SPC Ardmona and other Australian companies:

I think the idea that the Treasurer has now said, ‘Look the [age of] entitlement is over, we’ve got to all work pretty hard, it’s not going to be as good as we would like for a period’, as a backdrop for what we’re going to hear in May, I think is a good one.

Let’s hope that Mr Narev likes to eat his own cooking because clearly the topic of implied D-SIB subsidies while not an easy question is on the long menu that David Murray’s Financial System Inquiry looks set to need to grapple with – particularly given the federal Government’s budget position.

Disclaimer: Greg McKenna is a director of member-owned Police Bank and has worked at both Westpac and NAB as well as consulting with MARQ services with regard to the Mutual Sector.

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