Bank hazards divide the pundits

The debate over what to do about banks that are too big to fail continued last week. There is a certain orthodoxy that appears to be emerging in terms of the establishment view, but there remains a rump of other influential players who are advocating more radical change.

Former Deputy Governor of the RBA, Stephen Grenville, reiterated the establishment view when writing in the AFR early in the week. He made the observation that it is difficult to imagine a world in which banks would be so small that the failure of one would not be contagious. Given the way that global banking has developed since deregulation of banks around the world commenced in the mid-80s, this is a fair point.

As for dealing with those that do get into difficulty, he argued that such banks tend not to be nationalised because governments don't have the capacity or management skills required to run a large bank in financial difficulty. Moreover, nationalisation would result in governments taking responsibility for a failing bank - an outcome that most governments would want to avoid.

Thus banks that are too big to fail (TBTF) must be managed through tighter regulation, supervision and capital requirements that penalise risky activities. Ideally, this approach will make certain activities unattractive, with affected banks undertaking a voluntary separation of such activities.

Moreover, TBTF banks must prepare a 'living will' - the term now being used to describe a document that sets out how to replace management and break-up a failing bank with minimal disruption to the rest of the banking system.    

This approach was echoed later in the week when the US Senate Committee on Banking, Housing and Urban Affairs released the latest proposal for restoring stability to the US banking system. Like each proposal put forward before it, it was widely criticised, indicating that the US is no closer to taking any decisive action.

However, some of the key proposals made, seem quite reasonable in the context of the establishment view just outlined. TBTF banks will be subjected to stricter regulation, supervision and capital requirements and they will need to prepare their living wills.

These actions will be supported through the creation of a new Agency for Financial Stability, which will identify and address systemic risks posed by large, complex organisations, products and activities. The Agency will write the rules for capital, liquidity, risk management etc., and also have the power to require TBTF banks to divest some of their holdings, if they are judged to be a threat to stability.

The power to order divestments is a more contentious proposal. In rejecting Democrat calls for the breaking up of TBTF banks Federal Reserve Governor, Dan Tarullo, suggested that a more 'subtle' approach may be to return to interstate banking prohibition such that commercial banks and their affiliates are restricted from holding any more than 10 per cent of insured deposits nationwide. Again this illustrates how difficult it is going to be to reach any agreement on reform in the US.

Another key proposal is for the establishment of a single Federal bank regulator, to end the current system of multiple regulators at a state and federal level. This would seem to be eminently sensible but no doubt will prove extremely difficult to do.

Among those who favour more radical change, the consolidation that has occurred in national banking systems as a result of the GFC is now being viewed as a competitive threat. So much so, that the French Finance Minister, Christine Lagarde, asked the Financial Stability Board to examine whether consolidation in the banking industry is hurting competition, and especially in the US. Speaking after a meeting of Eurozone finance ministers she outlined concerns about the formation of oligopolies in banking products and markets.

In this context it was surprising to hear former Westpac CEO, Dr David Morgan, claim that the power of the big four banks in Australia will increase over time as the second tier financial institutions become rapidly extinct. He expressed this view while arguing that Australia's role in the G20 will adversely impact the Australian banks with excessively stringent capital and liquidity requirements.