Make banks suffer more in a crisis

Author: Sam Wylie
Australia’s four big banks are vehemently opposed to the Murray Financial Systems Inquiry recommending a large increase in the amount of capital that they must hold. They are likely to be disappointed. The interim report of the FSI states that the goal of the committee is to recommend changes to the Australian financial system that will promote stability, equity and efficiency. The problem for the too-big-to-fail banks is that an increase in their minimum capital requirements will tick all three of those boxes. That makes a recommendation of a capital increase a fait accompli. Stability considerations in regard to the capital levels of the biggest banks are a balancing act. Banks must hold enough capital to absorb large shocks to the economy without becoming so distressed that household and consumer confidence is damaged. But capital requirements that are too large will make Australia’s largest banks uncompetitive against their global counter-parts. The right balance is ultimately a judgement call.
It would be better if instead of subjective judgement we could rely on bullet proof economic modelling to tell us how much capital banks need to hold to reduce the probability of a crisis to an acceptable level. Unfortunately, modelling of the probability of a banking crisis occurring over the next 5 years is no more accurate in 2014 than it was before the GFC. There just isn’t enough observed examples of banking crises to formulate, test and calibrate those models. 
The FSI committee appear to be making three judgements that bear on their considerations of the capital requirements of Australia’s too-big-too-fail (TBTF) banks. First, that the inability of the global economy to either fully recover from the GFC or to resolve all the issues that caused the GFC in the first place, leaves a heightened probability of another crisis. Second, that the growing complexity of the global economy makes the set of things that could cause the next crisis unknowable. Third, that the total cost that a banking crisis imposes on a modern economy is much greater than commonly realised and the cost of a crisis is a very large multiple of the annual costs of extra bank capital that is needed to prevent or ameliorate a crisis. 
Australia’s largest banks reach different judgements. They believe that Australia’s unique circumstances make the probability of a severe banking crisis in Australia much lower than in countries that currently have similar bank capital requirements. The banks also observe that healthy bank operating profits of over $40 billion per year – arising principally from the operating efficiency of the big banks -- would absorb large loans losses without eating into bank capital. Moreover, the high market value of Australia’s big banks (2.6 times their common equity capital) would allow them to raise tens of billions of dollars of new capital by issuing new shares – even in a banking crisis. 
The equity question in bank capital policy centres on the subsidy of the shareholders and customers of TBTF banks that is provided by Australian taxpayers. The Federal Government would never allow any of Australia major banks to fail by defaulting on their bonds. That implicit guarantee of the bonds of TBTF banks reduces the interest rates paid on over $400 billion of bank bonds. Those saved funding costs are good for bank shareholders and customers who receive then has higher profits and lower loan interest rates respectively. But taxpayers are equally worse off. The Federal Government is acting like as an insurer that provides insurance coverage but does not charge any premiums. The missing premiums are the subsidy of TBTF banks provided by taxpayers. 
If the Federal Government wants to decrease the cost to taxpayers of providing free insurance to banks then it can simply increase the ‘excess’ on the insurance. Excess in an insurance policy is the loss that the insured party must suffer before the insurance claim kicks in. The higher the excess the lower the premium. So, it is in banking. The higher the banks’ equity capital then the greater the losses that bank shareholders must suffer before taxpayers pick up the remainder. More bank capital means that the cost to taxpayers of providing free insurance is lower. 
What is it that the banks are so vexed about regarding the possibility that the FSI committee will recommend an increase of $24 billion, the commonly muted figure, in the total amount of extra equity capital that they will have to hold? Is it that they will have to pay more corporate tax? Lets see, if the interest on the $24 billion of debt replaced by equity is 5%, then before tax profit will go up by $1.2 billion. At a 30% rate, corporate tax will then be $360 million, but about 75% of that will be refunded through dividend imputation, so lets say $100 million of extra corporate tax. That sounds like a lot but it is small change for the big banks. 
Banks are vexed about the possible reduction in their TBTF subsidy. If $24 billion of equity that investors expect a return of 10% on replaces debt that bondholders accept 5% on then the cost of funding of the TBTF banks goes up $1.2 billion per annum. Banks don’t get any of that back in lower debt costs because their debt is already implicitly insured by the government. But the loss to shareholders is less than $1.2 billion per annum for two reasons. First, the existing equity becomes less risky when new equity is added and that creates value for shareholders. Second, some of the extra cost of funding will be passed onto bank customers in higher interest rates. But there is no avoiding the fact that if banks are forced to hold $24 billion of extra capital then taxpayers will be better off and bank shareholders and customers combined will be worse off in equal measure. That measure is large. 
The final issue is economic efficiency. The TBTF subsidy of large banks around the world has come about by accident rather than design. It is a consequence of the consolidation of banking over the last 30 years that has been driven by globalistion, deregulation and technology changes. The TBTF subsidy distorts the flow of capital in the economy by favouring big banks over small banks, the domestic bond market and the securitisation channel. Removing distortionary subsidies of all kinds should be part of our economic reform agenda, but it always meets with a lot of resistance. 
Associate Professor Sam Wylie is a Principal Fellow of the Melbourne Business School.
A brief version of this article ‘Make banks suffer more in a crisis’ was published in the Australian Financial Review on 5 September 2014.