Wednesday, July 08, 2009

Banking in Oz

Under the breathless headline the SMH today reported on a joint call by Joshua Gans, John Quiggin and four others for a new financial systems enquiry.

It appears that the idea of a "People's Bank" is people gleaning from the submission's suggestion of a Government institution with a stabilisation function in finance, particularly mortgage finance. This is based on the economists apparent concern about the instability created for the institutions of having an unmatched balance sheet, that is long term loans financed by short term deposits.

I can assure the economists that this is not a problem for banks in a world without derivatives. The "credit risk" or "market risk" can be calculated and managed. The risk comes if lending practices veer out of control, such as increasing exposure to assets undergoing rapid price increases.

The economists talk approvingly of the wonders of competition that swept through the Australian mortgage market with the development of the residential mortgage-based securities market and how supposedly this funding greatly advanced the regional banks. Actually, this market largely destroyed the economics of Australia's co-operative banking sector (at the same time as their long running income tax exemption was removed).

This market has been, of course, the real false dawn. This was a money market with no effective controls. The securities were traded by banks operating under Basel II rules, so the capital adequacy was measured on credit rating agency terms, and as the underlying assets were houses ... well they all got AAA. Meantime the move of so much housing lending "off balance sheet" means that prudential regulators couldn't use other devices, like changing the risk weighting of residential mortgages, to allow for the greater lending risk inherent in lending in a market with rapid asset price inflation.

By all means we should probably have the enquiry. But can we perhaps focus on how many of the problems we now confront have been created by economists peddling the snake oil of the efficiency of markets. Can we also recognise that a small dose of regulation might be better than a big dose of government guarantees.

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