Some modest proposals to make the financial system even stronger

"Australia's financial institutions survived the GFC without much visible damage. Can we afford to rest on our laurels? Can we do better, not just in banking but insurance, capital markets and superannuation?"

The GFC and Australia

Australia is a modern 'miracle economy'. Culturally we are Anglo-American, geographically we are in the Asia-Pacific region and our exports go disproportionately north to Asia. With sensible monetary policy and not too much wasteful stimulus spending, the Australian economy sailed through the Global Financial Crisis of 2007-08 (GFC) with little disruption.

However, it was judged essential for the government to guarantee bank deposits and the overseas wholesale borrowing of Australia's banks, building societies and credit unions as well as locally incorporated subsidiaries of foreign banksat the height of the GFC, which says there was a perceived potential crisis of confidence in the financial system of our 'miracle economy'. I can attest to a conversation with a well-to-do friend who several days before the guarantee was put into place said he was withdrawing $2 million from his bank to put in a safe deposit box. This was a tactic used during the depression of the 1890s in Australia, and which led then to savage bank closures, in some cases outright failure.

On the global stage, the greater cause for concern was the failure of American, British and Icelandic banks and other financial institutions. In September of 2008, contagion was the big fear, and financial institutions were being bailed out with billions of dollars of taxpayer support. Curiously Lehman Brothers was not bailed out, an event that unleashed a 'torrent of mistrust' among bankers everywhere. The world's financial system trembled on the brink at that time, and the guarantee must have seemed to Australia's econocrats as an inexpensive safeguard.

Can we afford to rest on our laurels? Certainly not. The massive overseas borrowing by Australia's banks is directly related to spending in excess of income by business, households and governments. This spending is sometimes justified as Australia Inc 'gearing up' to finance growth. If all the overseas borrowing was going into productive investments, that would be fine, but too much of the borrowing goes, directly or indirectly, to finance consumption and/or investment in private dwellings.

Twice in Australia's history, excess borrowing has made for misery when the global markets decreed that Australians needed to stop borrowing and repay debt. Both in the 1880s and the 1920s Australians lived beyond their means and had to face serious disruption in the 1890s and 1930s when the lenders stopped lending and demanded their money back.

Unless and until Australians decide to live within their means, Australian banks and other financial institutions will be at risk of classic 'runs' at a time of global uncertainty. Maybe a government guarantee will be effective each time this happens, but who can be sure of this.

For many years, Australian households have fully shared other western nations' propensity to spend ahead of income, accumulating debt in the process. Encouraged by tax policy, Australian firms have geared up. There is clear evidence of higher saving by households and deleveraging by businesses in the wake of the GFC, but this move to more conservative behaviour cannot be relied upon. The Federal government is committed to return the budget to surplus, although the structural budget will remain in substantial deficit unless policy changes. The fundamental reform is to persuade Australian consumers to live more nearly within their means. How to achieve this is far from obvious. A move away from income tax and in favour of expenditure tax would help, but seems unlikely for the foreseeable future. So too would education about the perils of excessive borrowing. Have you ever wondered why ASIC does not prosecute retailers who offer 'interest free loans' of several years duration? This must be wrong, and just as misleading as a mining mogol claiming he has a firm contract when what he has is a memorandum of understanding.

Modern capitalist nations, it seems to me, have gone much too far along a consumerist road. The prevailing ideology of economists is 'maximisation of lifetime consumption', so the consumerist bias has some powerful backing. This capitalist bias is creating vast differences in saving patterns between 'developed' and 'developing' nations, and this is the source of great opportunity for swings in currency values (if exchange rates are flexible) or in ownership of assets in the high saving nations and growth of international debt owed by the low saving nations. Current imbalances among the family of nations seem unsustainable and it would be useful to develop a more coherent economic policy framework. To this writer, a modified ideology for developed nations with explicit weight on 'acquisition of knowledge' and away from simple consumerism would be a good start.

One specific change to present general tax arrangements would be for developed nations in particular to place greater weight on consumption taxes and less weight on income or wealth taxes. This would tend to limit consumption in the developed nations, and thus help to harmonise the fiscal imbalances which are causing so much global economic instability. It would also provide a tax that would help to even out the ebbs and flows of economic activity, as a semi-automatic increase in consumption taxes in booms and decreases in downturns would provide a more efficient economic moderating mechanism than current income and wealth taxes. I am not seeking a way to iron out fluctuations altogether, because of the benefit of times of economic boom or even euphoria. Rather I am proposing a more effective automatic stabiliser, one that would more strongly test the reality of booms and reduce the severity of busts.

Governments also have a legitimate role in devising and maintaining sensible rules about various features of the financial system. The first such feature should be doing whatever can be done to encourage prudent and ethical behaviour by financial institutions and financial salespeople. I do not go so far as simply advocating the old rule of caveat emptor – let the buyer beware – thought this approach is tempting to people, like me, of a libertarian inclination.

This said, it would be helpful to include courses on the essence of modern finance in school programs, courses that teach people to beware of conmen and that if something looks too good to be true it probably is. Naturally, proven fraud must be punished, and that is a feature of regulatory systems that need constant attention. But as Charles MacKay said in his wonderful book Memoirs of Extraordinary Popular Delusions and the Madness of Crowds: 'Nobody seemed to imagine that the nation itself was as culpable as the South-Sea company. Nobody blamed the credulity and avarice of the people - the degrading lust of gain, which had swallowed up every nobler quality of the national character, or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors'.

Rules for prudential management of banks should require them to hold sufficient capital to provide real discouragement to practices that too easily allow, indeed encourage, funding of asset booms. Some form of dynamic capital ratio regime is desirable, with required reserves as a ratio to assets rising as a boom gathers strength. The aim should be not to stop an asset boom, but to make sure it has been properly tested and is not being engorged by a diet of easy money.

I am happy to stand with Paul Volcker - the world's greatest central banker - in calling for the return of the Glass-Steagall law in the United States, and equivalent rules elsewhere. Such laws separate financial institutions into 'commercial banks' which are closely regulated may have government-backed deposit insurance and 'investment banks' that are lightly regulated but with no government guarantees. It is also desirable to use anti-monopoly laws to attack the problem of institutions that are seen to be 'too big to fail', though with global financial institutions this probably requires at least international coordination through one or other of the relevant international financial organisations. Clearly, regular stress-testing of bank balance sheets is highly desirable and one expects this to be done with global outcomes in mind.

It is far harder to anticipate and to provide similar resistance to new forms of finance. But, as we have seen, new forms of finance, including the now infamous securitised sub-prime loans, are part of the landscape of boom and bust. The trick is to find ways of preventing the generals of financial regulation from fighting the last war but one. Listening with respect to outsiders is one technique that might be suggested to senior regulators, perhaps reminding them that it is the grain of sand that produces the pearl. Firing or requiring the resignation of a regulator who has failed is of course applying a classic capitalist technique to encourage the others and should probably be used more often than it has been.

This writer believes that, in a sufficiently serious crisis, it is desirable for large financial institutions that are at risk of failing to be rescued by relevant governments. This is a controversial matter. The standard objection to bailout is that it encourages what economists call 'moral hazard'. If financiers develop foolish management practices leading to failure, but are rescued, they (or their successors) have little incentive to behave more sensibly in future. Extreme free market economists say allowing failed financial enterprises to go broke will remove this moral hazard and make for a more robust, sustainable financial system. The trouble is, if failed financial enterprises are big enough to create a serious, potentially global, depression, avoidance of this will dominate thinking in any real crisis.

President George Bush said while announcing his bailout plan during the Global Financial Crisis: 'I'm a strong believer in free enterprise, so my natural instinct is to oppose government intervention. I believe companies that make bad decisions should be allowed to go out of business. Under normal circumstances, I would have followed this course. But these are not normal circumstances. The market is not functioning properly. There has been a widespread loss of confidence, and major sectors of America's financial system are at risk of shutting down.

'The government's top economic experts warn that, without immediate action by Congress, America could slip into a financial panic and a distressing scenario would unfold'. This could be put more simply. I recall seeing President Bush saying on global television something like 'I didn't want to do this, but they told me there would be a great depression if I didn't'.

The trouble with not providing bailout has been seen many times before. To take just two examples, the inability of the Victorian colonial government to bail out the financiers in Melbourne in the 1890s meant many sound banks as well as unsound financial institutions were forced to shut their doors, making the downturn far worse than it might have been. The US government's inability or unwillingness to save the myriad of US banks was also a material factor in making the Great Depression of the 1930s far worse than it might have been, as current US Fed Chief Ben Bernanke's own research shows.

In the Global Financial Crisis of 2007-08, the risks of declining to bail out a major financier were seen in the case of Lehman Brothers. This unlovely organisation no doubt deserved to fail, but its failure produced a situation of massive financial gridlock that caused the world of finance to wobble on its axis, and could well have turned a nasty downturn into another Great Depression. There is still risk of such an outcome, focussed on the twin issues of global inflation and sovereign debt default, so we need to be crystal clear that bailout is necessary – with provisos.

Government bailing out companies 'too big to fail' should take equity in the failed enterprise so that taxpayers have a chance of recovering their investment. The rules should also provide for the dismissal with minimum or no compensation for the most senior executives and board members as soon as replacements are installed. This requires that unequivocal failure – defined as requiring taxpayers' funding – is like proven fraud as a case for dismissal without the usual protections of contract law. These two rules should help to overcome the so-called 'moral hazard' implicit in bailout with no real sanctions.

Governments also have an interest in the design of incentive plans for executives in major financial institutions. How this should be implemented and enforced is worthy of debate, but I am confident that rules are desirable that encourage executives to take a long-term view of the profitability and viability of the financial institutions that they manage. Similar rules may benefit other corporations also but the mooted change is vitally important for the health of a nation's financial system. Indeed, in the cases of major global banks and other financial institutions, it is vital for the health of the global economy.

Principles that are highly desirable include the following: bonuses go into a trust that is not paid out until some time, eg five years, after the executive retires; clawback allowed (indeed required) on some pro rata basis if losses are made, so that executives cannot benefit from taking large risks and being rewarded only for success, with no penalty for failure; bonuses earned in this way might be taxed when received at the normal capital gains rate.

In the absence of sensible changes to the regulation of global finance, the world faces a repeat of the extreme financial boom and bust that led to the Global financial crisis of 2007-08. There is evidence that boom and busts have been getting both more frequent and larger. The risk is that a future boom and bust will lead to a global downturn that becomes a great depression.

Vote for serious economic and financial sector reform, gentle readers. You will be doing your children and grandchildren a great favour.