A forgotten financial failure

The principal regulatory response to the crisis in the US has been the 2,300 page Dodd-Frank Act. The Act is meant to prevent 'too big to fail' but effectively institutionalises it by extending bank-like regulation and supervision by the Federal Reserve to any financial firm that might be deemed to 'pose a threat to the financial stability of the United States.' US financial institutions can be designated systemically important at the whim of regulators. They don't even have to be a source of actual financial instability, the mere threat instability is sufficient.

Once so designated, the Fed can effectively control anything and everything about the activities of that firm. The effect of the Act will be that every major financial institution in the US will now have to do the government's bidding, whether it is designated systemically important or not. In return, the US government offers protection from failure, which is the logical conclusion of the false view about the causes of the crisis expressed by Charles Goodhart at the RBA's symposium. It will reward those institutions that curry favour and are well-connected with Washington at the expense of new entrants who would otherwise pose a competitive threat to incumbents. Dodd-Frank is completely silent on the elephant in the room, the two government-owned enterprises that continue to account for 92% of new mortgages in the US.

In Australia, the financial crisis had a relatively modest impact, not least because Australia did not have government policies that sought to extend housing finance to those who could afford to repay a standard mortgage. The quality of the Australian banks' mortgage books is consequently very high and household borrowing is mostly undertaken by high income households who can readily afford to service their debts.

The Australian government has guaranteed retail deposits and the wholesale borrowing of major banks. During the crisis, Australia had little choice but to follow the rest of the world in this regard, as internationally mobile capital fled to the most secure and highly regulated jurisdictions. We will never know how important these guarantees were in providing for the stability of the Australian financial system, but they will have unfortunate long-term consequences. The government has established that it will not allow a major financial institution to fail, removing a significant market-based discipline on the behaviour of these institutions. In the absence of such market discipline, the Australian government, like governments around the world, will have to substitute increasingly heavy-handed and proscriptive regulation, but this is likely to stifle innovation and competition in financial services. It will make life particularly difficult for potential new entrants into the financial services industry. As RBA Governor Glenn Stevens has noted, the main effect of these regulatory actions will be to increase the cost of financial services to wholesale and retail borrowers, but with very uncertain benefits for the stability of the financial system.

The 'twin peaks' system of regulation put in place after the 1997 Wallis Inquiry served Australia well through the crisis. This system assigns the prudential regulation of financial institutions to the Australian Prudential Regulation Authority (APRA), while financial markets are supervised under a disclosure regime administered by the Australian Securities and Investments Commission (ASIC).

That said, the Wallis inquiry recommended that the regulation of financial markets and institutions should be reviewed after 10 years. We are past the 'best by' date on the Wallis reforms and another inquiry that draws on the lessons of the financial crisis is warranted. However, such an inquiry needs to be based on a factually correct narrative of the causes and consequences of the crisis and not the false narrative that has been designed to let US politicians off the hook for their role in causing one of the worst financial crises in human history.