Financial system inquiry

David Murray's Financial System Inquiry wasn't sexy when it was released in December. And amidst the debate on leadership, terrorism and the Budget, it is even less sexy now. In this environment, we need to be careful not to let Murray's central, and most egregious, recommendation sneak into law. That's the recommendation to force banks to lend less money.

In technical terms, the recommendation is to require banks to have fewer risk-weighted assets (which consist mainly of loans) relative to their 'common equity tier 1 capital' (which consists mainly of paid-up shares and retained earnings). Murray's aim is for Australia's major banks to be ranked in the bottom quarter of world banks according to this measure, a somewhat arbitrary target that would put Australian banks at the mercy of foreign banks' lending policies.

But the more important point is that government meddling in bank lending is unwise. Unlike government regulators, banks have both the expertise and the incentive to ensure they lend money to people and businesses that are likely to repay it.

Murray argues that banks would take fewer risks if they cared about what their failure would mean for the rest of the economy. But he is only looking at one side of the coin. You could just as easily argue that banks would take more risks if they cared about what their successes mean for the rest of the economy.

Murray cites literature outlining how human behaviour is irrational, but applies this to bankers, not to regulators.

He ignores the perverse incentives that influence government regulators, who get little credit when the financial system is humming along nicely but plenty of blame if a bank gets into trouble. This motivates regulators to put banks in straitjackets, even if it stops them from lending money to people and businesses with good prospects.

The odd thing is, Murray's recommendation would actually make banking less safe. It reinforces the silly and dangerous idea that the role of government is to attempt to reduce the risk of bank failure. This leads to the conclusion that a bank failure is partly the government's fault, in which case the government has an obligation to compensate the bank's depositors, creditors and even shareholders. So, contrary to Murray's claim that he wants to reduce implicit guarantees, his recommendation entrenches the idea that the Government will bail out a failing bank.

A bank failure is undeniably a traumatic event. The bank's shareholders and depositors take a hit, as does any other bank (along with its shareholders and depositors) that lent money to the failed bank.

But a bank bail out doesn't avoid this pain; it just redistributes it. Instead of the pain being concentrated on those who decided, directly or indirectly, to invest in a bank that made the wrong calls, the pain is spread across taxpayers who made no such decision. And instead of some of the pain falling on foreigners who invest in Australian banks, it would rest entirely with Australians.

A bank failure takes time to clean up. Administrators are brought in, court cases proceed, and various depositors, creditors and shareholders would rely on taxpayer-funded welfare while they wait to get some of their money back.

But this period of pain pales in comparison to the lingering pain associated with bank bail outs. Japan's stagnation following its bank bail outs in the early 1990s clearly shows what to expect.

What Murray should have done is acknowledge that the banks already have an incentive to avoid failure. He should have acknowledged that government efforts to reduce the risk of bank failure generate government responsibility for any subsequent failure. And he should have recommended that options to bail out banks ought to be closed off, including through removing the discretion of the Reserve Bank to bail out a bank without parliamentary approval.

Murray's belief that bank bail outs should remain an option, and his faith in the effectiveness of regulation, should come as no surprise. Murray is a former banker, and his report was prepared by bureaucrats from agencies that regulate the banks. The lesson we should draw is that the financial industry shouldn't be reviewed by insiders wedded to the idea that the industry is special and needs special regulation. It should be reviewed by outsiders who are intelligent enough to understand the industry but are not captured by it. The Productivity Commission may be a better choice.