The Banking Royal Commission and the risk that dare not speak its name

The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry has uncovered explosive evidence of lending and reporting practices that are challenging to accurately describe. Words like "negligent", "slipshod", and "careless" all spring to mind. In some cases, "dishonest", "fraudulent", and "illegal" might be more appropriate. Or "duplicitous", "brazen", and "shameless". But we are not writing headlines here. The one word which applies generally is "risky". And if risky lending and reporting is widespread in the banking industry, then the issue of systemic risk arises.

What is systemic risk? Handily, the Commission's terms of reference discuss systemic risk. It is the risk which it is the job of financial regulators to contain. It is risk which has "widespread implications for the financial system as a whole". But the Commission's terms of reference specifically exclude it. So we find ourselves in the quaint situation of having a Commission uncovering evidence of systemic risk but being unable to ask questions about it.

Should we, as Australians, be worried about systemic risk? Not according to the Turnbull Government. The Commission's terms of reference boast that Australia has "one of the strongest and most stable banking, superannuation and financial services industries in the world", with "world's best prudential regulation and oversight."

Whether or not this is true will become clearer in time. At the very least it is a matter for debate. What is not a matter for debate is that Australia's banking sector is the most concentrated and most profitable in the world. Australian property prices are amongst the world's highest, as is Australia's household debt to income ratio. One might argue that these facts alone scream systemic risk with the volume turned to eleven.

It is a terrible shame that the Commission can't ask questions about systemic risk, because the person most qualified to discuss systemic risk is right at hand. That person is Dr Ken Henry, the Chairman of the National Australia Bank (NAB).

For the decade before he joined the board of NAB, Dr Henry was Secretary of the Treasury. The Treasury Secretary does not directly supervise the the banks. This is done by the Australian Prudential Regulatory Authority (APRA), the Australian Securities and Investment Commission (ASIC) and the Reserve Bank of Australia (RBA). The Treasury Secretary doesn't even directly supervise these, our world's-best regulators. But each regulator is a creature of legislation, and that legislation is administered by the Treasury.

The Treasury is, in essence, the ultimate macro-prudential regulator. It regulates the regulators. While Dr Henry was Treasury Secretary, the APRA Act was amended 20 times. The ASIC Act was amended 43 times. The RBA act was amended 10 times, and the Banking Act itself was amended 20 times. It would be fascinating to hear Senior Counsel Rowena Orr QC asking Dr Henry which of these amendments Treasury intended to ameliorate systemic risk and which might have increased it. But alas, no. She isn't allowed to ask such questions.

When Dr Henry started as Treasury Secretary, the total loan book of the big four banks was $602 billion. When he left a decade later, it was $1.8 trillion. It would be just as fascinating to hear Dr Henry's opinion of whether a tripling of bank loan books in a single decade might create systemic risk. But alas, no.

Let's not forget off-balance sheet business: foreign exchange, interest rate and credit derivative trading. In 2001 the total value of this business was an eye-watering $5 trillion, and a decade later, a truly mind-boggling $18 trillion. One might reasonably ask whether this colossal expansion indicates systemic risk. One might even ask why this business is off the balance sheet in the first place. Dr Henry surely would know, but the Commission can't ask him.

As a former Treasury Secretary and now as a bank chairman, Dr Henry has had, one might say, a foot in both camps, and at the highest level. This is merely an observation, and is not to suggest that Dr Henry has done anything untoward. In fact, he is merely following in the footsteps of his immediate predecessor, Ted Evans.

That the position of Treasury Secretary appears now to be a natural stepping stone to chairmanship of a bank raises fundamental questions of systemic risk. Australian banking regulation has fallen victim to that trap which the ancient Latins knew as lupo ovem commisisti. We have entrusted the sheep to wolves. For the last two decades at least, whilst the banks have been growing like a bloating tic on the body of the Australian economy, the question of whether wolves have been guarding the sheep has seemed largely irrelevant. The current Commission exists because the banks wrote to the Prime Minister and asked for it. But Royal Commissions often occur after a disaster. If Australian property is a bubble, and if that bubble bursts, then the question of whether the guardians of the sheep were in fact wolves all along suddenly becomes highly relevant. Another Royal Commission will inquire into how and why the disaster happened, and who to blame. Almost certainly Dr Henry will be there, front and centre, answering questions about systemic risk after the fact. It would be far better to ask those questions now, before the fact.

Commissioner Hayne has admitted that the word "systemically" carries a lot of baggage. It has arisen already several times in passing. The phrase "systemic fraud" has arisen once or twice, as has the phrase "systemic risk culture issue", which would seem to sail very close to the wind indeed. The Commissioner has hinted, tantalisingly, that he might look into the attitude of the banking industry generally to the notion of obedience to the law. If he does, Commissioner Hayne will have to dance delicately around the issue of systemic risk, because systemic risk is the risk that dare not speak its name during the course of this Commission.