Establishing a People’s Bank

Today I am going to consider the political sensitivities surrounding the profitability of the major banks. I will also put the counter-intuitive argument that simpler banks like Bendigo & Adelaide are in many respects safer than the majors despite what investors and the credit rating agencies say. And I will conclude with some recommendations on what Ahmed Fahour can do with Australia Post in the context of the controversial debate regarding a so-called “People’s Bank”, which I have recently considered. In short, I will propose that there is a case for a new public banking capability in regional and rural Australia. But in the metro markets I would encourage Fahour to stick to much simpler third-party distribution, and open up his 4,000 outlets as commercial conduits for smaller lenders.

The commentariat has started serving up some high quality fodder on these subjects. Indeed, Business Spectator’s own Stephen Barthomoluez has produced an excellent column in which he warns the big four banking “oligarchs” (perhaps this will become a new descriptor in the local lexicon) from acting as pure profit maximisers:

A sharp rebound in profitability would be contentious and politically sensitive. There are already calls for federal government intervention to create more competition for the majors. The appointment of former senior National Australia Bank executive Ahmed Fahour to head up Australia Post has sparked urgings for the creation of a post office bank.

While it is vital that the majors remain solidly profitable - the wreckage in financial sectors and fiscal settings elsewhere illustrates how destabilising and destructive an unprofitable system can be - it would be a sign of an unhealthily concentrated and uncompetitive system if the majors were too profitable. It would also almost inevitably lead to government intervention.

Now although I have not always seen eye-to-eye with Bartho, he must rank among Australia’s best banking analysts (I think my previous divergences with him at least partly validate my capacity to make such an assessment). And I mean “analyst” in the genuine sense of the word. The more conventional market analysts are not paid to critique public policy, or to reflect on abstract changes to the banking business model--they earn their crust by accurately valuing these companies and thus predicting how they will behave (or, put differently, forecasting their future cash-flows).

This makes analysts rather useless when it comes to evaluating the actions of banks from a public policy perspective. I have noticed a similar phenomenon with economists. When I first started out I thought that the market economists would make great sparring partners in debates about monetary policy. Yet they actually proved to be surprisingly unwilling and ill-prepared accomplices. I appreciate this might sound odd, but it is true. I am friends with many of these guys. And a very senior sage explained the problem to me one day. In response to a criticism I had levied against him about his disinclination to question the RBA, he averred, “Mate, it is not my job to think about what the RBA should or should not be doing - it is my brief to predict their behaviour; if anything, I need to spend more time thinking like them”.

Anecdotally, I have found an inverse relationship between the forecasting prowess of economists vis-à-vis monetary policy and their preparedness to critically appraise the RBA. This is no surprise, since the aforementioned analyst also opined that if he relentlessly questioned the RBA the central bankers would be less disposed to sharing their views. The concern is that if you take on the bank you will be removed from the informational flows. Dr Stephen Kirchner of the CIS and I have independently argued that exactly the same dynamic can be applied to journalists. And, of course, the principle is germane to banking analysts - can you imagine a leading analyst making the sort of statements one reads here and then expecting seamless access to the big four CEOs? I don’t think so. (As an aside, notwithstanding my regular questioning of the RBA I actually find them to be very open-minded - it has not appeared, for example, to impact on our professional relationship with them.)

Returning to Bartho’s recent column, he canvasses an important point, which is something I raised with him some time ago in a debate about the oligarchs. In previous posts I have presented RBA data that shows that the major banks’ return on equity declined only modestly during the GFC. That is, their RoEs have remained in solid double-digit territory and are no less than those experienced in the early 2000s. Leveraging off CBA analysis of its own cross-divisional returns, I (and others) have also belaboured the fact that their underlying businesses have been hugely profitable on a cash basis - it was the large expected losses in their business lending areas (aka “impairments”) which dragged down their reported profits. Naturally if the anticipated economic Armageddon does not come to pass, these impairments will evaporate and future profits will soar. This is the origin of Bartho’s concerns given that the sustenance of such profits during the recent calamity has relied directly or indirectly on the public purse.

Yet whenever I have suggested that the majors should be able to absorb more of their funding cost pressures, I have met with the refrain, No we need to protect the banks’ profits or their ability to raise equity capital will suffer. This logic is, however, flawed.

One of the principal behavioural complexities we face today is the relentless focus on returns to the detriment of risk. If you are assuming a much higher probability of loss (viz., risk) in order to generate better returns, your risk-adjusted returns have not increased. This is why equities are not the wonderful investment class that many in the commentariat claim. I recently came across the statement that your best asset-allocation bet since the 1970s was Australian shares. This is certainly true on a raw return basis. But when you risk-adjust the historical returns using any standard methodology, such as a Sharpe Ratio, Australian shares stack up poorly against many fixed income alternatives. The commentariat’s pathological tendency to ignore risk and focus mums and dads on raw returns is a real problem: we seem to have this mental blind-spot where we erase from our minds the 40-50 per cent price falls seen in global equity markets in 1987, 2001 and 2007-08. Punters get lured into the market by commentators acting like casino promoters. The challenge is not just for retail investors: as I have regularly highlighted here, the same behavioural biases afflict many retail super funds’ asset-allocations, which have amazingly highly 60-70 per cent weights to global equities. And slowly but surely this is starting to attract the appropriate criticisms from regulators and asset consultants.

Coming back to our oligarchs, there is nothing wrong with a decline in the major banks’ return on equity (which is, in fact, likely to increase significantly in the next few years) if that is accompanied by a commensurate reduction in their expected risk. And that is precisely what we have observed since the start of the GFC. As is now well understood, taxpayers have effectively said that they will insure away the risk of bank failure. This is an incredibly important policy innovation since it fundamentally changes the perceived risk of these enterprises. Banks are clearly not just “private concerns” as many would have us believe. At the first sight of mortal adversity, taxpayers were compelled to guarantee all of their funding sources at no price in the case of most deposits, and at an arguably sub-market price in respect of their wholesale liabilities. Furthermore, a taxpayer funded lender to the banks, the RBA, supplied them with cheap loans that were a vital lifeblood of liquidity during the darkest days of the crisis when extreme counterparty risk eviscerated liquidity for even the most creditworthy institutions. This is, in fact, one of the RBA’s key responsibilities - as a lender of last resort to private banks that are otherwise prone to fail.

Setting aside the significant new moral hazard concerns that have emerged from this crisis, what do these actions tell us? They clearly illustrate that bank shareholders get the benefit of a raft of (call-option like) protections that are not supplied to other private companies. Given taxpayers have revealed that they are willing to insure away much of the downside risk associated with catastrophic bank failure, these institutions have, by definition, significantly lower equity risk.

If the probability of loss associated with investing with the majors has declined care of these profound changes to our prudential system (APRA was founded in 1997 on the explicit basis that it would never, ever guarantee any institution), the expected returns should also fall. That is, investors should be more than happy to accept lower returns since the risks associated with putting your dough with the banks has also fallen.

This touches on another one of those rarely-discussed nuances. That is, the tension between CEOs and their shareholders, who are mostly focused on maximising raw returns in the short-to-medium term, and the much longer-term system-wide interests of taxpayers and policymakers who would like to see these institutions behave in a manner that minimises the prospect on them calling on our insurance (i.e., bank bailouts).

This now situates us at the heart of the regulatory questions that are being asked by some academics, politicians and policymakers: given their protected-species status, should the banks be subject to stricter regulatory constraints on what businesses they can and cannot operate? Should they just stick to their knitting and focus on savings and loans? Do they need to be stockbrokers, corporate financiers, investment bankers, proprietary traders, and bankers to businesses and home owners in, say, China? For some observers, and for Glass and Steagall way back in 1932, the answer to most of these questions was “No”.

These issues raise another incongruity. Everyone appears to agree that the oligarchs need to reduce their reliance on short-term wholesale debt and boost the funding they source from deposits (setting aside the fact that whether you use deposits or wholesale debt, you still have a profound asset-liability mismatch that is the source of the fragility that sits at the heart of the banking business model). From memory, the major oligarchs derive around 60 per cent of their funding from deposits, which is up from circa 50 per cent prior to the GFC.

In comparison, the much more lowly-rated Bendigo & Adelaide Bank sources around 93 per cent of its funding from deposits. Even more importantly, Bendigo & Adelaide Bank very much conforms to the highly conservative “narrow banking” model that Glass and Steagall, and some contemporary policymakers, aspire to see. That is, it sticks to the core business of providing safe-harbour for savings and redistributing that capital as credit to businesses and households throughout the economy. There is no investment bank. No proprietary trading desk. No stockbrokers. No certain-to-embed-much-higher-risk “pan-Asian” banking designs. (I have frequently drawn attention to the apparent contradiction of the major banks rushing to expand overseas following the GFC when it was the claimed absence of these exposures that many believe protected Australian banks from the crisis in the first place!)

Rather than being rewarded for its highly conservative approach (notwithstanding some minor miss-steps that originate from the Adelaide Bank legacy), Bendigo has been punished by investors, ratings agencies and even policymakers. Yet if you evaluated Bendigo’s business purely through the lens of the risk of catastrophic failure outside of the core savings and loan domain, you can mount the case that it is a demonstrably safer concern than the majors who have embedded so many other independent hazards into their activities (NAB reportedly acquiring a UK bank, Northern Rock, is just another example of this). Now in the “base-case” (aka the “good times”) it can be argued that these independent operations diversify bank earnings. But whether it be through investment banking operations, trading of stocks, currencies or commodities, or direct foreign banking exposures in the US, UK, Indonesia, or China, these non-core activities all boost the probability of catastrophic loss.

This is exactly what happened to the long line of once plain-vanilla banks during the GFC. A striking example is Royal Bank of Scotland (RBS), which morphed from a simple Scottish retail banking concern to a global trading and investment banking powerhouse. Yet it was precisely these investment banking exposures that brought it down. Today the UK taxpayer owns more than 84 per cent of RBS.

The experience during the GFC undermines the notion that private banks are inherently safer than publicly-owned enterprises. Indeed, if history tells us one thing, it is that private banks have a very high propensity for failure due to the asset-liability disconnect that is the source of so much of their instability.

This brings us to the question of the People’s Bank. I have spent much of the past two years arguing, with some success, that the Rudd Government should create more competitive neutrality in the banking and finance sectors by establishing a level playing field between deposits, wholesale debt and securitisation. And they have made some inroads here with the $16 billion of liquidity they’ve injected into the RMBS market.

To my mind, there does not seem to be a super strong case for a People’s Bank in the mainstream markets. As I noted last time around, we already have a strong second tier of smaller banks, credit unions and building societies outside of the oligarchs who, with appropriate public encouragement, could bring significant competitive pressure to bear. And a new non-bank model will inevitably emerge as securitisation spreads compress.

Yet even the most hard-headed of major bankers have privately confided to me that there would potentially be a role for Australia Post to deliver banking services in rural and regional Australia. To be sure, Bendigo & Adelaide Bank valiantly services part of this market. But with the retreat of the majors from rural Australia during the 1990s and 2000s there is an argument for a simple, low-cost banking service furnished by the state. Those living in rural Australia are members of the taxpayers I highlighted above who have supplied so much direct and indirect protection to the banking system throughout the GFC. And let there be no doubt that “banking” is a necessary public good that all Australians require access to in order to make their way in life. This is why, for example, academic research has shown that micro-finance is crucial to pulling families out of poverty.

So Ahmed Fahour could secure his first banking mandate in rural Australia. This would also provide Kevin Rudd and Wayne Swan with a powerful political wedge. The Nationals would find it impossible to oppose empowering Australia Post to deliver banking services to their constituencies. At the same time, the “dry” faction of the Liberal Party would presumably be opposed to any form of state intervention in the banking sector even though such opposition would be based on an ideological fiction (the fact is that the state already underwrites much of the industry). In short, this would be a policy that would either cleave the Coalition in two, or represent something they'd be forced to embrace if the “dries” were rolled.

I recently had a long chat with Danny John at the Sydney Morning Herald about all of this, and he subsequently published an outstanding piece on what to expect from Aussie Post. Danny notes that Aussie Post is effectively a monopoly in decline. Standard mail is a thing of the past. So the main test facing our chief postie, Mr Fahour, is how to reinvigorate the franchise while avoiding the adverse political spectre of closing non-economic post-offices.

Here it occurs to me that there is another reason why Australia Post could achieve these aims while further enhancing competition in the banking and finance sectors. Australia Post has the one thing that many smaller lenders do not: an extraordinarily strong national branch network. With over 4,000 outlets nationwide they have a distribution capability comparable to the majors. So while Australia Post may not want to compete directly in the mainstream savings and loan markets in metropolitan Australia, they could develop a financial services distribution capability.

Imagine if in every post office you could find a dedicated professional who would have the capacity to offer you non-commission-based finance on behalf of the smaller banks, building societies and non-banks. Aussie Post could remunerate these professionals on a time-basis and avoid some of the conflicts associated with mortgage brokers. Concurrently, they could negotiate at the corporate level very lucrative distribution deals with all the non-major lenders in Australia on a volume basis. In time, it is easy to imagine this service being expanded to other staple products: for example, various forms of insurance, Australian government bonds, superannuation, and so on.

At the very least, this should be some food for Mr Fahour’s thoughts.