By Michael West
As the Rudd Government grapples with its "Rudd Bank" proposal to meet the impending corporate funding crisis in Australia, debate is underway this morning on Capital Hill in the US on the Obama Government's "Bad Bank" plan.
Kick-starting confidence in the banking system and stimulating lending once again are the objectives. As Hank Paulson's TARP plan had held out high expectations and failed - and this is a long shot - the expectations of success for Bad Bank are so low that it just might work.
The most perplexing element will be pricing. What price will Bad Bank pay for bad assets? Two essential elements are shaping as the foundation for the proposal: one, the Government buys toxic assets from the banks and, two, it provides a guarantee on other assets.
Both are, lamentably, rewards for failure. Wall Street bags the upside, taxpayers the downside. Short of taking actual equity in the banks - which Gordon Brown's Government in the UK has done but which Obama appears strenuously opposed to - this is unavoidable.
Bank share prices have been carved to one-fifth of their former value. The banks need capital to replenish their balance sheets, and to lend. Raising equity at such low levels is hardly an option and corporate credit markets remain expensive and illiquid.
The Obama program is to address what the new president labelled Wall Street's "shameful" and "outrageous" salaries first then hand down an $US800 billion to $US1 trillion stimulus plan (Bad Bank) as early as next week. It still risks filibuster in the Senate.
Combining the TARP handouts with other Federal lending programs such as the New York Fed's swapping US treasury bonds for toxic assets from the banks, the total taxpayer bail-out figures are in the trillions of dollars. Yet the Government has so far rebuffed Freedom of Information requests from the likes of Bloomberg to reveal who got the money, for what assets and at what price.
This sort of secrecy doesn't exactly inspire confidence in the system. And confidence and trust, above all, are what are needed to reboot the system.
Should the Australian Government similarly obfuscate with its Rudd Bank - and it will surely be under pressure from the banks and corporate borrowers to hide the substantial details - it could not expect to enjoy the confidence of its taxpayers either.
The banks are clearly behind the lobbying for the Rudd Bank initiative to fund commercial property loans. With foreign banks slimming down their exposures here and funding from corporate bond markets prohibitive, the local banks are spooked by the spectre of $10 billion in commercial property refinancings due this year.
The signs of a funding struggle are everywhere. Suncorp's insurance business recently bought $1.8 billion of Suncorp RMBS paper (residential mortgage backed securities) to meet its bank funding requirements. (Yes, Suncorp bought its own securities!).
"We were amazed that APRA (the prudential regulator) did not penalise SUN from a capital perspective on this front as it is clearly a related investment with circular risk profile," observed one broking analyst.
And the hit to the banks' mortgage books has only just begun. To satisfy its continuous disclosure requirements, Commonwealth Bank disclosed last night that it would see a 16% fall in first-half profits to $2 billion and swallow $1.6 billion in bad debt charges.
The latter was on expectations and the former some 20% ahead of analysts' forecasts although the news is unlikely to win much pricing support as, like all our banks, the bulk of the CBA's earnings derive from its mortgage book. And the pain in mortgage-land has only just begun.
Our politicians tell us repeatedly that our banks are well regulated. But should we take this for granted?
In 2001, the House of Representatives began an "Inquiry into Bank Supervision", which was later abandoned. The Inquiry followed an Australian National Audit Office "Bank Supervision Audit" report, which indicated some major holes in bank supervision at the time.
The Productivity Commission's Discussion Draft on the Inquiry into First Home Ownership sought "comment on whether current prudential requirements for deposit and non-deposit taking lenders are appropriate and, if not, what changes are required" - but the final report dropped these issues.
If it was too hard for the Parliament and the Productivity Commission to pursue these issues, how can we rely on politicians statements on bank regulation?
It is probably a fair call to say that our banks are better regulated, on the whole, than their foreign counterparts. Still, they appear to be lagging this credit-crisis cycle and have low equity/assets ratios. They need more capital.
For a start, banks with a higher reliance on wholesale and offshore funding should be required to have a higher level of capital. Does it make sense to borrow overseas to prop up domestic housing lending (and asset prices)?
Australian banks have a massive exposure to home mortgage lending. Under the capital adequacy regime, housing mortgages carry low risk weightings which improves their capital adequacy position (that is, relative to a situation where housing mortgages were to attract a higher risk weighting). However, housing mortgages may prove to be riskier than the current risk weighting implies.
Then there are potential black holes like credit default swap exposures, whose gross/notional values run into the trillions.
Marvelling at the sorts of massive bank losses in the UK and the US, our banks are travelling brilliantly by comparison, for now. And surely they will survive (thanks to taxpayer support) the crisis in far better shape than their offshore peers. But they are not out of the woods yet. In fact, they are hardly past the first few trees.
Addressing the issues
One putative solution to the dilemma of bank funding could be to get the borrowers to provide capital rather than investors. It would be a tough one to introduce but William Wild, an Australian and head of project finance syndication for a London bank, argues it would address both the moral hazard and the illiquidity issues of the credit crisis.
The traditional lending model is for the capital to support a bank's loan portfolio to come, at arm's-length, from share market investors and other capital instruments. The return to these investors is effectively paid over the life of the loans by the borrowing firms through the capital charges are built into the loan margins.
Essentially, borrowing firms have traditionally paid (or should have paid) investors to provide the capital to support their loans.
However, Wild reckons it could be effective in the current climate - to simply have the owners of borrowing firms provide the capital to their lending banks directly.
''Economically, the return on their investment would come from the elimination of the now-redundant capital charges. In fact, this would remove an inefficiency in the traditional lending model in that arm's-length investors in bank capital have to be paid an uncertainty premium whereas, if the owners of borrowing firms provide the bank with capital, they would make a certain saving through the elimination of the capital charges on their loans.
''Of course in today's environment the owners of firms would be highly incentivized anyway to secure loans to their firms that might not have been otherwise available at any price.''
There are so many variables to address here: the effect on portfolio credit risk, dilution of existing capital, and counter-cyclicality.
And it would be supremely difficult for the industry to identify how banks might initiate such a process themselves, given that it would cross traditional boundaries between loan origination and bank capital management.
It would, further, require dynamic management of a bank's Tier 1 capital - something which banks have not traditionally done. Dilution is another factor to consider.
Wild argues that his model could be achieved in a relatively simple structure. Certainly it would involve government intermediating, but not investing (thereby eliminating the moral hazard).
''With respect to each bank under its regulation, a government could create and own a vehicle called, say, a Capital Investment Trust (CIT). The bank could then negotiate to provide loans to firms in exchange for those firms' investing amounts - equal to the Tier 1 regulatory capital requirement on those loans - in the CIT.
''The CIT would in turn invest those amounts in short-term UK Treasury Bills, and each firm would receive an ongoing return equal to its pro-rata share of the return on those Treasury bills, which would be continually rolled on maturity.
''The CIT would simultaneously provide the bank with a permanent committed facility (Capital Reserve Facility) under which the bank could, at any time, and at its option, draw up to the full amount of the funds invested in the CIT.
''In return for the drawings, which would be met by the CIT through repayment of Treasury bills, the bank would issue the CIT with new ordinary shares. The number of shares issued would be equal to [the amount drawn divided by the then current share price]. The CIT would distribute those shares to the firms that invested in the CIT on a pro-rata basis.
''Importantly, however, the FSA as national regulator would accept the undrawn Capital Reserve Facility as Core Tier 1 capital for the bank. As such it would be unnecessary for the facility to be actually drawn in anything other than a final liquidation of the bank, and there would thus be no dilution of existing bank capital or impact on the return to the borrowing firms unless such a scenario occurred.''
This is just one idea, but it's worth a run.
mwest@fairfax.com.au