By Adam Creighton
BANKS might have feared big changes after the global financial crisis. Millions around the world were thrown out of work as bankers pocketed pay that would make Croesus blush.
Taxpayers were shackled with world war-debt levels as governments rescued, even bought, banks deemed ''too big to fail''. The convenient fiction that banks competed at arm's length from government, subject to the bracing rigours of capitalism, was shattered.
Australia's banking system resembles Britain's: a handful of large retail banks dominate and offer investment banking services on the side.Credit: Louie Douvis
In fact, what played out - privatisation of profits and socialisation of losses - was a gross perversion of capitalism.
The Basel Committee on Banking Supervision, the international forum of bank regulators whose risk-management standards facilitated the disaster, retreated to Switzerland in deep introspection.
In December, it emerged with Basel III, a new set of ''tough'' rules that update Basel II, itself a new rule book that was being bedded down as the financial crisis got under way in 2007.
The minimum capital ratio (which affects the mandatory gap between banks' total assets and liabilities) would remain 8 per cent of risk-weighted assets. But the quality of its components would increase. Moreover, a new ''leverage ratio'' would limit banks' assets to 33 times (!) the value of their capital. Regulators would also get more discretion to bolster minimum requirements.
If that were not tough enough, full implementation would occur before 2019. It was as ferocious as unleashing a pack of poodles on a herd of elephants. Sighs of relief in Wall Street, Canary Wharf and Martin Place, where banks are already close to satisfying the new requirements, were almost audible.
Britain before the GFC was like an island hedge fund gone hopelessly long on financial services. It has suffered more than most countries - its public debt has surged more than 25 percentage points, or £400 billion ($A615 billion), to 85 per cent of national income.
Sir John Vickers, an Oxford don and former chief economist of the Bank of England, was commissioned last June to investigate how to make Britain's banks more robust and curtail the implicit subsidy taxpayers had been providing - a ''free'' subsidy estimated to be at least £10 billion a year, equivalent of the total annual profits of a handful of major banks.
The commission's findings, released this week, did not mince words. It thought Basel III "insufficient, albeit a major improvement", and argued "massive enhancement is needed". It's not hard to understand why.
The Basel III minimum capital ratio of 8 per cent, of which only a bit over half has to be ''cash under the bed'', is calculated as a proportion of ''risk-weighted'' assets. That's typically half the measured value of bank assets, so ''real'' capital ratios are closer to a handful of percentage points. Imagine being insolvent if your share portfolio dropped a few per cent. Moreover, risk weights themselves are arbitrary, clunky, and ripe for bank manipulation.
By contrast, Sir John's commission estimated that capital ratios of between 16 per cent and 24 per cent would have been enough to protect hapless taxpayers from forking out billions to prop up creditors, ''bonuses'' and shareholders. It would have largely excised the ''too big to fail'' problem.
He therefore reckons capital ratios up to 20 per cent of risk-weighted assets should be mandatory, about twice what Australia's big four banks now maintain. The commission also recommended that retail banking be ''ring-fenced'', meaning basic deposit-taking and personal and business lending would be strictly separate from banks' riskier wholesale and investment divisions.
Retail banks could still be part of larger financial groups, but ''ring-fencing'' would better align the costs of borrowing with the riskiness of the borrowed funds' use. British depositors' money would, for instance, no longer be available to clog the financial system with junk American loans.
The Chancellor of the Exchequer, George Osborne, indicated this week that he agreed with the recommendations. Yes, Australia avoided the worst of the GFC. Not a dollar of public money was spent to save the banks, notwithstanding the government lent the banks its AAA credit rating to help them borrow overseas.
But absence of a financial crisis in Australia does not mean the probability of a crisis was, or is, any different from in Britain. Should Australian house prices, say, fall as they have done in the US, and unemployment to rise significantly, Australia's banks - and, therefore, taxpayers - would be on the hook. APRA should consider the Vickers proposals as well.
To its credit, the Australian Prudential Regulation Authority will introduce the Basel III changes in Australia by 2016 rather than 2019. And the Australian government has announced it will slash its deposit guarantee to $250,000 from $1 million, mitigating public support for banks.
Australia's banking system resembles Britain's: a handful of large retail banks dominate and offer investment banking services on the side. And Australian taxpayers also provide a huge implicit subsidy, worth billions annually, to Australia's major banks.
At a minimum, APRA should avail itself of the scope within Basel III to make capital ratios permanently higher. It should not kid itself that it can tweak capital ratios according to the ''state of the economic cycle''. The International Monetary Fund was lauding banks' risk management in the lead-up to the financial crisis.
Higher local capital ratios would help competition among financial institutions. As the implicit subsidy to big banks dwindled, their ability to borrow more cheaply than smaller banks - even when their capital ratios are lower - would fall away.
Tighter capital requirements would cut banks' earnings in the short run (more debt boosts returns for banks as much as it does for any business), and probably push up the cost of loans a little too. But these are small prices to pay for financial stability.
In an ideal world, banks would be subject to no government regulation at all. They could manage their own risk, and depositors would choose who to trust with their money.
Alas, the GFC showed that it is impossible for democratic governments to let large financial institutions fail, however much they should. It is a government's job to free taxpayers from unwittingly providing unfair, distortionary, and imprudent subsidies.
Adam Creighton is a research fellow at the Centre for Independent Studies.