Don’t Just Target the Big Banks: Why all Banks Need Higher Capital

by Rodney Maddock and Stephen King, The Conversation

Banks borrow short and lend long. So if all of a bank’s depositors suddenly want their money, the bank would be unable to pay them. A bank may have made great loans but it can only unwind these loans slowly over time.

In most situations this doesn’t matter. Banks know their cash flows and play the probabilities, making sure they have a buffer of liquid assets to meet normal withdrawals.

However, a crisis can trigger a run on banks. Every depositor wants to get his or her money out of the bank before everyone else. The bank runs out of cash and closes its doors. It fails.

Bank regulation is at the heart of the current Financial System Inquiry chaired by David Murray. It will consider which regulations are important, which need to be strengthened and how international banking rules should apply in Australia.

Our recent research compares some of the different rules that may be used to limit bank risk. We find that increased bank capital requirements are the most effective policy but must be applied across all institutions to stabilise the banking system.

The global financial crisis

The 2008 crisis resulted in plenty of traditional bank runs. In the United Kingdom, retail depositors lined the streets to take their money out of the failing Northern Rock.

We also saw a different type of bank run during this period. For example, a bank run led to the collapse of Lehman Brothers. Yet this didn’t involve retail depositors. It was institutions that stopped lending to Lehman Brothers on the wholesale market.

Australia’s banking system in 2008 was fundamentally sound. Our banks didn’t have abnormal levels of bad loans. Legal differences meant the default issues plaguing bank mortgages in California, Florida and elsewhere in the United States couldn’t occur in Australia.

Yet our banks were still exposed to the crisis through their reliance on imported wholesale funds. The Australian government responded to this risk of an “imported crisis”. In October 2008, it introduced explicit deposit insurance and guaranteed bank wholesale borrowing.

But why did Australia’s sound banking system come under pressure in 2008? Is there potential for Australia to import a banking crisis in the future? And what sort of banking regulations do we need to deal with this possibility?

Importing a banking crisis

Wholesale funds now provide a large part of the total funds available to banks in many countries. This has changed the nature of the risks they face.

RBA Discussion Paper 2013-15 “Trends in the Funding and Lending Behaviour of Australian Banks“ Chris Stewart, Benn Robertson and Alexandra Heath

Australian banks source much of their wholesale funding offshore. This inflow of capital allows Australia to undertake more investment, generating higher levels of growth and enhanced well-being.

Before the crisis, Australian banks were borrowing internationally an amount equal to 5% of our gross domestic product each year. In 2008, international funds flowing though the banks funded about one-fifth of Australia’s total investment.

The flow of international funds did not stop during the crisis. However, they became more expensive, transmitting the pain felt by European and US institutions to Australia.

Banks were not the only institutions affected by the sudden rise in the cost of foreign funds. Foreign direct investment, foreign portfolio investment, offshore capital raisings by Australian companies, and government borrowings were also impacted.

However, the impact on banks was more significant. Unlike other institutions, banks borrow money for relatively short periods but use the money to lend to companies and individuals for the long term. When they depend on short-term international funds, a sudden rise in the price of those funds exposes banks to higher costs and potential failure. Any failure can also have significant economic and political implications. The failure of one bank can lead to a run and the failure of other banks.

This means governments tend to intervene if bank failure is imminent. For example, Bankwest in 2008 was owned by flailing UK bank HBOS. It was facing failure and, following government intervention, was bought by the Commonwealth Bank.

The government’s move to insure bank deposits and wholesale funding stabilised the banking system during the crisis. Yet these were ad hoc policy responses. Australia still needs to develop long-term policies to deal with the next financial crisis.

Developing the right regulation

Our recent research compares some of the different rules that are used, or might be used, to try to limit bank risk from offshore funding. This research is unique as we consider the consequences of specific policies at times of crisis and also during usual operations.

A policy may be effective at preventing a crisis but if it means that borrowers pay more and depositors receive less most of the time, then the protection provided by the policy may be overwhelmed by the day-to-day cost to the Australian public.

We take it as given that ordinary retail depositors will have some form of implicit or explicit government protection, so our focus is on the risk of bank default on bondholders. A bank fails if an increase in the cost of wholesale funds cuts its cash flows so that it cannot meet its debt obligations.

Regulators can do many things to limit banks’ exposure to imported wholesale funds and maybe make them less exposed to importing a banking crisis.

Regulations may require that banks use limited or no imported wholesale funds at all. Banks would have to be fully funded by domestic savings. Some countries like China have policies like this.

This policy is unlikely to work in Australia because it would significantly limit investment during normal operations. There would be no risk of importing a crisis but there would also be less domestic investment as borrowers would face higher interest rates. India has adopted this type of policy for many years and it has adversely impacted growth.

Depositors may gain from being a source of scarce investment funds but there would also be other costs. The banking sector would contract due to the restriction on fund access resulting in less competition.

Another policy that would reduce the likelihood of importing a financial crisis is for the government to have an explicit or implicit policy of bailing out bondholders. This occurred in the UK and US during 2008.

This policy has undesirable implications. If banks know that taxpayers effectively insure their bondholders, they will reduce the amount of equity issued and increase their amount of bonds. This would result in an increase in new entrants to the market based on excessively risky funding models.

Having a larger number of banks adopting a fragile funding model increases the likelihood of bank failures. If banks know they will be bailed out if they fail, then banks are more likely to fail. A bail-out policy actually increases the likelihood of future crises.

The most effective policy for dealing with wholesale funding risk is to increase the amount of capital banks are required to hold. While regulators have asked banks to hold more equity capital as insurance against lending risks, this policy can also reduce funding risks.

If a wholesale funding squeeze means that a bank cannot pay its bondholders, then the bank fails. If the squeeze simply reduces the dividend to shareholders, then the bank continues to operate. So requiring banks to hold more capital and less debt directly reduces the risk of failure.

While our research suggests that uniform minimum capital requirements can stabilise our banking system, it has been suggested these requirements only apply to “big” banks. Such an asymmetric policy would be undesirable. If there are weak funding restrictions on small banks, this will encourage the entry of a greater number of smaller and potentially more fragile banks. The result is an increased risk of future crises.

An asymmetric policy of increasing the capital requirements on large banks but not on small banks could have a stabilising effect if the government resolved never to bail out the small banks. Small banks could enter and leave the industry as funding conditions allowed and act as a shock-absorber to the system.

Politically, however, this is unlikely to work. Bankwest was not allowed to fail but was folded into the Commonwealth Bank. Even a small credit union like the Fitzroy and Carlton Community Credit Co-operative was folded into a larger bank last year rather than being allowed to fail.

Any new regulations to deal with the possibility of a future crisis must also deal with political reality. Minimum capital requirements on all banks can stabilise the banking system. However, a policy that just targets the big banks is unlikely to succeed.

Stephen King and Rodney Maddock received funding from CIFR for this project.

Stephen King does not work for, consult to, own shares in or receive funding from any company or organisation that would benefit from this article, and has no relevant affiliations.

This article was originally published on The Conversation. Read the original article.