Brent Sheather:Taming the finance monster

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If there is one thing that keeps local Reserve Bank and Treasury officials awake at night it is probably the thought of a banking meltdown whereby one "too big to fail" bank fails and the whole system wobbles.

Residential property is clearly the "elephant in the room" but as yet it is also "the dog that hasn't barked". If house prices fell sharply people with large mortgages could default. The higher house prices go the more risk there is thus the NZ government's recent concerns. Research cited in the Economist suggests that NZ and Australian house prices are high relative to both rent and wages. A collapse in house prices is an unlikely scenario but as we saw when we reviewed the book Safe as Houses back in June of 2012 it has happened many times before.

This is an important issue because the banking and finance sector is such a large part of the economy. Many would argue it is much too big. In a recent paper Paul Woolley of the London School of Economics questions why "the finance sector, no more than a utility facilitating trade and investment, has become the largest and most richly rewarded global industry". Indeed. Politicians around the world are now assessing how best to improve and de-risk the system.

Recall that in the last five years banks in the US, the UK and Europe have presented huge problems for governments requiring unprecedented support ranging from the obvious like direct injections of equity to the less obvious subsidy from low short term interest rates. At the same time that they have lost money it has come to light that some banksters have been behaving badly regarding their clients as "muppets" to be exploited. Examples of this exploitation range from manipulating wholesale interest rates to selling complex products guaranteed to lose money for the client with the bank conveniently sitting on the other side of the deal. Think CDO's in the US and interest rate swaps in Europe and NZ. The front page of the London Financial Times of 4th April, which I just happened to be reading when writing this article, had three finance related headlines;

"High pay fed ethical vacuum at Barclays"

"Bundesbank starts new probe of Deutsche Bank"

"Goldman Sachs banker hides US$8.3bn in futures positions"

The FT's editorial of the same day lists Barclays problems as "favouring transactions over relationships, the short term over sustainability and financial over other business priorities." As Shakespeare might have said if he were alive today "something is rotten in the world of finance."

The question before the panel is thus what needs to be done to sort out the banking and investment industry and at the same time minimize the impact on our banking system (and thus tax payers) from any adverse economic weather. One of the obvious ways to improve the robustness of a bank is to increase the equity that the bank has, i.e. decrease gearing. According to James Grant writing in Grant's Interest Rate Observer levels of bank gearing have been steadily increasing over the last 100 years. Unfortunately bankers resist this sort of obvious cautionary move because the higher the gearing of the bank, all other things being equal, the more money banks and bankers make. You can't blame the banksters for resisting these moves because they know that if it all turns to crap the Government will probably step in to bail everybody out, or will they? The conventional wisdom has been that if governments would bail out mongrels like Royal Bank of Scotland and South Canterbury Finance then all big banks have a defacto government guarantee including the big four from Australia.

But Mr Grant reckons that the experience in Cyprus is a turning point and that the new era involves "bail ins" rather than "bail outs". In Cyprus when some major banks failed depositors took a haircut. Coincidentally an executive from the Reserve Bank speaking to the Institute of Directors soon after the Cyprus disaster said that whilst the risk of NZ banks failing was low NZ had ruled out deposit insurance and under the present system losses are firstly borne by the banks shareholders then a portion of depositors accounts are frozen. In an email the Reserve Bank was more specific about how this would happen and it said "Once the bank is placed under statutory management the Reserve Bank will assess the scale of losses to determine that a sufficient amount is frozen. The bank will reopen for business the day after it is placed under statutory management at which time depositors will have full access to the unfrozen portion of their accounts which will be subject to a Government guarantee".

One obvious problem with this strategy is that investors will see that they have lost money with XYZ bank and look nervously at bank's ABC, CDE and FGH. The more astute amongst them will note that because XYZ's remaining bank deposits are now Government guaranteed that they are risk free so they will likely shift money from the "yet to go bust" banks to XYZ.

The banksters like to say that they are not earning extraordinary profits but the (admittedly) simplistic analysis below suggests otherwise. Look at 10 year sharemarket returns. The numbers for Westpac, ANZ and CBA are 14.5 per cent pa, 12.0 per cent pa and 17.4 per cent pa respectively. In the same period the Australian stockmarket ex resources has returned 9.7 per cent pa. If we look at what returns the four major Australian banks are achieving on their capital invested their return on equity is around 15 per cent to 16 per cent which is well ahead of that of major NZ companies like Fletcher Building and Fonterra.

This is not surprising because with an average equity to total assets ratio of about 6 per cent, shareholders equity in banks is about a tenth that of Fonterra and Fletcher Building. If we consider the risk of banks another way and look at the assets of the four major Australian banks they total almost $3 trillion. Australian GDP is $1.4 trillion so Australian banking assets are considerably more than double the size of the economy. Grant's say that in the USA the comparable figure is 85 per cent and Cyprus was 716 per cent.

It is pretty clear that the banking and investment world needs some attention and the good news is that governments and academics are putting their mind to improving things. It is therefore probably a pretty fair bet that the finance sector, as a percentage of the economy, will shrink in the next 20 years so readers contemplating a career should probably look more closely at engineering, for example rather than corporate finance.