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Economics References Committee
Effects of the global financial crisis on the Australian banking sector

DAVIS, Professor Kevin Thomas, Research Director, Australian Centre for Financial Studies

CHAIR: Welcome, Professor Davis. If you would like to make an opening statement, please do.

Prof. Davis : Thanks for the opportunity to come and talk. In our submission to the committee the Australian Centre for Financial Studies argue that a wide-ranging review of Australia's financial sector was now warranted, and there are several reasons which are related to the subject of this inquiry. The important one is that there is a virtual tsunami of regulatory change washing over the financial sector, both with domestic and international origins. Much of that is a piecemeal response to problems identified in the GFC, the global financial crisis. But a critical question is whether those changes are just papering over the cracks in a structure that is ultimately unstable.

While the Australian financial sector weathered the GFC well, it was not without quite massive government and regulatory assistance. More importantly, we should be thinking about designing the desirable financial sector of the future. In my view, 'if it ain't broke don't fix it' mentality needs to be replaced by asking the questions of while it may not be broke, could it be better and how do we ensure that it will not break in the future. In that regard there is already a deal of international discussion and some resulting action about whether a more root-and-branch approach to the restructuring of financial sectors is required. The recent British proposals for retail banking ring-fencing are a good example of this.

There are two important considerations here. First, what is the underlying vision of how financial markets operate and the appropriate form for regulation? Second, can we design the structure of the financial sector to operate more efficiently and robustly or do we simply take as given the existing structure which historical evolution reflecting the interplay of market and regulatory forces has endowed us with? Some people might see the Schumpeterian competitive forces of creative destruction, which involves the ongoing evolution and adaptation of the system to external shocks and innovation, as a process which society cannot improve upon. However, I think the applicability of this notion to the financial sector, where exits of failed firms can create massive disruption and dislocation and thus lead to government involvement, is, I think, a questionable view.

My view is that there is an inherent dynamic within the financial sector towards increasing complexity, which, if accepted as a natural state of affairs, leads to increasingly complex, costly and intrusive regulations and which prompt innovative responses by financial institutions aimed at escaping the regulatory straightjacket. But I think there is a possible alternative. Legislation could design a simpler structure where some financial institutions face well-defined limitations on their allowable activities and consequently require simpler regulation. In such an alternative scenario, the other financial institutions could be less fettered provided that if or when they fail their exit is graceful with minimal disruption to the financial sector and at no cost to taxpayers.

The British ring-fencing and the US Dodd-Frank Act and the associated Volcker rule will change the structure of those financial systems. Proposals for requiring use of central clearing counter parties for over-the-counter derivatives are also relevant in that regard. But whether such changes are good or desirable and whether they have lessons for an optimal design for Australia's financial system are questions that require substantial study.

In thinking about why legislative interference in the design of the financial sector might be appropriate, I would note that banks have several rights and benefits conferred upon them by legislation or political processes. They can operate with limited liability, as can other businesses, where that was not always the case for banks. Shareholders often used to be exposed to double or unlimited liability. They can attract funds in the form of deposits without the need for a prospectus. They have access to Reserve Bank liquidity facilities. They can be and are highly levered. They benefit from—although some might deny it—an implicit guarantee from government.

Many of the recent regulatory changes are aimed at reducing these last two benefits of high leverage and implied guarantees, and the adverse consequences for competition and financial sector stability and risk to taxpayers. But I think it is questionable whether implied guarantees can ever be escheived in the case of core savings of unsophisticated households that have no chance of understanding the risks associated with the opaque institutions with which they are dealing. Perhaps it is better—as the British are hoping to do by ring-fencing—to limit such risks and guarantees by limiting the activities of certain designated privileged institutions.

That does not necessarily mean limiting the range of activities which a financial conglomerate—which includes a ring-fence bank—can undertake through its other arms. So any claims which may be made about interference with freedom are somewhat specious, particularly since the freedoms to operate under the protection of limited liability and to accept deposits are granted by legislation and law. It is already the case, for example, that some financial institutions and superannuation funds are required to be sole-purpose entities.

I should emphasise that I am not recommending a return to the intrusive, heavy-handed regulation which existed when we had separate trading and savings banks—and that was a distinction which was only removed back in January 1990. My view is that legislating to require alternative structures may enable simpler and less costly regulation of some core parts of the financial sector. But whether that is so and what set of structures is appropriate and achievable are something that can only be assessed as part of a large-scale study such as from a 'son or daughter of Wallis' inquiry.

In our submission we canvassed a number of other issues from the inquiry's terms of reference. These included the difficult issue of assessing the degree of competition in banking; the arguments relating to different regulatory requirements for large, systemically important banks; the pricing and structure of the Financial Claims Scheme; the impact of Basel III changes to bank capital and liquidity requirements; and bank loan pricing. I would be happy to answer questions on any of these or other relevant matters. Thank you for the opportunity to appear here.

CHAIR: Thank you very much, Professor Davis. You have certainly raised some interesting points which I think will provoke some thoughts in the committee. You started off by talking about the need for a wide-ranging review and you finished up on that as well. Your main focus on that was the need to examine the structure within which our financial system currently works, and you noted what has been done in the US and the UK. But you also mentioned at the end looking at the financial claims and the systemically important nature of some of the bigger banks and the state of competition and Basel III. One of our terms of reference is also to look at Basel III. How do you think that the current proposals for Basel III fit into what you described as a piecemeal approach to regulation? Is that well thought out or is that something which really should be considered as part of a major review as well?

Prof. Davis : I think there are several points here that are important. Firstly, I think Australia, as part of the international financial sector, cannot deviate too dramatically from what the rest of the world is doing in terms of regulation. If we did not follow the Basel Accord and the rest of the world is doing so, our financial sector would suffer in terms of its image in the rest of the world. There is much more emphasis now through things like the Financial Stability Board and their peer assessments of countries on how well or how closely various countries are following the international agendas. So, in a sense, we are stuck with that as a constraint within which we operate.

The other part of what you said went to the extent to which they are well thought out proposals. I think to some extent they are partly piecemeal, although there is an inherent logic behind them. The capital requirements are a response to a perspective that there was both inadequate risk weights attached to particular activities and also to the fact that they allowed in their previous form banks to become far too highly levered—and banks clearly arbitraged those activities. So I think they are clearly a response to a particular identified problem. I think they are part of an overall solution to those problems, although one has to ask the question as to whether in fact regulators or international agencies are not trying to be too clever by half. They have become very complex regulations. The approach of allowing the major banks to use their own internal models, which have turned out not to work so well, as the basis for assessing risk certainly is open to some question.

One of the things that is also in the new Basel III is the notion of having a simple leverage ratio—a ratio of minimum equity to total assets or total exposures, and I think that has something to be said for it. It provides a clear indicator that people can understand of when a bank is approaching a situation where regulators should step in and take action.

I think the liquidity requirements of Basel III are not so good. To some extent the requirement for a minimum liquidity coverage ratio which says that banks have to hold a certain amount of government securities ignores the fact that, if we do have a liquidity crisis, the central bank has to step in and provide liquidity facilities and, in doing that, it will accept either government securities or private sector securities in repurchase agreements—taking an effective haircut off the collateral to make sure that the central bank does not have an exposure to default.

A similar sort of issue arises with the net stable funding ratio. What that is doing is effectively reducing the ability of banks to undertake liquidity transformation—borrow short and lend long—which, from all economic textbooks, is one of the major economic functions that the banks carry out. So one has to be a bit careful about the extent to which that reduces the ability of banks to do the real functions that are key to them.

In conclusion to that question, we are stuck with what the rest of the world is doing. We cannot deviate too much, but we need to ask the question as to how they fit best into the structure of the Australian financial sector, particularly because our banks were not heavily engaged in the trading activities and so on previously but they might in the future.

CHAIR: I think it has to be acknowledged that we are part of an international group that has come up with these. We are not the only party. It is not in our interests to unilaterally deviate from what has been agreed. Given that, would it then be correct to conclude that your recommendation that we have a root-and-branch inquiry would in part analyse the impacts of what has been agreed internationally and then ensure that what we have in place in Australia works with that as well as works domestically?

Prof. Davis : Certainly. I think one has to take into account the existing and potential changes in the structure of the Australian financial sector, the special nature of the flows of funds in Australia, the dominance of superannuation and the impact that flows of funds into superannuation has on the overall flow of funds, and ask how one might adapt the Basel Accord and other regulatory changes to best suit the Australian situation. There is flexibility allowed in the Basel Accord, and APRA of course have already taken advantage of that in the sense that they impose I think tougher requirements for capital adequacy on the Australian banks than to other regulators because of not allowing certain deductions and so on. They have also brought it in much quicker than other institutions. We have to remember of course that the Basel Accord stuff will not happen fully until 2019. It is a long way away.

CHAIR: It is. Treasury this morning were saying that the Australian financial system is going through a transition that we are unlikely to see again a lot of the characteristics that existed prior to the GFC and what we will see in the end is transitioning to something different at this point. That argument, I think, you could use in favour of your recommendation that we have a root-and-branch examination but you could use it against and say that we should wait until that transition is finished and then have a look at a full inquiry. How would you respond to those two contentions?

Prof. Davis : The point I made in my opening comments was drawing on the economist Joseph Schumpeter's perspective that competition is a process of creative destruction and evolution effectively. The extent to which we should simply let evolutionary forces take their sway is that you cannot stop evolution, but governments certainly can influence it. One only has to look at the Australian financial sector to say that governments have influenced the development of the Australian financial sector over the course of the last 20 or 30 years, partly through tax changes, through superannuation, partly through other regulations. I think we need to be aware that financial institutions operate under a range of special privileges which governments concede to them or provide them. It is appropriate for governments to ask the question: are those privileges, those rights and those constraints they operate under the right ones in terms of the way in which the system is going to evolve? A good example would be the four-pillars policy which clearly constrains the way in which the financial system would operate. It constrains the system from becoming much more concentrated, but maybe one should be investigating that or other approaches. As I mentioned, ring-fencing is one which has some appeal to me, but there are lots of issues that need to be addressed in that as well.

CHAIR: What you are saying is that there are government entitlements that are provided but there are also government constraints. Given the government constraints, because it is a heavily regulated industry any way you look at it, it is appropriate to have timely examinations to ensure that those constraints are the appropriate ones and they are set up appropriately to give the best outcomes for Australian consumers.

Prof. Davis : Any inquiry would have to look at the balance of the benefits of having a licence to operate in particular parts of the financial sector against the constraints that are imposed, and what is the appropriate balance of those. It would also have to look at what that balance of privileges and constraints does to the overall efficiency of the financial sector. One of the characteristics of the Australian financial sector which is worth noting is that there is very little outside of banking, apart from superannuation. When you look at the total assets of the financial sector in Australia, if you take out banks and take out superannuation there is not much left.

CHAIR: You also raised the high propensity of variable loans in Australia, and you suggest adjustable-rate loans. How would adjustable-rate loans work and why do we have such a high level of variable-rate loans in Australia?

Prof. Davis : The reason we have variable-rate loans at the banks' discretion stems from history. Once upon a time, and I can remember when, bank loan interest rates for housing were strictly controlled and there were ceilings. In that sense, we never had customers or consumer representatives asking the question, specifically in the loan contract, about who bears the risk associated with changes in the costs of bank funding. We deregulated loan interest rates, but we did not ask the question: do we have the right sort of loan contract? The variable-rate loans that we have currently mean that if banks find that there is an increase in their costs of funding then they can adjust the rates on all their existing loans. Is that the right situation, where the customer should be the one that is wearing the risk associated with that, or should it be the bank shareholders—people like me—who are in effect going to bear the risk associated with banks finding an increase in the cost of funding when they have already provided loans to customers? My view is we would be better off having adjustable-rate loans where the bank enters a contract with the customer and says, 'Your loan is at, say, 100 basis points in excess of some indicator rates such as the three-month bank bill swap rate or the one-year government bond rate,' because that would mean that it is the banks which would bear the risks if, for example, their credit rating fell and they found that it was costing them more to raise funding. Then they would not be able to pass that extra cost on to the borrower but would have to bear it. They are the ones that should bear it as they are better placed to bear that sort of risk than are individual customers. Having said that, the existing system worked very well in protecting the banks through the global financial crisis.

CHAIR: Do you not think that would threaten the stability or solvency of some institutions?

Prof. Davis : Again, that is one of those big questions that requires a fair bit of thought and analysis. In my view, it should not.

Senator CAMERON: Thank you for your detailed submission. I held my breath when you started talking about Schumpeter and evolutionary forces, so I am glad you did not go down that track. I have been trying to find out who funds the Australian Centre for Financial Studies.

Prof. Davis : It was an initiative of the Victorian government with some seed funding. It brought together some of the Victorian universities, together with FINSIA, the financial services professional association—they provide some funding. We are a not-for-profit organisation run by a board of people from the universities and FINSIA. We try and beg, borrow and steal by doing various consultancy contracts, running research related events and so on.

Senator CAMERON: You are the research director?

Prof. Davis : Yes.

Senator CAMERON: I notice on your website that you are the point of contact for research in the organisation. Do you do much research for the big banks?

Prof. Davis : We have not done anything for the big banks recently. We have done one report for Abacus, for the mutuals, but that was to do with friendly society-type stuff. We do have some representatives of the Australian Bankers Association on one of our research reference groups to provide us with information about what they see as important events. We try to avoid doing contract consulting, if you like. We try to do stuff which is in the public domain, public interest-type area.

Senator CAMERON: I get the impression that you are concerned about the volume of regulation that is in place. I suppose you can understand the response to the global financial crisis caused by the finance sector, and that there had to be some kind of response. I said earlier today you reap what you sow, so it is fair and legitimate for governments to be questioning the operation of banks and the financial sector after the global financial crisis, isn't it?

Prof. Davis : Certainly, and they are not the only ones. One of the things that the experience of the global financial crisis has done is to bring lots of academics back to earth, recognising that the models that they were using to think about the financial sector were not really appropriate. A number of studies I have seen recently are asking questions about whether the financial sector is too big. If you look at the history of the financial sector since the deregulation of the 80s, the size of the financial sector has grown enormously, both in terms of total assets compared to GDP—not just here in Australia, but everywhere—and in terms of the share of the financial sector. A lot of people are questioning the extent to which that is well founded. On the regulatory side—

Senator CAMERON: Appropriate.

Prof. Davis : there is no question there is a need for a rethinking of regulation. Part of my concern would be there are regulatory changes coming from everywhere. It is hard enough to analyse the effects of any one regulatory change, let alone try to analyse the effects of all of those things happening simultaneously.

Senator CAMERON: But in reality there is legislation coming from two main areas, which is Basel III and the ongoing approach of that area, and any domestic legislation. A lot of domestic legislation is based on the Basel I, II and III approaches, isn't it?

Prof. Davis : Certainly for the banks, yes. It is worth making the point also that banks ain't just banks. Banks cover the whole range of activities across the financial sector. Basel is focused on banking activities, but we know that banks in Australia are dominant players in wealth-management activities, in provision of advice, in providing platforms, in producing various types of financial products for self-managed super funds to invest in and so on. It is important always to bear that in mind in thinking about banks. We used to talk, 15 or 20 years ago, about the blurring of boundaries between banks and others. I think the boundaries have now gone.

Senator CAMERON: The Chinese walls are not there anymore, are they?

Prof. Davis : Not necessarily, no.

Senator CAMERON: Can I ask you a couple of specific questions?

Prof. Davis : Certainly.

Senator CAMERON: I understand what you are saying about the legislative effects on the industry and I know that Senator Bushby has raised the issue of costs of the regulatory programs that are in place and may be put in place. Surely the costs of the regulation would be infinitesimal compared to the costs for the international community of the deregulated approach that allowed the global financial crisis to happen?

Prof. Davis : Posing things as regulation versus deregulation is probably not the best way to do it, because clearly there has to be some level of regulation. I think the question is: what is the appropriate form of regulation? As I mentioned in my introductory comments, the nature of the smart people in the financial sector is to go out and invent new services, new products and try and sell them to people who do not necessarily understand them. That is where money can be made. It is an increasingly complex industry, and we need to recognise that and say: are there ways in which we can influence the direction of it? Perhaps ring-fencing is a way to do that—

Senator CAMERON: That is not the question I am asking. Surely, compared to the cost that the financial sector imposed on working-class people all over the world—jobs being decimated, communities being decimated, individuals losing their savings—the cost of some more financial regulation on the banking industry, either international or domestic, is infinitesimal compared to the cost that the financial sector has wrought on workers around the world?

Prof. Davis : I think infinitesimal is too strong a word. The issue is one has to assess the costs and the benefits of regulation. It is certainly true that the regulatory structure we had, together with inadequate supervision in a lot of countries, meant that there were very large costs imposed on lots of unsuspecting customers of banks and other people who were affected through the impact on the economy. On the other hand, asking about the costs of regulation is a difficult and complex question. One can certainly imagine types of regulations which would be worse than having the regulation that we had before.

Senator CAMERON: Worse in the context of bringing the international economy to a grinding halt?

Prof. Davis : You could bring the world economy to a grinding halt by imposing massive taxes on financial regulation.

Senator CAMERON: You are beginning to sound like Tony Abbott—do not do that. I want to bring you back to a bit of reality. Nobody anywhere in the world is arguing about imposing massive financial taxes on the banking industry, are they?

Prof. Davis : No.

Senator CAMERON: You are raising that and I do not know why. Let us move away from that, as I think I have made my point. I am not sure if you have seen any of the stuff that Professor Stiglitz and Professor Krugman have done in relation to the banking industry.

Prof. Davis : I have read their stuff, though not all of it.

Senator CAMERON: Professor Stiglitz says that there has to be some reduced rent-seeking and a levelling of the playing field in the banking industry. He goes on to say that you should curb excessive risk-taking in the too-big-to-fail and too-interconnected-to-fail financial institutions. Is that a fair and reasonable proposition?

Prof. Davis : I think so, yes.

Senator CAMERON: I want to get a fair and reasonable response from you and then you can come back and go into detail, if you like. Stiglitz says that you have to make banks more transparent, especially in their treatment of over-the-counter derivatives.

Prof. Davis : Yes.

Senator CAMERON: That is fair and reasonable. He says that you make the banks and credit card companies more competitive and ensure that they act competitively. Is that fair and reasonable?

Prof. Davis : I have no problem with that.

Senator CAMERON: He says that you make it more difficult for banks to engage in predatory lending.

Prof. Davis : I have no problem with that.

Senator CAMERON: And you curb the bonuses that encourage excessive risk-taking and short-sighted behaviour.

Prof. Davis : I have no problem with that either.

Senator CAMERON: Are any of these or all of these issues that I have put to you in the Australian banking system?

Prof. Davis : In the case of, for example, predatory lending, not being privy to the details of individual loan contracts, it is clear that our banking system was moving towards the situation of excessively high loan-to-valuation ratios and various lending practices that were perhaps not in the best interests of customers. But we had not got anywhere near I think the situation of other countries, and here we have had legislation about know your customer and more emphasis on banks being able to assess the suitability of loans.

In the context of remuneration and incentives, I have for a long time been of the view that remuneration is too high and too much designed towards short-term benefits rather than long-term stability in the financial sector. It is fairly well known that financial salaries are very high. One of the benefits I would see of things like the British ring-fencing approach would be not just that you are separating one part of the institution from the other more risky activities, it is that you might actually change the nature of the people who are engaged in those two things so that the people who would be working in the ring-fenced retail bank would not have salaries that have got high-powered incentives to cause them to go out and make silly loans. You would not get the spillover of the investment banking salary structures and high bonuses across into the retail banking activities.

Senator CAMERON: And some of that has happened within Australia?

Prof. Davis : I think it has, because basically we have in the banks the wide range of activities in the one organisation.

Senator CAMERON: The banking association denied this morning that there is a problem.

Prof. Davis : Okay. Steve and I disagree on many things.

Senator CAMERON: I come back to another issue raised by Stiglitz, the issue of risk-taking. It goes to some of the issues you have just described. He says that particularly large banks act in a risk-loving way, they like risk and that attracts people with specific behavioural patterns to the banking industry. The organisational incentives attract these people—that is what we have just been talking about. The individual incentives—the salaries. Self-selection—people go, 'This is where I want to be.' Then there is what is described as pervasive irrationality, which is described as the financial sector systematically underestimating risk and the investors not understanding the risks of leverage and underestimating its consequences. Is this a reasonable assessment of issues for the Australian banking industry as well?

Prof. Davis : I think it is appropriate for any banking industry, and there are two points there that are really worth drawing out. One is the inability of people externally to the banks, customers and even the sophisticated people in financial markets, to actually understand what is the level of risk-taking within banks. The second point is the point about banks taking on excessive risk-being risk takers. We could turn that around and say that is the fault of government because governments effectively bail out banks when they get into trouble and therefore as a bank shareholder I should be happy for the bank to go for high risk because I get the benefits but the taxpayers get the downside.

Senator CAMERON: The 'too big to fail' argument.

Prof. Davis : We have to think about those issues very carefully and find the appropriate balance that enables appropriate risk-taking within the financial sector but where the benefits and the risks of loss are borne by the relevant people.

Senator WILLIAMS: Is Macquarie Bank the only bank in Australia that is actually ring-fenced?

Prof. Davis : It is not ring-fenced as such. It operates as a non-operating holding company, which means it has separate subsidiaries one of which does banking, one of which does other things, but they are not ring-fenced in the sense of there being restrictions between interrelationships between the two parts.

Senator WILLIAMS: For the record, could you explain ring-fencing, please? You have talked about it several times in your presentation today.

Prof. Davis : Certainly. The British ring-fencing approach involves a number of considerations, one of which is that there are certain activities that can only be undertaken by the ring-fenced bank. Those are things like taking retail deposits, running the payment systems for small businesses and individuals. It also has restrictions on what the ring-fenced part of the bank cannot do. In other words, it cannot get out there and speculate in financial markets, it cannot take positions with other financial institutions that would lead to spillovers if those other financial institutions got into problems.

Senator WILLIAMS: So it segregates the bank from the riskiest arms, basically.

Prof. Davis : And it segregates it by some of those restrictions but also by the fact that it can operate as part of a conglomerate, so it could be part of Macquarie Bank for example, but it has a separate board that is focused on that. Importantly, protections for customers like deposit insurance would only apply to the ring-fenced bank. And ultimately when governments step in and bail out banks they would only bail out that part of the bank. There are lots of issues with whether that system actually can work or not, but effectively it is one of trying to say that a large organisation can do whatever it likes under, let us say, a non-operating holding company but this part of it over here, the ring-fenced part, does these activities and cannot get engaged in other activities that create excessive risk to its customers and to the taxpayer through governments having to come in and bail it out.

Senator WILLIAMS: It is essential that we have strong banks, and luckily in Australia we have strong banks, except for Bankwest but that was reliant on overseas money. To ring-fence a bank, if we as regulators were to insist on that, would that be expensive for the banks to introduce? The last thing you want to do is make a whole lot of regulations that are going to cost a whole swag of money to the industry and then of course they will pass on to consumers and Joe Blow on the street will pay for it. Would it be expensive?

Prof. Davis : I would take you back to the days of trading and savings banks. Initially they were very separate in terms of regulations separating what they could do but when you walked into the banking office you did not necessarily know whether you were operating in the trading bank or the savings bank. The same teller took the cash over the counter and so on. I think the critical issues would be in the context of the information systems and so on, because an important part of the British ring-fencing proposals is that if the other parts of the bank get into trouble the ring-fenced bank can keep on going, which means it has to have IT systems and all of those ancillary requirements so that it can continue as a self-operating entity even though the rest of the organisation is going down the gurgler.

Senator WILLIAMS: The global financial crisis of 2008 was brought on by banks packaging up loans and selling them off. I think it was President Bill Clinton who altered the regulations in America where a bank had to have 95 per cent of their loans prime and 5 per cent subprime. Then they could package them off to places like Iceland. Those loans might have financed someone into a house. It could be a $400,000 house and they might lend them $420,000 to pay all the stamp duty and costs to get into it, no deposit, thinking that in 12 months time that house is going to be worth $500,000 but in 12 months time that house is worth $350,000. The equity is gone. Has the banking system around the world learnt a lesson from this activity?

Senator CAMERON: The answer is no!

Prof. Davis : I think it may have. The question is how long it will have learnt the lesson for. We know that typically—and there are arguments of this sort, such as the Minsky argument about cycles in banking—you have a crisis and then everything gets tightened up, gradually people forget what has happened and then you start again. But in the context of what you were saying, I think part of the issue was the fact that there was a separation of incentives from responsibility. The people who were selling loans knew that these were going to be packaged up and sold off to someone else who was bearing the risk without actually understanding it. Therefore, just like any salesman, if you want to—

Senator WILLIAMS: You sell it.

Prof. Davis : You sell it, get the commission and so on. Part of the regulations, including the Basel stuff, is to do with requiring that the organisations where the loan originates have some skin in the game—that they actually have to hold some of the risk—which, one hopes, makes them more careful about what they do.

Senator WILLIAMS: My final point is that the Corporations Act in Australia says that companies must return the best result for their shareholders. Are we facing a situation in Australian banking and financing whereby the market is simply flooded with loans and, as the banks' boards and CEOs strive for more profit and more business, that then takes them out into the higher-risk fields, because the average secure loan is soaked up. Is that the case in Australia, which actually led to a lot of the write-offs and troubles? What I am asking is, is it the case that at some stage the bank is going to say: 'Look, this is a level of profit we are happy with. We can only grow at one or two per cent instead of seven or eight per cent'? Is the industry in Australia getting flooded with debt?

Prof. Davis : There are three points I would like to make in response to that. One is that it is certainly the case that one of the dangers of a competitive financial system is that institutions take on excessive risk in the search for higher returns. We saw that in the late 1980s, when we had deregulation but did not put in place proper governance and supervision arrangements. The second point is that the critical thing in that whole process is the quality of supervision. I think it is worth putting on record that Australia has done very well through the activities of APRA in terms of its supervision of banks to make sure that we do not get into that situation. The third point I would like to make comes back to your comment that banks have to operate in the best interests of the shareholders—to make a profit for shareholders.

Senator WILLIAMS: All companies do.

Prof. Davis : All companies do. However, there is a question about the governance responsibilities. If one looks at life insurance companies, the board of a life insurance company is charged with putting the interests of policy holders first. One could ask the question, 'Why don't we have that for banks?' In a sense it is the same issue, because in life insurance companies policy holders have this contractual relationship with the organisation, which spans a period of time. Again, the organisation's obligations to them are generally much larger than their obligations to the shareholders. The same is true in banking. The depositors have a lot more to lose than the shareholders. So yes, it is certainly the case that our corporations law and history have been of the sort that says that the first responsibility of the director of a company is to the shareholders—or to the company, actually. But there is no reason that legislators cannot say, 'If you want a banking licence, then here are the conditions associated with that.' And one of the conditions could be that the first responsibility of the board is to the depositors. Whether that is a good idea or not, I am not sure. But it is the sort of thing that is worth tossing around.

Senator EGGLESTON: I have a couple of questions about Basel III. What is the likely impact of the quicker or faster implementation of Basel III on the international competitiveness of Australian banks?

Prof. Davis : Next to nothing, I would say, for several reasons. One is that the banks are basically already there, in the context of their capital requirements. The argument that would be posed as to why that might reduce international competitiveness would be the standard argument that says that the more equity you have to use, the higher will be your total cost of funding. If I put my academic's hat on again—to please Senator Cameron!—I could refer to a whole lot of theory that says that there are only certain situations in which equity is actually more expensive than debt. The standard argument is that as a bank gets more levered, then yes, they are using more deposits or debt—which looks cheaper—but the cost of their equity is going to go up. Shareholders are going to demand a higher return because of a higher risk.

The critical thing in the case of the Australian banks that distinguishes them from banks in almost every other country in the world is that we have a dividend imputation tax system. One of the big incentives for companies and banks to use debt and deposits is the tax deductibility of interest. Then the problem they face is that when they pay dividends, the dividends are effectively taxed twice under a classic tax system. We do not have that. We have a situation, with dividend imputation, whereby—to the extent that the tax is paid at the company or the bank level -when shareholders receive the dividends they get tax credits, if they are Australian shareholders. So any sort of tax induced costs, which is one of the main effects to the Australian banks, is pretty small, I think. Again, that is a debatable issue, because some people would say that the tax credits—the franking credits—are not worth much; others would say they are worth a lot. It is an empirical question, but it is certainly not as significant an effect for Australian banks under the imputation tax system as it would be for banks in other countries under the classical tax system.

Senator EGGLESTON: There is a view that I have heard internationally that Australia, because of its regulation of its banking system, would be less in need of or less affected by the Basel III proposals. Do you agree with that?

Prof. Davis : I think so, because—

Senator EGGLESTON: They are less relevant, in effect.

Prof. Davis : Do you mean they are less relevant to us?

Senator EGGLESTON: Less relevant to Australia, yes.

Prof. Davis : I think they have less impact on the activities of our banks, and the costs of our banking. Again, I would come back to the point that supervision is much more important than the regulations per se.

Senator EGGLESTON: With respect to the smaller banks, APRA's submission states:

The accelerated timetable is unlikely to impose any burden on smaller ADIs, given their current high capital ratios and generally lower level of regulatory adjustments.

Do you agree with that?

Prof. Davis : I think there are two offsetting bits there. One is that most of those small institutions operate under the standardised approach in Basel, and the changes that are occurring there are not dramatic in terms of their effects on the capital side for small institutions. On the other hand, for the small institutions, most of which are mutuals, higher capital requirements are a real potential problem because, in general, with a few exceptions, the only way in which they can get more capital is to retain greater surpluses—I still like to use the word 'surplus' rather than 'profit' in the case of mutuals—and of course that reduces their competitive ability. So I think it is an on-the-one-hand, on-the-other-hand situation in the case of small institutions. The changes to a standardised approach, I do not think have a big impact, but the requirements for higher levels of capital are a potential issue.

Having said that, I should actually make one other point: Basel II, which came in the in middle of the financial crisis, where the large banks were able to use their own internal models, meant that they were able to have much lower risk weights associated with housing lending. So some part of their interest back at the time of the global financial crisis, and before that, in increasing their housing lending involvement, was because of the fact that it used less capital. On the other hand, the mutual institutions were still stuck with a risk weight for housing loans of 50 per cent. So there are, I think, potential distortions there as well, particularly since housing lending has become the main business of the small mutual institutions.

Senator EGGLESTON: Are you talking about in Australia?

Prof. Davis : In Australia, yes. It would be relevant worldwide, but I was focusing on Australia.

Senator EGGLESTON: Certainly not the United States.

Senator CAMERON: The Mortgage and Finance Association of Australia put forward a submission this morning that we should adopt a similar approach to lending, as in Canada—

CHAIR: For securitisation.

Senator CAMERON: For securitisation: the Canadian mortgage bond approach. Has your organisation looked at that? Is there any benefit in serious consideration of that approach in Australia?

Prof. Davis : We have not done serious research on it. I have certainly looked at the Canadian approach. I would suggest that we should stay away from it, because it involves governments providing guarantees in various forms. The Canadian system is a very complex one, as far as I can see—it is not simple. And I think the last thing governments should be getting into is providing guarantees. It is very hard to price them, and very hard to operate them, I think. So I think there are other ways in which we could get the securitisation industry back into a better position to provide greater competition in the housing market than going down that route.

Senator CAMERON: If you want to provide us with details of that, it may be helpful.

Prof. Davis : Certainly.

CHAIR: Thank you, Professor Davis.