All's Well in Banking, Right?

Basel III regulations pull one way, banking profits pull another...

THE GLOBAL BANKING SECTOR – Australia included – is generally in a state of denial about the future, writes Dan Denning in his Daily Reckoning Australia.

New banking reforms (Basel III) came out of the last crisis to prevent the same problem from happening again. The main problem was too much leverage. Banks built huge pyramids of assets on a tiny little base of liquid capital. When asset values fell quickly, capital was wiped out and had to be replaced (either by private investors or mostly by the government and central banks).

What compounded the problem was that the banks had financed long-term lending (expansion of assets on the balance sheet) with short-term borrowing (expansion of liabilities). But while the assets and the liabilities might be matched in terms of size, they weren't matched in terms of duration.

Without getting too technical, the "duration gap" is a measure of the risk associated with having mismatched liabilities and assets. That risk is mostly from interest rates. For example, if you've borrowed short and lent long and interest rates rise, it means your borrowing costs go up right away while the value of your long-term assets goes down – interest rates tending to rise with inflation, of course.

Double plus un-good.

The main problem, however, is that in the last 30 years this approach to banking has become an incredibly profitable business, especially for the men who run the banks. Expanding the balance sheet (more loans) is the way to grow earnings. And most bank managers seemed happy to do this in the credit boom, especially since the global cost of capital was absurdly (and artifically) cheap and all asset markets everywhere were going up.

No one (except Dr. Kurt Richebacher) seemed to recognise it as a worldwide credit-fuelled asset bubble. And when banks finally realised what had really happened (what they in part created), they were caught with falling assets and an urgent need to raise new capital. Which brings us to today.

Europe's banks alone will have to raise as much as $3.2 trillion in order to meet the new liquidity requirements of the Basel III bank regulations. "Basel III, due to be implemented in 2019, proposes requiring banks to hold enough cash or liquid assets to meet liabilities for a year," Bloomberg reports. "The aim is to wean banks off the short-term funding from other lenders that dried up during the crisis and sent Lehman Brothers Holding Inc. into bankruptcy."

You wouldn't expect banks to like any kind of rule that limits their profitability. But that's where all this, if left unchanged, is headed. Another set of regulations – the European Union's Solvency II regulations (which are due to come into effect in two years) – would make it more difficult for insurance companies to buy long-term bank debt. Banks would be unable t match long-term loans with long-term bonds.

Simon Willis from Daniel Stewart Securities Plc in London says if banks can't sell corporate bonds to insurers, they will have to borrow more from other banks, increase their deposit base to use as a source of funding, or – horror of horrors – lend less. An increased cost of funds eats into profits. And lower lending levels definitely eat into profits. It is hard to build your art collection with lower profits.

It's no wonder Australian banks (and the Treasury) are resisting the G-20's push to label Australia's big four banks as "too big to fail." This would require them to hold even more capital than already proposed. The Aussie banks assure us they are well-regulated and not at risk of causing a systemic crisis because they have lent prudently and have plenty of liquid capital. Got that?

There are two forces at work here, then. One is the banks, who really want to go back to the good old days when they could borrow freely and loan liberally and not be constrained by capital and liquidity requirements. The other force is regulatory, which sees unlimited bank balance sheet growth (and low interest rates) as the sort of thing that can blow up a global economy (not desirable).

What does any of this have to do with covered bonds? Funny you ask! That question came up yesterday over a beer with a friend. The conversation went something like this...

"Come on, Dan. You're not seriously arguing that an Australian bank is going to fail if the housing market crashes...and that the RBA is going to have to print money so the government can bail out depositors...are you? I mean, covered bonds wouldn't cause all that, would they?"

"No, that wasn't my point."

"Well you should make your point, because it wasn't very clear."

"Okay. My point was that Australia's financial system looks a lot like all the other ones that got into trouble. Introducing loan guarantees...buying up residential mortgage-backed securities...allowing for covered bonds...and introducing the Financial Claims Scheme...all of it manages to accomplish one major result."

"Which is?"

"Australian banks offload all of the risk from bad lending decisions to the taxpayer, via the government. The banks have every incentive to maximise profit because all the losses are going to be backstopped by the government. This isn't capitalism at all. It's what I called it yesterday, The Great Australian Bank Robbery, only the banks are robbing the people by forcing a set of regulatory changes that shift the risks on to the public."

"Oh. Well, you act like it's a bad thing that banks are trying to find a way to funnel more money to the housing market. A lot of Australians own houses. The government and the banks should support the housing market or else a lot of people might lose a lot of money."

"That's not capitalism either. That's organised asset price inflation. And it's just inflation. It's not real wealth. Increasing a nation's productive capacity (its capital stock) through investment produces real wealth. Trading houses between one another at higher and higher prices using more and more borrowed money is not wealth creation. It's gambling. And it's going to blow up."

"You're such a buzz kill..."

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