The 2008 global financial crisis (GFC) developed over a long period of time. It included a housing bubble in the United States and then a slow squeeze in liquidity that brought down banks around the world. Europe and the USA, in particular, are still suffering from the crisis.
So why did Australian banks survive?
Robert Marks has a ‘timeline’ of the GFC published by the Royal Society of NSW. It is like reading about a slow motion train wreck. In 2007, some familiar names start to pop up in the timeline, such as UBS, Northern Rock and Citi. By mid 2008, it is clear that panic has set in. Banks are bailed out and, in some cases, nationalised. Whole countries, such as Iceland and Ireland, face a credit squeeze. Economies move from growth to recession.
One thing that stands out is how little Australia is mentioned. Robert includes a range of Australian events in the timeline, but we appear more like spectators than active participants.
Yes, occasionally the regulator, the Australian Prudential Regulation Authority (APRA) steps in. Sometimes the Australian Government has to act, such as on October 12 2008 when it announced a guarantee on all bank deposits up to $1 million and also guaranteed banks’ wholesale funding. And the reader suspects that the Australian authorities were like a duck – calm and composed above the water with legs going full speed out of sight under the water. But the overall message is clear. Australia’s banks survived the GFC remarkably well.
Australia’s ‘exceptionalism’ was noted early on. In March 2009, former Reserve Bank of Australia governor, Ian MacFarlane, suggested that it reflected our ‘four pillars’ banking policy.
The ‘four pillars’ policy, which dates back to the Hawke-Keating government in 1990, prevents mergers between Australia’s four largest banks – Commonwealth Bank, Westpac, ANZ and NAB. It has been criticised as anti-competitive, for example, by the 1997 Wallis inquiry into Australia’s financial system. And the claim that Australia’s banking system ‘needs’ more competition appears to be a regular catch cry by politicians seeking a popular cause. So did a lack (or at least a limit) on competition save Australia’s banks from the GFC?
The idea that there can be ‘too much’ competition in an industry like banking reflects problems of corporate governance. Shareholders face asymmetric returns. If a company takes a gamble and this pays off, then shareholders get all the upside. If the gamble fails, the shareholders are protected by limited liability. The company may be bankrupt but the shareholders don’t have their personal wealth at risk. Other creditors, such as bondholders or, for banks, depositors, should have an incentive to stop excessive risk taking. But if these creditors are dispersed then each might have only a small incentive to monitor the business. And if the business is a bank, and creditors are either explicitly or implicitly protected by government guarantee, then creditors’ incentives to keep a check on management are further weakened.
The nature of banking exacerbates the corporate governance issues. Banks ‘borrow short and lend long’. So if there is any fear that a bank may have financial problems, creditors can either try to change the bank’s behaviour or just take their funds and leave. When the latter occurs, a ‘bank run’ can result. No bank carries enough short-term funds to pay out all short-term creditors, and no creditor wants to be left behind if other creditors withdraw the existing short-term funds. The resulting panic can bankrupt even a healthy bank.
If increased competition leads to increased risk taking by banks, this can raise the vulnerability of the banking system to a ‘run’. Limited competition and strong regulation, which limits banking activities and requires banks to have more equity (i.e. shareholder funds) and more secure investments, can lead to a more secure banking system.
Of course, this could go too far. If there is too little bank competition then customers are likely to get a poor deal. And if a bank is so big that government cannot let it fail, for political and macroeconomic reasons, then the incentives for creditors to keep the bank from taking excessive risks disappear. Further, regulation has costs and can potentially prevent desirable and profitable banking activities. Banking, by its very nature, involves risk.
What role did bank competition and regulation play in the GFC?
A recent International Monetary Fund paper argues that there is a “U-shaped relationship between bank competition and stability” and that “an intermediate degree of bank competition is optimal”. While the data is messy, Australia, along with Canada, appears to have had a ‘middle’ level of bank competition in 2008. And both country’s’ banking systems did well in the GFC.
Effective regulation also seems to matter. Belratti and Stulz, in a paper for the European Corporate Governance Institute, provide a broad brush comparison of banks in a variety of countries pre- and post-GFC. They note that “banks with the highest returns in 2006 had the worst returns during the crisis”. They hypothesise that banking practices that appeared profitable in 2006 were the same ones that exposed banks to risk in 2008. Further banks that “had a higher Tier 1 capital ratio in 2006 and more deposits generally performed better during the crisis”. In other words, the crisis hit banks whose operations were more reliant on wholesale funding than on shareholders and traditional deposits.
The larger Australian banks seem to fit into this category. They had a strong base of deposit funds going into the GFC. Smaller Australian banks were more reliant on wholesale funding, but the government moved quickly to insure that funding and avoid a run on the smaller banks.
While it is harder to tease out the differences in regulation, from the Belratti and Stulz, analysis, it appears that prudential oversight, including restrictions on banking activity; strict oversight of bank funding; and regulatory independence, all raised the likelihood that a bank survived the GFC. Again, Australia had strong prudential regulations before and during the GFC
So it appears that Australia’s banks did well during the GFC for three reasons: Goldilocks competition – neither too hot nor too cold; strong regulation; and decisive government intervention when needed.
It is worth remembering these factors, because the 2008 GFC was not the first financial crisis to hit the Australian financial system, and it will not be the last.
A. Belratti and R. Stulz, (2009) “Why did some banks perform better during the credit crisis? A cross-country study of the impact of governance and regulation” European Corporate Governance Institute, Finance Working Paper No. 254/2009, July.
R. Marks (2013) “Timeline for: Learning Lessons? The global financial crisis five years on”, Journal and Proceedings of the Royal Society of New South Wales, vol. 146, nos. 447 & 448, pp A1-A43.
L. Ratnovski (2013) “Competition policy for modern banks”, International Monetary Fund, WP/13/126.
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