Higher Bank Capital: What’s Wrong with That?

Posted on January 30, 2012
Filed Under ACFS Commentary, Banking, Financial Institutions and Markets, Funds Management & Superannuation, Publications | Leave a Comment

Published in AFR, Social dimension to bank capital ratios, 30 January 2012

Suggestions from the IMF for Australian banks to increase their capital have elicited the usual negative response from that sector. Unnecessary, unfair, undesirable (for economic growth) are the sorts of reactions one gets used to hearing. But really, what does the social cost/benefit ratio look like?

It is important to realise that, in essence, bank capital requirements are no more than restrictions on the funding mix used by a bank. Higher capital requirements mean more use of equity and less of deposits and debt to fund a given level of lending and investments. Why might regulators want more capital, and why do bankers oppose this?

The call for higher capital is based on the fact that shareholders then bear more of the risk associated with bank activities, with their equity investment providing a buffer to protect depositors and debt holders from losses. That is good for financial stability and for taxpayers (if governments compensate depositors when banks fail), and the call is premised on a view that bankers will choose a level of capital which is too low on a social cost-benefit analysis.

Bankers economize on equity capital funding because of the view that deposits and debt funding is cheaper. Using other people’s money to make profits for shareholders is the name of the game, and the more of others’ money and less of shareholder money the better.

But are deposits and debt cheaper, and if so why? At face value the interest cost looks lower than the rate of return demanded by shareholders, but that is only part of the story. Increasing leverage (deposits and debt relative to equity) increases the risk (variability of returns) faced by shareholders causing them to demand a higher rate of return.

Taking this implicit cost of higher leverage into account, there should be no reduction in the average cost of funding unless there are some other relevant market imperfections (as Nobel prize-winning economists Modigliani and Miller pointed out many years ago). And, of course, there are such imperfections which are worth examining in more detail.

One is that depositors and debtors, who also face greater risk (from bank failure) of increased leverage, do not adequately increase the interest rates they demand from banks to compensate for that risk. And that will be the case if they believe that governments will protect them from losses, either explicitly via arrangements such as the Financial Claims Scheme, or implicitly by bailing out failing banks.

Thus banks, acting in the interests of shareholders, have a private incentive for higher leverage than is socially optimal because of an implicit taxpayer subsidy.

But maybe current regulatory capital requirements mean that Australian bank leverage is sufficiently constrained, such that risk of failure is so small as to be negligible and the taxpayer subsidy of minimal or no import. That may be so, but then the question arises of what is the cost of a higher capital ratio which decreases leverage, shareholder risk, and the required return of shareholders.

Not much is the answer, particularly under the Australian dividend imputation tax system where debt (deposit) financing has no (or little) tax advantage. The average cost of bank funds may increase by 5 to 10 basis points for each 1 percentage point increase in equity capital/assets – or not at all if shareholders act as proponents of efficient financial markets theory should suggest and reduce their required rates of return.

Of course, any higher bank funding costs mean higher costs for borrowers – but this can be offset by Reserve Bank interest rate policy. The main risk would be that banks respond to higher requirements not by raising new equity capital, but by reducing the scale and risk-weighting of their balance sheets.

The current unsettled global financial climate may be an inopportune time for banks to raise equity. But offsetting this is the ongoing wall of money flowing into Australian superfunds, including self managed super funds, with much of that looking to be invested in (particularly blue chip) Australian equities.

Whether higher bank capital ratios than current are needed or desirable can be debated, but that debate (like those over other regulatory changes) needs more attention paid to social cost/benefit analysis than has occurred to date.

This Commentary is written by Professor Kevin Davis, Research Director of the Australian Centre for Financial Studies.

info@australiancentre.com.au

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Finance Sector Employment on a Slippery Slope

Posted on January 18, 2012
Filed Under ACFS Commentary, Banking, Financial Institutions and Markets, Funds Management & Superannuation, Insurance, Publications | Leave a Comment

Published in AFR, 17 January 2012

Despite their consistently good profitability and cost/income ratios which KPMG’s annual performance survey indicates are relatively favourable compared to their international peers, the announcements of staff reductions by the major Australian banks should probably not come as a surprise.

Three interrelated factors are driving bank attempts to cut labour costs. While one is perhaps cyclical, the others appear longer term in nature, and the interesting question is whether this will herald a downsizing of financial sector employment and activity as a whole, or a shift in its composition away from banks.

For historical context, total financial sector employment was a relatively constant share of total employment during the “noughties”, at around 3.7 per cent. This was despite the ratio of financial institution assets to GDP increasing from 2.5 to 3.5 over the decade and the finance sector’s share of value added (GDP) increasing from just under 9 to over 10 per cent.

In the 1990s, the employment share dropped from 4.7 per cent to 3.7 per cent, while assets/GDP increased from 1.7 to 2.5 times and share of value added increased from around 8 to around 9 per cent.

So, over the past decade, a rapidly expanding financial sector has not increased its share of total employment, and in the previous decade financial sector growth saw a declining share of total employment. If technological change has meant that high growth has just sustained sector employment, a slowing of growth seems likely to lead to reduced employment.

Thus, the first factor driving employment cutbacks in banking is the marked decline in banking sector growth rates following the Global Financial Crisis. Credit growth (including securitisation) has fallen from an average of 14.4 per cent p.a. in the four years prior to June 2008 to 2.9 per cent p.a. in the two years to November 2011.

Higher growth on the deposit side of bank balance sheets offset that effect for a while with M3 growth rate averaging 17.8 per cent p.a. in the two years to June 2009, as depositors returned to the major banks during the unsettled times and as banks tried to replace offshore funding with local deposits. But over the two years to November 2011 that growth rate dropped to an average of 7.4 per cent p.a.

Bank operational structures based on anticipation of ongoing high growth rates obviously needed reassessment.

A second factor is regulation. Bank CEOs have pointed to an increased cost burden from recent regulatory changes, and it is hard to dispute that these must involve some increase in costs. But any employment effect is primarily indirect as attempts by banks to pass on those costs reduce customer demand for their financial services. And it seems more likely that the slowdown in credit and monetary growth reflects the effects of economic conditions and uncertainty on customer demand for financial services than increased costs of regulation.

Moreover, any regulatory induced decline in banking may be offset by growth elsewhere in the financial sector, eventually providing employment opportunities elsewhere for bank ex-employees. Even if banks still maintain their share of intermediation, they may find that regulatory changes make it preferable to adopt a production process which relies more on outsourcing some activities. Mortgage broking comes to mind, although offshoring of some other activities will not help newly unemployed bankers.

Ongoing technological innovation is, of course, the third relevant factor. In the late 1980s and early 1990s the major banks, responding to deregulation, advances in technology, and a massive decline in profitability which threatened the survival of some, reduced branches and employment and earned the wrath of the Australian public. Technological advances are again causing a reassessment of labour requirements, with ever increasing growth of internet banking and “apps” which enable customers to interact with their banks on a virtual basis.

But in an environment where banks remain relatively profitable and financial sector pay remains absurdly high, look forward to a resurgence of the “banks are bastards” grumbling, which the banks had worked hard to get rid of over the last decade.

This Commentary is written by Professor Kevin Davis, Research Director of the Australian Centre for Financial Studies.

info@australiancentre.com.au

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