Financial Regulation

Financial regulation is in the news again this week with Obama criticising fat cat bankers for just not "getting it". The administration is frustrated by the opposition to regulation, the continuing payment of excessive bonuses, the spending of huge sums on lobbying and the failure to lend.

There's no doubt that they're not getting it because they don't have to. The problem goes a long way back, including during the Clinton administration, which gave to much credence to the financial sector's power and seemingly enjoyed its support. Indeed many in its economic team were integral players in the financial structure. At least Obama is trying to do something.

In Australia the view from Reserve Bank governor Glen Stevens is that the regulatory problem is related to just 30-40 "bad apple" banks and that regulators should be careful not to overdo the changes.

We should try to ensure, however, that the cost is no more than necessary. The most egregious behaviour was mainly that of 30 to 40 large, globally active banks. They have imposed very large costs on their own banking systems, economies and taxpayers, and on the global economy. But there are thousands of other banks in the world whose risk appetite did not get out of control, that have remained solvent, and that have not needed public capital injections. So it will be sensible to ensure, as far as we can, that the proposed measures act effectively to constrain the worst excesses of the former without unnecessarily shackling the latter.

The real question is why Australian banks did well during the crisis. Was it because of more effective regulation in Australia, the continuing growth of the Australian economy that kept borrowers solvent (compared to the situation in many other countries), the high level of investment in housing and mining that meant that there was less 'loose' money to invest in the types of schemes that brought the US and European banks undone, the lessons of the financial debacle of the late 1980s.

To my mind all of the above played a role, but imagine a slightly alternative scenario where Australia did go into a deep recession and unemployment rose significantly or one where the Rudd govt did not support consumption and housing. Given the significance of home lending for the big banks in Australia, the banks books might not have looked so good if bad debts and the housing market had been affected by rising unemployment.

There is still much that could go wrong and indeed part of the problem for the future might be the belief that Australia is invulnerable and that our policy-makers are omnipotent. There is still a lot of debt in the system and if that debt increases then it makes Australia more vulnerable rather than less.

But the RBA is not worried at all.

Maybe they're right, but is it possible to keep increasing debt?