To be risky or to not be risky, that is the question.

Kevin Rudd is pushing bankers in two directions at the same time.

On the one hand by guaranteeing all loans to banks he is in effect handing them a license to take high risk gambles with no impact on their effective credit rating or their cost of borrowing. So long as the government stands guarantor on every loan to a bank then no matter how risky the banks investments the people lending money to banks (depositors and other banks) need not worry about getting their money out if things go pear shape. And of course chasing higher returns irrespective of risk means that the more bullish banks can pay better interest.

On the other hand Rudd is promising to punish bankers that take high risks.

Which will win, the carrot or the stick?

20 thoughts on “To be risky or to not be risky, that is the question.

  1. Rudd is becoming embarassing. his lack of understanding of how business works is staggering. reading the second article, it looks as if Rudd is advocating govt control of bank employees pay. if that is the case, that is ‘extreme socialism’.

    no bright graduate in their right mind would ever consider working for an Aussie bank again.

  2. Look at the graph for oil, copper, silver or just about any other commodity in short supply, they are behaving in pretty much the same way as gold, including the recent sharp fall ( because we all believe a recession is coming).

    Gold is just another commodity, it’s only given mystical powers by people hankering for the past and all the problems that result from limiting the money supply to the quantity of a particular commodity available.

    Back to the banks. The guarantee is for three years, not for ever, further I think it shows a little more insight to see this as a guarantee that APRA is doing it’s job. I think it would be fair to say the average depositor places his faith in APRA, not the banks. Been too many near bank failures/failures to place your faith in banks.

    As for the additional intervention argument, I think you would be hard put to argue that APRA didn’t already have very tight control over the behavior of banks. If the Australian Government wants to control bank executive salaries that is the way it will be, banks after all are little more than an extension of the reserve bank, an attempt to have the private sector allocate resources. If they charge too much for their service the reserve bank is entitled to find alternate methods.

    If you step back a little further, Australia is a net capital importer, if the economy is going to keep humming the capital has to keep coming.

    And please don’t argue that capital import is a bad thing, Australia is building economic assets at a clipping rate. If China and India keep growing there will be a payoff.

  3. We don’t want bright Aussia graduates working for an Australian banks. Australian banks are useless and get in the way. When they turf their ponzi-racket and decide they are going to be wealth-creators and not counterfeiters than perhaps we might want some people with brains working there as opposed to these welfare queens and crooks.

  4. Graeme, by all means try to be funny, which at least makes silly posts about fractional reserve readable, but how is a bank employee sensibly described as a welfare queen?

    Rudd is a control freak and now he can justify controlling bank salaries.

  5. jc

    Expensive public servants about sums it up. I think ours being the most expensive is stretching it a bit, the English bankers get paid more, and going forward I think you would be hard pressed now to call US bankers anything other than public servants, it will be interesting to see how the US go controlling banker salaries.

    The allocation of resources by the private sector failed. I don’t think there is a better system, but failure brings contempt.

  6. I have been wondering about something else also. Mortgage Choice and others now organize mortgages on behalf of banks. How long before they cut out the middle man and start organizing them directly for the RBA.

  7. Some interpretation of the hyperbole is required.

    The government is not guaranteeing all loans to banks. Just deposits. Banks borrow a lot of money in addition.

    There will be some stuffing around in an attempt to limit executive salaries, but it’s window dressing. There’s no practical way they can do it. I expect they’ll end up trying to compel bonuses to be linked directly to shareholder returns. That outcome is long overdue although I don’t think it’s the government’s job to impose it.

    But the point about risk is quite valid. If the banks offered an interest rate of 10% on deposits they’d obviously attract a lot of money. If they then loaned it out at 8% with poor security they’d ultimately go broke and the taxpayers would have to stump up for the deposits. I wonder if Kruddy has thought about that.

  8. DavidL,

    My understanding is that inter bank loans are also guaranteed. I’m happy to be shown that this is incorrect if you have some reference that says so.

  9. terje is right – the govt is guaranteeing all senior debt raised in the wholesale market for a term of 5 yrs for the next 3 yrs (yes, it’s confusing).

  10. I was wrong. The government is guaranteeing wholesale borrowings, including from overseas. Turnbull is rabbiting on about an early end to the overseas debt guarantee, which I had only half heard.

    I now agree with JC. They’re all public servants now.

  11. From the article:

    “Firms with executive pay packages that rewarded short-term returns or excessive risk taking would have to observe higher capital requirements under the Rudd plan.”

    There is a problem in the banking sector generally of a misalignment of the interests of senior execs and the long-term interests of the banks and its shareholders.

    One of the features of markets is herding. Take for example the carry trade. Investors will pursue the carry trade (borrowing out of low yielding currencies to invest in high yielding currencies) up until the point that positioning risk is very high.

    The dynamics of this is such that over the short-term you have a very high chance of making money by pursuing this strategy. However, rationally, over the long-term you will lose any gains, because the drawdown when people exit the position will kill you. For you to make money over the long-term, you have to beat the crowd when they all rush out of the same investment at the same time. In practice this is impossible to reliably do this.

    It was the same with MBS market. The last banks to enter the business in a big way were the ones that bought at the top and were left holdng the bucket. (Goldmans was the only smart bank to short the MBS market at its peak).

    The point is that in a bonus driven incentive scheme you can exploit this dynamic. If you want to maximise your earnings over 1 or 2 years, you can direct the firm’s resources to pursue the latest bubble. You will make a lot of money, and when the drawdown kicks in and the firm loses money, you will simply quit and go work for someone else.

    Banking can be a rather testosterone driven, alpha male, “I can beat the market” type of environemnt, and the pressure builds for individual decision makers within the banks to follow a similar strategy.

    Hence, there may be a problem with banking pay. One possible solution could be to pay senior banking excecs in 10-year options, which would them more likely to make decisions that are in the long-term interests of the bank (and by extension the broader business cycle).

    Anyway, a quandry.

  12. Cross currency borrowing and investment only entails positional risk because the governments of the world adopted floating currencies. When the currencies of the world were essentially fixed via the gold standard then cross currency borrowing and investment was a useful arbitrage that provided a timely price signal. Today those price signals are distorted by the need to second guess central bank thinking.

  13. I agree with your point about price signals being distorted by the need to second guess central bank thinking.

    Monetary conditions do need to be established for local conditions however and price stability is a desirable thing.

    Fixed exchange rates always come unstuck at some stage and they invariably need defending via capital controls and regulation.

    Pegging to gold is very arbitrary and doesn’t take into account fluctuating demand for money. As such, output volatility would be higher, similar to when money growth pegging rules of the UK in the early 80s.

    We do need to get rid of central banks though and somehow harness the collective wisdom of the market to establish local monetary conditions.

  14. “Monetary conditions do need to be established for local conditions however …”

    In which case Sydney, Dubbo and Perth should all use different currencies and they should all float relative to eachother.

    The case for floating separate currencies is weak. Robert Mundell did all the pioneering work on “optimal currency areas” decades ago and his conclusion is that most of, if not all of the world should share a common unit of account. As in fact most of the world did for most of the last 500 years (just not the last 50 years).

    http://en.wikipedia.org/wiki/Optimum_currency_area

  15. I could live with a world currency unit and as globalisation progresses, that will look more and more likely.

    Gold is not the answer though, I think we should use dolphin teeth.

  16. As globalisation progresses? We had more globalisation in 1900. We also had a world currency in 1900. We are not progressing in this sence, we are merely restoring what was lost (hopefully).

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