Why the banks are gambling with our money: Gottliebsen

Australia currently sits smug because our bank boards and management have not made the stupid mistakes that US and European bank directors and CEOs have made. Yesterday, former Reserve Bank governor Ian Macfarlane explained how our banks, and Australia as a nation, were simply lucky.

Australia needs to recognise its near miss, but also needs to understand that we still face dangers because some of our banks may still be capable of doing silly things, particularly if they are tempted to take big risks trying to recover the looming fall in bank profits. Australia needs to take steps to stop high risk-taking by banks, to make sure our bank capital base is not endangered.

To explain some of the reasons why the US banks went wrong, I need to go back to some of the causes of the 1930s depression which, in the US, were remedied by the so-called Glass-Steagall Act of 1933.

This act prohibited banks that took retail deposits from purchasing securities for their own account (up to a certain limit) and from engaging in the business of “issuing, underwriting, selling, or distributing, at wholesale or retail, or through syndicate participation, stock, bonds, debentures, notes or other securities”.

In other words, investment banking – which today is dominated by massive trading in derivative products – could not be undertaken by retail deposit-taking banks. A lesson from the 1930s depression was that it was wrong for banks to risk depositors’ money in the pursuit of high profits.

Over the decades that followed the 1930s, US banks managed to water down the Glass-Steagall Act, so that by the 1990s it had no effect and they were free to endanger depositors by taking big investment banking risks to boost profits.

We also now know that the US and European banks’ high risk-taking caused them to lose all their shareholders’ funds and forced governments into rescuing deposit holders and the global banking system.

The world now appreciates that if the wisdom of Senator Carter Glass of Virginia and Congressman Henry B Steagall had been remembered 70 years later, we would have avoided the current crisis.

Australian banks in the first few decades after the war did not take big risks. But a McKinsey study of the National Australia Bank in the late 1990s and similar conclusions of other banks decided that the profits from investment banking and aggressive trading in securities were too great to be ignored.

The NAB looks like blowing a few billion in the US from playing silly games over there, and most our banks have lots of risky derivative-based trading positions.

It makes perfect sense for banks to hedge genuine risk exposures, but if they go further and take a punt they are gambling with depositors’ money. The US banks started their synthetic CDO game by protecting loan exposure. But then they decided to gamble.

APRA and the Reserve Bank need to recognise the wisdom of Carter Glass and Henry Steagall and stop any Australian bank from gambing with deposit holder money.

Better still, Australian directors of banks should jump in. Some have already curbed high trading profits. It’s time to learn from what has happened abroad and go back to traditional banking – enticing local depositors, kicking tyres and not asking rating agencies to do the work, and only lending to people who have the capacity to repay.

The trouble is that curtailment of high-risk activities means that bank executive salaries must be reduced. European and US governments are going to make sure bank executive salaries are slashed and that there is no repeat of the errors of the 21st century as they return to the wisdom of Glass and Steagall. We need to follow.

This article first appeared on Business Spectator