Central Bankers Caught Napping By The Financial Crisis

"Of all the gin joints in all the towns in all the world..."

Humphrey Bogart's famous line from Casablanca is probably the least amusing line of all right now to Ian Macfarlane, the former head of the Reserve Bank of Australia, and lauded by some as the best central banker of his era in the world.

At one stage, there was even talk Macfarlane would be approached to take over the US Federal Reserve - despite the minor sticking point that he isn't American. He was roundly praised by Alan Greenspan, his US counterpart, and others in Washington.

So how could Macfarlane have ended up as a director of ANZ Banking Group, the Australian bank likely to suffer the worst hangover from the greatest international debt binge in history?

Of all the banks, in all Australia ...

The unfolding farce at ANZ, with its $650 million in loans to Opes Prime - a collapsed stockbroker mixed up with colourful business characters, fast cars and, so the Federal Court was told, money-shuffling through exotic tax havens - has exposed the bank to ridicule for lending practices that go well beyond what normally would be described as lax.

Then there is its failure to comply with the Corporations Law by not declaring its interest in 88 companies, 12 of which were holdings above 20 per cent - the takeover trigger.

On top of that is its massive exposure to another failed broker, Tricom, which it kept afloat this week by pumping in an extra $10 million in rescue loans. It's cheaper to keep it afloat than risk further damage.

Appointed in February last year, not long after he relinquished his role as governor of the Reserve Bank, Macfarlane was the newest appointment to a heavyweight board.

But given his role as governor - and, by proxy, guardian of the Australian financial system - Macfarlane was in a unique position to see the relative strengths and weaknesses of every player, big and small, on the Australian financial scene.

That he couldn't see the effect of the debt explosion and where it would wreak the most damage on his own turf lends weight to the argument that no one at the moment has a clue about where the carnage on world financial markets will end - least of all the regulators. The credit crisis now engulfing the globe has caught every single regulator in every region by surprise. Which raises the question: what have they been doing all this time?

Each month, the central bank governors or their senior advisers meet in Europe to discuss the global financial system at the Bank for International Settlements.

So how come the Federal Reserve - which oversees the world's biggest financial system - didn't see the looming crisis?

Citigroup, the world's biggest bank and clearly one that would show up on the Fed's radar, had to be bailed out by petro-dollars from Dubai. And in the past month, the collapse of Bear Stearns - a non-bank to be sure but one of Wall Street's financial powerhouses - was averted only when the Fed handed out billions of dollars to JPMorgan to buy its smoking ruins. This was the first time since the Great Depression the Fed had intervened on behalf of a non-bank.

Similarly, the Bank of England had no idea what was around the corner. As the subprime crisis raged through the US financial system, Northern Rock, a British mortgage lender, hit the skids. Like our very own RAMS, it was borrowing cheap, short-term cash on the American markets and lending it out at higher rates for 25 years in Britain.

European authorities appear to have been equally in the dark, judging by the demise of Germany's Sachsen Landesbank and the $40 billion in losses racked up by the Swiss-based global giant UBS.

The first round of the debt fallout hit US real estate.

But surely the authorities could see the housing boom was being fuelled by a flood of cheap loans, to the point where US mortgage providers were joking about NINJA loans - housing debt provided to those with No Income, No Job, No Assets?

Apparently not, just as every regulator has failed to see the looming crisis in credit card and corporate debt.

This week, the International Monetary Fund took a swipe at the supposed guardians of our international financial systems, accusing them of being hopelessly out of touch.

"Financial sector supervision and regulation ... lagged behind the rapid innovation in and shifts in business models leaving scope for excessive risk taking."

Boom markets breed complacency. And we've had an extended boom. In the commercial world, the pressure was on to do the deal, whatever the cost. That meant pushing regulations to the limit and finding loopholes. And there were loopholes aplenty.

Companies found ways to disguise their true debt position, moving it off their balance sheets. Investment banks found ways to "protect" that debt by inventing instruments that in themselves turned into tradeable commodities.

Dud housing loans were packaged together as "collateralised debt obligations". These were sold to institutions, which borrowed to buy them. The CDOs were yielding 10 per cent. Borrow at 5 per cent and pick up the difference. Take out an interest rate hedge contract against someone else who has borrowed to finance it. On and on it went, and the regulators either didn't see it, didn't understand it or didn't want to know about it.

What we've seen in the past five years was hailed as a financial revolution. Now it's time to clean up the mess and restore some proper government.