Taming risks may plant seeds for crisis

Sydney Morning Herald

Friday April 1, 2011

ERIC JOHNSTON

Through a combination of tough regulation, a relatively conservative banking system and a dose of good luck, Australia avoided a direct hit from the financial crisis.But will it fare so well in the crisis of 2015? This is a question regulators and some bankers are mulling over even as the clouds from the financial disaster of 2008 slowly lift.The lessons from the past few years have been clear. More was needed to be done to make the financial system safer. In response, new global bank and insurance regulatory regimes have been introduced to avoid a repeat of what started out as a North American sub-prime mortgage crisis. Banks today are now facing tougher control around capital, liquidity and leverage.But could efforts to cut back on risk be planting the seeds for failure down the track?Barrie Wilkinson, who works with the financial services consultancy Oliver Wyman, has tried to pin down the unintended consequences of rising regulation. His findings, in a paper titled "The financial crisis of 2015: an avoidable history", sound like a cautionary tale.The study outlines how banks, unwilling to accept the lower returns on equity that result from requirements to carry higher levels of capital, could inadvertently be fuelling a new asset bubble by chasing high returns in commodities or emerging markets.Regulators, by focusing on curbing the risky behaviour of banks, may drive risk-taking into unregulated funds that also pose danger to the system, the study finds.The shadow banking system has been singled out as providing the conditions to inflate the US housing bubble, which quickly evolved into a global crisis. Banks found they could write more loans by packaging their existing loans into securities and derivatives. All this took place in a market without the probing eye of regulators.The Oliver Wyman report tells bank executives and shareholders to accept that returns of the past are unsustainable and that they need to do a better job of monitoring risks, especially in areas that produce unusually high profits.On the back of this, Commonwealth Bank, when it handed down interim results last month, reported a thumping rate of return on equity of nearly 20 per cent. This makes CBA one of the more profitable banks in the world, based on a measure of shareholder returns.Asia-focused ANZ has also signalled that it intends to reach the 20 per cent mark. To put these numbers in context, at the peak of the credit boom, CBA's return on equity was running at a little over 22 per cent.Over 30 years the average return on equity of the big banks has been 16 per cent. This suggests there is still a debate to be had over what is an excessive return.While Australia missed the worst of the banking crisis, the scenario laid out by Oliver Wyman suggests the local banking system puts it in line for a direct hit.In the 2015 scenario it points to high commodities prices creating incentives for commodities-rich, emerging economies to launch expensive mining projects - creating an oversupply of commodities relative to the demand coming from the real economy.The narrative driving the global commodities bubble assumes a continuation of the increasing demand from China, the largest commodities importer in the world. Right now materials such as gold, copper, coal and iron ore are changing hands at or near record prices.But any hint of a slowing Chinese economy sends tremors through global markets. And with China throwing everything at tackling inflation, a slowdown is possible.At the same time, the study also warns of Western banks building up large and concentrated loan exposures in Asia and the resources sector.Here lies the dilemma. The regulatory trend of coming down hard on the banks will increase the amount of risk in the shadow banking sector. It is possible the imbalances that are driving up levels of risk in the financial system will not be redressed by any of the new regulations, Wilkinson concludes.The only question is where these risks will go. Squeezing them out of the more transparent and manageable banking system could prove to be a mistake.