Thank you to the organisers for the opportunity to speak to this group about such an important topic. The central concern flagged as the theme for this session is whether the post-crisis regulatory reform program has distorted provision of finance in this country in a way that impedes our growth prospects. So I would like first to talk about those reforms, before moving on to discuss what they mean for how economic activity in Australia is financed.

The crisis showed that the global regulatory structure existing at the time was not delivering the degree of system safety that society expected or wanted. Australia had already built a bit more conservatism into its prudential framework than the global minimum standard. So did some other countries that were less affected by the crisis. I would argue that events have vindicated that choice – not to eliminate risk entirely, but to manage it appropriately. In a couple of respects, the Basel III package of reforms to global banking regulation represented a catch-up to where Australia and some other countries already were.

The post-crisis reform program goes well beyond the Basel standards and making banking safer. Far-reaching reforms have also been implemented or proposed in the areas of over-the-counter (OTC) derivatives trading, resolution of failing financial intermediaries, and the so-called ‘shadow banking’ system outside the perimeter of prudential regulation. These are the four areas that Australia has advocated focusing on in its G20 presidency year. (Barry Sterland will have more to say about the G20 regulatory reform agenda later in this session.) There is still some work to do to implement some of these agreed reforms. But the Australian authorities have taken the view that any new initiatives from here cannot really be described as necessary responses to the crisis. The global regulatory community needs to set a high bar for proposals beyond what has already been agreed.

If the Australian authorities have limited appetite for continually adding to the reform program, we have even less appetite for rolling it back. A return to the pre-crisis set-up would be a mistake. Australia went into the crisis with a financial system that was better placed to handle the shocks than some other systems were. But there were some things that could have been better and have since improved. Consumer protection rules now cover a wider range of loan types. Funding structures in banking now better reflect liquidity risks. The authorities have some more effective ways to resolve financial firms if they do fail. And protection for depositors has been strengthened and clarified. Those are just a few examples of the work that has been done in recent years.

The Australian authorities have been actively engaged in developing the post-crisis reforms. In doing so, we have worked to ensure that global reforms can still fit local conditions. We are just one voice among many – and a fairly small one. Even so, our efforts have met with some success. For example, the new Basel liquidity rules needed to be workable in countries like Australia, where there is not much government debt. Partly because of the efforts of the Australian authorities, an option was added to allow banks to meet the Liquidity Coverage Ratio through a committed liquidity facility with the central bank. Several other countries in a similar situation will be using the same approach.

Tailoring global rules for local conditions is a very different thing from ignoring global standards entirely. Walking away from these global reforms is not an option for Australia. Australian financial firms play in a global financial system. They diversify their investor base by tapping global markets. So they need to be able to show that they meet the minimum standards that the global market expects. For banks, that includes the Basel III package. And the Basel III package always contemplated that banking systems that could meet the new capital requirements ahead of the deadline should do so. Other financial firms and infrastructure will also need to meet the global standards relevant to them.

Setting up global regulation takes time and effort. So does complying with new regulation. But harmonising global financial regulatory standards surely benefits firms with business in many countries, compared with the alternative of each country going entirely their own way. I can't help noticing that there has been less attention given to harmonising regulation globally for other industries where the suppliers are also often global firms and the customers are also generally local households and businesses. Pharmaceuticals, household cleaning products and children's toys and car seats are all markets with substantial market shares going to global producers. Safety matters a great deal for all of these products. Yet there is no Basel Committee for cleaning products regulation. We don't have information-sharing arrangements or common rules for over-the-counter medication the way we do for over-the-counter derivatives. Those industries just have to wear the costs of complying with national regulation.

Part of the reason for the difference is that if something does go wrong in one country, there is not the same spillover to other countries, the way there is in finance. Financial regulatory gaps and lapses in other countries can hurt us, as the financial crisis showed. It is in all countries' interests to cooperate on regulatory standards and promoting financial stability. Regulators cooperate for the benefit of the people of their countries, not for the benefit of the regulated firms.

Complying with regulation still does take effort, though, and absorbs resources that could be used for something else. Regulators do need to be mindful about compliance burdens. The regulated entities also need to be alert to inefficiencies in their approaches to compliance. If the imperative to comply with new regulation were to spur a rethink of outmoded business practices or inefficient systems, that could be a good outcome.

With a reform program as extensive as the post-crisis reforms have been, it is natural to wonder if there might be some unintended consequences. In the lead-up to the crisis, it was apparent that, globally, risk was being underpriced. By implication, credit was too easily available. Some of that spilled over to Australia, most notably for business credit, which over 2007 expanded at an annual rate of more than 20 per cent. Even now, it seems that the price of risk has again declined to low levels, though not quite as low as in early 2007. Volatility in financial markets is also quite low at the moment. Some market participants might again have become complacent about the risks they are taking. Policymakers are rightly wary of excessively exuberant credit supply. But at the same time, it would be unfortunate if the post-crisis policy responses had the effect of restricting credit supply too much and of shutting out worthy borrowers.

The text in the conference program introducing this session exemplifies this concern about financing economic activity. Banks, it claimed, are being turned into glorified building societies, lending for mortgages and not much else. I don't think that is a completely accurate characterisation, but it is a claim we should take seriously.

In asking what the post-crisis reform program has meant for particular sectors, we need to be mindful of an important principle: that bank capital should be allocated according to risk. If a particular loan or other asset is riskier, then banks need to hold more capital against that asset than they must hold against a less risky asset. Lending to business is riskier than mortgage lending to households. The US experience has shown that it is possible to have a bad outcome on mortgage lending, even before an economic calamity, rather than as part of one. But the breakdown in lending standards you need to get that kind of an outcome is extreme. The losses on mortgage lending, over decades and across many countries, are simply lower than losses on business lending. Other episodes of losses on mortgage portfolios have generally been the result of an economic downturn, not the cause of it. That is the evidence.

The evidence is also that finance for small business in Australia was not particularly badly hit by the crisis. Bank lending to unincorporated businesses – that is, sole traders and partnerships – held up better than lending to the corporate sector in the post-crisis period. It was the foreign bank branches that, as a group, contracted their lending most. They normally lend to the big end of town, more so than to small business and start-up ventures.

The concerns about availability of finance for small business hark back to some of the complaints one used to hear about banks in the 1970s and 1980s. Banks wouldn't support innovative Australian business, went the story, so those businesses had to move offshore to get funding. When it came down to it, most of the complaints seemed to be about the rotary engine. But underneath it all was a legitimate concern. Start-up businesses, innovation and entrepreneurship are a large part of what society needs to move forward and raise living standards. Yet they are also inherently risky propositions. Many new businesses fail. Their creditors will make losses.

If something is a riskier proposition, lenders ought to hold more capital against the loan than against something safer. That is as it should be. But more than that, maybe that business shouldn't be funded with debt, or at least not entirely so. Such businesses might be better funded by equity-type finance that allows for an unprofitable build-up phase of the business, and that can absorb the anticipated volatility in profit. But that kind of investment isn't a loan, and it isn't the kind of asset that should dominate the balance sheet of a bank.

Remember that banks accept deposits.^[1] There is a huge social value in having some kind of asset that people can trust in, so that value will be there when they come to make payments. As a society, we have decided that private entities should be able to offer such a safe asset. But if their liabilities are to be so safe, and so liquid, they must be regulated and supervised appropriately.^[2] Part of that regulation and supervision is designed to limit the riskiness of the assets backing those deposit liabilities. So rather than looking to banks for loans, perhaps new businesses need finance that looks more like venture capital.

The Bank raised similar issues in its submission to the Financial System Inquiry (RBA 2014). Over the years, there has been a lot of attention given to the level of competition in the residential mortgage market. But as we said in that submission, the supply of mortgage finance is ample. There is no need for new policies that would advantage lending for that purpose.

If there are structural impediments to competition in finance, they are more likely to manifest in small business finance. Unlike larger corporations, small business does not have access to non-intermediated market alternatives, especially global bond markets. There are things that can be done to improve the infrastructure in the capital market. But there will be limits to how much difference this will make for start-up firms. Someone would still have to perform a credit assessment on those firms, and evaluate their business plans. This is costly, bespoke work, where relationship banking provides an information advantage.

So there are some impediments to debt financing of small business, but I doubt that the post-crisis reform program has made them any worse. There is nothing in the Basel III package that makes housing finance relatively more attractive compared with other lending than was already the case in Basel II and before. And those relativities are designed, however imperfectly, to reflect risk. The exact numbers in those risk weightings have changed over time, but the relativities have not.

It should also be remembered that some of the additional conservatism in Australia's prudential framework is precisely in this area. APRA set the local rules to require banks using their own models to hold more capital against housing mortgages than a plain-vanilla version of the Basel standards would require.^[3] Banks in some other countries actually hold much less capital against mortgages than the big banks here do. It could perhaps be argued that Australia should go further and be even more conservative in its treatment of housing finance. That would, of course, make mortgages more expensive and less available than they otherwise would be. Whether and how far to go in this direction is something the Financial System Inquiry may want to examine.

The upshot of all this is that banks have advantages in assessing creditworthiness that financial markets cannot completely replicate. So banks will probably always play an important role in financing small and new businesses. Because they take deposits, though, they need to ensure that their assets are not too risky, and that they hold sufficient capital for the risks they do run. So they probably cannot be the only source of finance for these ventures.

If there is a segment of business finance that is riskier, perhaps much of it should be structured more like equity than debt. It therefore probably needs to come from another class of investor, not prudentially regulated deposit-taking banks. In Australia, the superannuation sector more or less equals the banking system in size. Its asset base includes a lot of equity exposures: it is a sector that clearly can take some investment risk. So some observers naturally wonder if the superannuation sector could be somehow induced to direct its funds in ways that fulfil various social goals and perceived funding needs. But as the Bank pointed out in its submission to the Financial System Inquiry, the goal of the superannuation system is to provide retirement incomes for its beneficiaries. Superannuation assets should be managed in the best interest of fund members. Their allocation should not be distorted in pursuit of other ends.

The availability of appropriately structured finance is an important issue for the Financial System Inquiry to consider. The committee will be releasing an interim report in coming weeks. I don't want to speculate on what that report contains, or make suggestions for what it should contain, given that the text has presumably already been finalised. If I look back at the Bank's submission, though, I see a few other themes that I hope the Inquiry has examined further. One important issue relates to Australia's superannuation system, namely its cost and pricing. Analysis from several sources suggests that at least some parts of the sector incur costs and charge fees that are quite high compared with other countries. There is no social benefit to paying more for the same funds management services. Every dollar that is paid in fees to trustees, fund managers and all the other layers of the industry is a dollar that is not going into Australians' retirement savings. I'm pleased to see that Treasury has recently taken up that particular issue.^[4]

To conclude, public policy needs to ensure that the stability and safety of the financial system meet society's actual expectations. It also needs to ensure that this stability is not at the expense of the innovation and entrepreneurship that can raise living standards. The objective is not to eliminate all risk. But those risks need to be structured in ways that limit the chance of a systemically bad outcome. They also need to be allocated to those parties best able to bear them. In large part, that is what the post-crisis reform program has been designed to do.

Thank you for your time.

Endnotes

Throughout this speech, I use the term ‘bank’ to include any institution engaged in banking business, specifically deposit-taking. In Australia, authorised deposit-taking institutions include credit unions and building societies as well as institutions that are actually called banks, but to keep things simple I use ‘bank’ to refer to all of them. [1]

They also need to have access to central bank liquidity. For more discussion of this, see Debelle (2011) and Ellis (2013). [2]

I have discussed this previously in Ellis (2013). See also RBA (2014), Box 6A. [3]

See Gruen (2014). [4]

Bibliography

Debelle G (2011), ‘Collateral, Funding and Liquidity’, Address to Conference on Systemic Risk, Basel III, Financial Stability and Regulation, Sydney, 28 June.

Ellis L (2013), ‘Stability, Efficiency, Diversity: Implications for the Financial Sector and Policy’, Paul Woolley Centre for the Study of Capital Market Dysfunctionality Conference, Sydney, 18 October.

Gruen D (2014), ‘Towards an Efficient and Stable Financial System’, CEDA State of the Nation 2014 , Canberra, 23 June. Available at <http://www.treasury.gov.au/PublicationsAndMedia/Speeches/2014/Towards-an-efficient-and-stable-financial-system>.

RBA (2014), ‘Submission to the Financial System Inquiry’, March.