It’s the system – stupid!

  • By Pat McConnell

One could almost hear the penny drop in a speech reflecting on the 10th anniversary of the GFC by Reserve Bank of Australia deputy governor Guy Debelle.  

In the speech, Debelle, remarked that, while the similarity of the business models of the Australian banks was probably [interesting use of this word] beneficial in the GFC, “their similar behaviour and similar reaction functions to events such as falling house prices run the risk of amplifying the downturn in the housing market”.

Some commentators talked about the banks behaving as a ‘pack’.

At some point, Debelle must have mused on whether the ‘similar behaviour’ may have contributed to rising prices (and risks) during the now-receding housing boom.

And watching the royal commission, the deputy governor may have wondered whether ‘similar behaviour’ could have led to the big banks operating as a wolfpack when: duding customers over fees for no service; selling unsuitable insurance products; approving loans that were unsustainable; and lying to or disregarding the regulators.

Debelle may also have looked at the BBSW and foreign exchange manipulation scandals and the daddy of them all, the New Zealand Tax Avoidance scandal, as examples of the largest Australian banks hunting in packs.

Fleecing borrowers, herding and groupthink

The ACCC didn’t make Debelle’s sleep any easier when it produced a report last week that said the major banks had behaved like a pack of hyenas by synchronising “their significant increases to interest-only rates … at a significant cost to those borrowers”, in short, fleecing all interest-only borrowers.

But there again, uber-economist Debelle may have pushed such heretical thoughts out of his mind. OMG - what if those crazy behavioural economists were right all along?

The realisation that banks exhibit ‘herding’ behaviour is hardly news. Anyone, certainly someone as well-read as the DG of the RBA, would have encountered similar observations by other banking regulators.

Some commentators talked about the banks behaving as a ‘pack’.

For example, the official Nyberg Inquiry into the Irish Banking collapse found frequent “behaviour exhibiting bandwagon effects both between institutions (“herding”) and within them (“groupthink”), reinforced by a widespread international belief in the efficiency of financial markets”.

Sounds familiar?

Herding amongst financial institutions in the USA was apparent prior to the GFC when banks jumped on the CDO [collateralised debt obligation] bandwagon, loading up on securities they didn’t understand, as a result of ‘fear of missing out’ (FOMO).

In the UK, most of the country’s biggest banks jumped on the Payment Protection Insurance craze which has cost the UK banks over $70 billion in remediation so far.

Systemic operational risks

The raft of instances of misconduct across the banks that appeared in the royal commission relate to what, in international Basel regulation, is known as ‘Operational Risk’ (OR) or what some CEOs call ‘non-financial risk’.

In Australia, operational risk is regulated by APRA and banks must report on their Operational Risk Management (ORM) processes in the so-called Pillar 3 quarterly risk report.

The largest banks are required to follow a so-called Advanced Management Approach (AMA) to managing OR and a bank’s AMA must be approved by APRA. So, APRA must be held at least partially accountable for its failure to ensure banks properly managed their operational risks.

Where a bank loses money due to a failure to manage operational risk, the loss is known as an ‘Operational Risk Event’ (ORE) and banks are required to build a database of all ORE’s (above a certain value) which is then used to calculate the Operational Risk Capital (ORC) required for the bank to meet Basel’s minimum capital requirements.

For example, the $700 million fine of CBA by AUSTRAC would be an ORE under the classifications: ‘Clients, Products & Business’ (CPBP) and ‘Money Laundering’. This particular ORE is ‘idiosyncratic’ or specific to just one firm, here CBA.

Where the same loss events are incurred by multiple banks across the system, they are known as Systemic Operational Risk Events or SOREs. Examples of such SOREs in Australia would be the market manipulation scandals and the NZ Tax Avoidance scandal where the big four banks were fined a total of over $1.7 billion in 2009.

The raft of instances of misconduct across the banks that appeared in the royal commission are… known as operational risk or what some CEOs call ‘non-financial risk’.

Regulating systemic operational risks

Who regulates systemic operational risks?

The short (and unfortunately also long) answer to this important question is NO ONE!

In Australia, regulation of systemic risks is based on the assumption, beloved of economist such as  Debelle, that markets WILL regulate themselves. With efficient markets, complete information and perfect competition, firms that misbehave will be punished by the market. As a result, it is obvious that there is no need to regulate the bad behaviour that seeps insidiously across a market.

In a brilliant book with a very silly title, ‘Phishing for Phools’, two Nobel prizewinning economists, Robert Shiller and George Akerlof, explain why these assumptions are often wrong.  Following the economic dictum of ‘bad money drives out good, they show how ‘bad behaviour drives out good’.

In February, the Hayne Royal Commission will hand down its Final Report and will undoubtedly make far-reaching recommendations on reforming the banking industry and its regulators.

Given that the commission has found ample evidence of misconduct across the system, it must be hoped that they recommend a new level of systemic regulation, whether independent of existing regulators or embedded in a separate regulator, such as the RBA, adding another Peak to the existing Twin Peaks.