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Bank Rip-Offs Revealed - Click
for Video
Prior to the deregulation of the Australian Banking industry in the 1980’s, the amount of money which Australian Banks could loan out was limited by regulation as up to 30% of their assets had to be held between:
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the Liquid Assets and Government Securities (LGS) requirement, whereby 18% of banks' assets had to be held in either cash or government securities; and
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the Statutory Reserve Deposit (SRD) requirement, which obliged the banks to have between 5% to 12% of their assets on deposit with the Reserve Bank.
The LGS was used as a liquidity requirement as a safeguard in the event of a bank run - that is to say where a significant number of depositors seek to withdraw their savings simultaneously due to lack of confidence or the fear of a bank collapse.
The SRD was used by the government to restrict the amount of money which the banks could lend out. By lowering the SRD, the banks could lend more out and raising it would restrict the amount they could lend out.
Both of these together formed the Prime Assets Requirement, or Prime Assets Ratio (PAR).
Banks could only create so many loans (or assets) on their balance sheets, as they were restricted not only by the high PAR requirement but also by the amount of liabilities they had, that is, the amount of depositors’ money.
However, since deregulation, banks have been able to build their loan books (and hence profits) at an unprecedented rate for the following reasons:
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the SRD requirement has been entirely dropped
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the overall PAR requirement has dropped by 2/3 rds since the late 1980’s; and most importantly
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banks are not longer limited by the amount of money they are holding as deposits to create new loans. They can now go out and create billions of dollars in new loans (assets), and then go and simply purchase the funds in the wholesale financial markets to prop up their balance sheets (liabilities).
Thus, banking has not only become far more profitable for the banks, but also far, far riskier. We’ll expand upon points 1 and 2, and then point 3 to explain why.
1. & 2. – Decline of Prime Asset Requirement
The following table is sourced from APRA data and shows a sample of the PAR ratios as a percentage of Australian Bank assets from end Dec. 1988 through end Dec. 2000:
|
Date |
Prime Asset Ratio |
|
31-Dec-1988 |
12.4% |
|
31-Dec-1992 |
7.9% |
|
31-Dec-1999 |
5.7% |
|
31-Dec-2000 |
3.3% |
As we can see, it’s been dropping like a rock. The PAR was originally a risk management tool. Specific ratios were imposed upon commercial banks by the government via the Reserve Bank to ensure sufficient bank liquidity.
However, since deregulation, risk management has shifted from being primarily government imposed to "self-managed", that is the banks are now responsible for their own risk management systems.
In the early days of deregulation, a number of banks failed largely because of poor credit risk management. They had not evolved adequate risk management systems quickly enough after deregulation to hedge against the inherent risks. Amongst the failures were the state banks of South Australia (1992) costing the hardworking taxpayers of that state $4 billion, and the State Bank of Victoria, the 5th largest bank in the country which bit the dust in 1991, costing Victorian tax payers $3 billion at the time.
Of course now, the banks claim they have a better handle on it and are able to adequately manage the risks inherent in their desire to create more and more credit, and thus profits. How have they done this? The answer is largely via the use of derivative financial instruments such swaps, options, futures, and forwards. These are highly specialised financial contracts with the aim of transferring risk from one institution to another who is prepared to bear the risk in exchange for a price. These instruments often do not even appear on a bank’s balance sheet. Warren Buffett, founder of Berkshire Hathaway and often hailed as the world’s no. 1 share investor, warned in an article in March 2003 of the precarious state of international finance due to the proliferation of these instruments. It’s like building a house of cards – if the institution to whom you think you have transferred the risk fails, you’re left holding the bag. If this in turn causes your bank to fail, and you have hedged the risks of others… what is the end result? Global financial meltdown?
3. Purchase of Liabilities
As stated, Australian Banks are no longer limited by the amount of money they are holding as deposits to create new loans. They can go out and create millions of dollars in new loans (assets), and then go and purchase the funds they need in the wholesale financial markets to prop up their balance sheets (liabilities).
This means they can now can grow their loan books at an unprecedented rate.
Prior to deregulation, about 90% of banks' liabilities were made up of customer deposits. This ratio fell to 60% by the mid 90's, and has likely dropped like a bomb more recently, compounded by the very low rates of interest paid for depositors' money and the bank's appetite to lend big and continue to fuel the housing bubble (making it all the harder for the average Australian to afford a home).
Why should they pay reasonable rates of deposit? They don’t really need depositors' money now. After all, the banks can now go out and borrow in the domestic and international financial market places to enable them to create new loans. But again, there is inherent risk in this as offshore capital is extremely vulnerable to trading and currency fluctuations. The banks of course will claim they have derivative cover to hedge against these risks.
Management’s over-confidence in the bullet-proof nature of their expansion strategies has only too often been proven by history to have been misplaced. We are only too aware of what has happened just recently to the AMP in what are "stable" economic times.
We hope for the Banks sake and ours that Warren Buffett’s prediction of a derivative based financial time-bomb is unfounded.
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