1. Basel 3, Financial Regulation Reform and Implications for Australian Banks Professor Kevin Davis Research Director, Australian Centre for Financial Studies

2. A recipe for disaster? Create organizations which –Invest in assets which are non-marketable and hard to value –Are very highly levered, and allow creditors to withdraw funds at call –Are opaque – difficult for outsiders (or even insiders) to understand value and risk –Reduce the level of regulation they are subject to, particularly when technology is making the business more complex and risky

3. And it came to pass!

4. The GFC prompted a “Belts and Braces” Response Unfreeze/restore liquidity Shore up public confidence Bail-outs Failure management Temporary regulations Macro-economic stimuli Regulatory forbearance And then:

5. The GFC experience prompted A Global regulatory agenda (Basel, IOSCO, FSB, G20) And national agendas UK, EC,USA etc Shift in views on working of financial markets A “grand vision” or “tinkering at the edges”? –What are the aggregate effects of plethora of changes?

6. Problems and Responses: The Global Agenda

7. National/Regional Responses UK Retail Ring-fencing proposal –limiting implicit government guarantees –Reducing spillovers Higher Loss Absorbency (Capital) Depositor Preference Bail-in powers Europe Tobin Tax proposal Remuneration D-SIBs (“Too big to Swallow”) USA Dodd-Frank Act

8. A Changing Paradigm? Applicability of Econ 101 model of market efficiency to financial markets? Slapped in the Face by the Invisible Hand: Banking and the Panic of 2007

9. A Changing Paradigm? Recognition of importance of network externalities (adaptive systems)

10. A Changing Paradigm? Questioning of merits of larger financial sector –Not new..we are throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to their social productivity. JAMES TOBIN (1984) – Nobel Laureate, Economics Questioning of merits of increasing complexity of regulation

11. Australian responses Financial sector emerged relatively unscathed from GFC (luck, management, supervision) –Apart from non-regulated sector failures, securitization freeze, stock prices! But lets not kid ourselves –There was massive government/ regulator/ taxpayer support Wholesale debt guarantee subsidy Deposit insurance and implicit guarantees Expansion of RBA liquidity facilities RBA-US Fed FX Swaps

12. Local Regulatory Agenda FOFA Competitive and Sustainable Banking System Insolvency reforms MySuper National Consumer Credit Protection Equity Market Trading Reforms “If not why not” disclosure OTC derivatives & CCCPs Superstream Short form PDS & prospectus Covered Bonds Managed Investments Act review LAGIC Disability Insurance National Disaster Insurance Scheme Financial Market Infrastructure Price Signaling Superfund Prudential Standards Financial Claims Scheme

13. But banking regulation…. Much of the wide-ranging regulatory agenda affects banks, but: “If it ain’t broke don’t fix it” attitude prevails Can it work better? Might it break in the future?

14. Australian Bank Regulation Implement Basel 3 –Continued “tougher” bank capital requirements – what is the cost? –Liquidity requirements (LCR and NSFR) RBA committed liquidity facility Impacts on deposit markets and pricing Enhanced resolution and failure management powers for APRA “Living will” requirements Potentially - Central Clearing Counterparties (CCPs) for OTC derivatives trading?

15. The Unresolved Issues Banking (whole of financial) sector competition –Major banks dominate “financial sector supply chain” D-SIBs “too big to swallow” – and have similar exposures – systemic issues Designing policy for a world of implicit guarantees –Did we ever believe that big banks weren’t guaranteed? Charging for explicit guarantees (Financial Claims Scheme)

16. Possible Responses Retail Ring-Fencing a la UK –Reduce risk of “utility” banking, reduce spillovers, limit implicit guarantees “Volcker rule” a la US –Separate trading activities from banking

17. Possible Responses Higher capital ratios (including contingent capital) for D-SIBS (or special taxes!) “Bail-in-able” debt Charging for deposit insurance “Nudge” bank management incentives –Remuneration, director liabilities More generally – “Tobin tax” Happening overseas - reduced power of financial oligarchy to stymie change (failures, scandals (LIBOR, AML, “the whale” etc))

18. Consequences? Banks and “shadow banks” –Savings and investments institutions where should govt. protection stop? –Trading and dealing If banks don’t do it, others will –just shifting source of potential problems? Banks and capital markets –Strong incentives for growth of capital markets for funding (and as outlet for savings) Optimal size of financial sector –It may be smaller?

19. Conclusion “You never let a serious crisis go to waste. And what I mean by that it's an opportunity to do things you think you could not do before. “ Rahm Emanuel Have we? Or have we done lots of things without fully thinking through the consequences? A “Son of Wallis” Inquiry warranted –Stocktake of costs/benefits and consistency of recent regulatory changes –Assessment of consequences of distortions caused by tax, guarantees, compulsion –Consider how D-SIBS should be treated