Brian Fallow: Banking on Australia can’t add up

Michael Cullen is suspected of being willing to outsource the supervision of New Zealand's banks to the Australians.

He should drive the thought from his mind with blows and curses.

He protests that no commitment to a single regulator has been made and that transtasman talks on banking supervision are "an open-ended exercise with no predefined end point".

But somehow one is not reassured. The big Aussie banks control 85 per cent of the sector here. They may like the idea of having one less regulator to deal with, but owners are not the only stakeholders in a bank. The interests of its borrowers, depositors, suppliers of wholesale funding, employees and fellow-taxpayers also matter.

The economy's need for a functioning banking system in the wake of a crisis matters too.

So here are six reasons to regard handing over the supervision of our banks to the Australian Prudential Regulation Authority (Apra) as a profoundly bad idea - one for every Australian state, which New Zealand after all is not.

Reason No 1: Apra is worse.

The Apra model of regulation is inferior to the one we already have.

It is not just that, by all accounts, it is heavy-handed and costly.

It is the kind of behind-closed-doors oversight that New Zealand abandoned years ago.

It reinforces incentives the banks already have to conceal problems.

Professor Ed Kane of Boston College, an American expert on banking regulation who has just spent a couple of months studying the New Zealand system, prefers it to the Australian kind.

The New Zealand model is based on public disclosure and attestation. It puts the onus on directors, who have to sign off the quarterly disclosure statements "after due inquiry", to tell the Reserve Bank if problems are developing. Their reputations are at stake.

By contrast under the Apra model, the regulators are supposed to find the problem. It is an inherently more adversarial relationship, a game of cat and mouse or hide the cheese, Kane says.

One of the reasons former governor Don Brash gave for introducing the disclosure-based regime was to avoid the situation where the central bank as regulator found something untoward in a bank's books and then faced the dilemma of either publicly expressing concern, making the situation worse, or remaining silent and to some degree complicit if the situation deteriorated.

If the public believes the regulators' silence signifies consent that can create an expectation that the central bank and, therefore, the taxpayer has to stand behind a failing bank, because it had failed to blow the whistle earlier. The New Zealand regime avoids that "moral hazard".

Part of the attraction of outsourcing regulation to Apra seems to be that it also oversees non-bank financial institutions.

Finance companies are virtually unregulated in New Zealand and there are concerns about some such institutions that are heavily exposed to the property market. But deficient regulation of one sector is hardly an argument for moving to inferior regulation of another.

Reason No 2: The absentee landlord effect

One of the concerns about moves towards a more seamless and integrated banking market between New Zealand and Australia is the hollowing out of banks here.

That is not just a matter of back-office processing. It is a question of where decisions are made about whether a customer gets a loan.

The desire of Australian banks to run their New Zealand subsidiaries like branch operations in any Australian state, understandable as it may be, increases the chances that for larger corporate borrowers those credit decisions will be made in Sydney or Melbourne.

The discretion will lie with bankers with whom they do not have a personal relationship and who may have an imperfect understanding of New Zealand conditions.

Sometimes, in contrast to the old saying, distance lends disenchantment to the view.

Reason No 3: Risk to the fisc.

Australian banks already have an incentive to book profits in Australia rather than New Zealand, because the company tax rate is lower and they can distribute imputation credits to more of their shareholders.

Financial services firms make up a hefty proportion of the corporate tax take - though not as big as it ought to be in the Inland Revenue's view. Most of the Australian-owned banks are in strife with the IRD over aggressive use of the rules structured finance transactions. Hundreds of millions of dollars are at stake.

After his meeting with Treasurer Peter Costello last month, Cullen was asked if there was a risk that moving to a single transtasman banking regulator might reduce tax revenue. "Not necessarily," he said. It depends on the "arrangements between the Australia and New Zealand elements of that banking system".

The semantics of that response are ominous. We are not talking about elements of a single banking system but national boundaries between tax jurisdictions. Where a bank chief executive might see a "seam" to be removed, you might expect Cullen, as Minister of Revenue, to see material risk of a lower tax take.

Reason No 4: It's not future-proof.

The call for a single regulator is predicated on the Australians owning 85 per cent of our banking industry.

That is testament to the openness of the market here. In Australia, however, an offshore bank wanting to take over an Australian one would have to satisfy the Treasurer it was in Australia's national interest for it to do so. But if an Australian parent bank were swallowed up by a larger global one - HSBC or Citibank, say - we could end up with a New Zealand bank that was ultimately owned by a British or American one but regulated by the Australians.

Reason No 5: Can you trust them in a crisis?

The Reserve Bank has put a lot of effort lately into strengthening arrangements to ensure that the New Zealand subsidiary of an Australian bank could function on a standalone basis if its parent got into trouble.

Such a crisis would be the acid test of any regulatory regime. The risk is that a troubled Australian bank might drain capital from its New Zealand operation.

"It's so easy to move money across the Tasman and locate the losses in New Zealand and the money in Australia," said Kane.

Even if it proved impossible to quarantine a New Zealand bank from the failure of its parent, how robust can any guarantees of equal treatment of New Zealand depositors and other creditors be?

Costello held out the prospect of extending Australian depositor protection to New Zealanders as well, as an inducement to go for a single regulator. But giving local depositors preference over offshore creditors might not be terribly smart. New Zealand runs chronic and large balance of payments deficits and remains dependent on foreigners' savings to fund the shortfall. Much of that is intermediated through the banking system.

A change that would worsen the position of the overseas providers of that funding is liable to increase the country risk premium that already keeps our interest rates systematically higher than most other developed countries.

Reason No 6: It ain't broke.

Officials for the Treasury, Reserve Bank and Ministry of Economic Development have advised against the single regulator.

And, having canvassed views within the industry, they concluded that seamless regulation was not a priority for the banks.

The larger picture seems to be a sense that after more than 20 years of closer economic relations the trans-tasman relationship is drifting. It needs to be re-energised.

Hence the call for a "Single Economic Market". But how to give that slogan content and meaning? Because tax harmonisation and currency union are off the table, the temptation may be to "do" banking supervision because hardly anyone cares about it. But by the time they do, it may be too late.