Obama's Plan For a Banking Catastrophe | BTalk

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Peter Swan

(Episode 422; 17 minutes 21) This week we heard of the US government's plan to ban proprietary trading by retail banks and moves to limit the size of banks. It's a move to protect customers and taxpayers from unnecessary risk.

On today's BTalk Peter Swan talks about the irony of Barack Obama's apparent focus on bank customers when his bail-outs have been in the interest of banking shareholders. He should have let them go to the wall is Swan's view. The result is a sector prepared to take high risk with the assumption that taxpayers will bail them out in times of trouble. Well, it's happened before!

Prof. Peter Swan, from the Australian School of Business, says the Obama proposal is poorly thought out populism that will have do nothing to reduce risk taking by the banks, but it will hit liquidity. He also questions why he is taking aim at deposit-taking institutions when there's no evidence of retail bank collapses caused by trading with customer funds.

Hear Peter Swan's views in today's podcast. Click on the play button on the player at the top of this post.

• Transcript

Phil Dobbie: Hello, I'm Phil Dobbie, welcome to BTALK. Today, the Obama Bank Plan, an effective way to rein in the unrealistic risk taking of the banking sector or just a bit of populism to defect his flagging performance in the opinion polls? That's today.
Well, as we know Barack Obama is set to take on the banks in the United States, intending to limit their size or their market share and their trading operations. Retail banks won't be able to run high risk hedge funds or private equity funds. Instead, they'll be expected to have more of a focus on their consumers, or their customers, while they're reducing their risk. Professor Peter Swan from the Australian School of Business says Obama's assault on the banks is counterproductive and he's on the line now. Now Peter Swan, he has to do something doesn't he? The banks are taking risks and getting bailed out if they fail. They're bound to treat risk with less caution than the rest of us aren't they?
Peter Swan: That's the fault of both the former President and Obama. Basically, the buck stop is not with the politicians like Obama, but this stops with the shareholders. Now in other words, the shareholders are there to monitor their investments and to make sure that management performs for shareholders. Now we've had both republicans and the democrats systematically pull the cart from under the capitalist system, we're much closer to a purely socialistic system where the tax payer is actually the bunny here who's forced to step in to bail out non-performing management. The reason they're forced to step in is because the government has literally left the shareholders in place and subsidised their poor management of the executives.
Dobbie: There's another party of course as well. We've got the tax payers, we've got the shareholders, we've also got the bank's customers as well.
Swan: That's right. And shareholders know that happy customers make for successful performance. And, the way this works is that banks make all sorts of investments. And perhaps the most critical one from Obama's point of view is that they pursue investments which appear to be unrelated to their customers. That is they trade on behalf of the house. Now those house trades, which Obama plans to ban, in many cases are actually there to assist the growth of the bank by helping customers and providing liquidity in periods like the recent crisis where liquidity is most required.

Dobbie: Now you're still going to be able to trade obviously if you're an investment banker. He's only banning it for retail banks. And with retail banks, surely the customer who might be saving money to buy a house, for example, is going to feel happier that their money is being used for safer purposes rather than risky investments.
Swan: Yes, there's probably a finer distinction between retail banks and investment banks. And I think that many of so-called investment banks were forced probably to accept money from the bailouts actually fell under this regulatory system that applies to so-called retail banks. So any bank that accepts any form of deposit is classified as a retail bank whether that's a minor or major part of their business.

Dobbie: Isn't it going to be easier to regulate though if we have a clearer distinction? As you say, the waters are a bit muddier. If we had a clearer distinction it might be easier to see where the risk sits within the industry, if indeed the industry needs any more control. I'm sensing that you're thinking well hang on a second, why do we need to control it? The free market should be allowed to run its course in banking.
Swan: For a long time, in fact for hundreds of years, governments have tended to protect depositors in banks, particularly to say retail banks. Now that the governments have stepped up to the mark not to protect depositors but to protect shareholders, the whole edifice of the capitalist system is under threat from governments. And the implication of protecting shareholders is the ultimate one, the path down which Obama is proceeding, where everything is actually owned and controlled by governments. And where private enterprise has very little if any role.

Dobbie: Right, but forgetting about those bailouts and just looking towards his plan now, it looks as though he has gotten more of a focus on the customer, hasn't he? He's saying that we want to protect you from high risk investments or at the very least, if a bank makes a high risk investment with money that you've given to us to look after, you at least get some payback on that investment, rather than seeing that money disappearing in high profits and high executive salaries.
Swan: These accounts run by the banks, in-house investments, are technically being made using shareholders' funds, not depositors funds. The returns, if they're successful, go to the shareholders and if they're unsuccessful then the shareholders bear the losses. And this is how the system operates.

Obviously banks can, and many of them do, run over long periods of time successful in-house investments of this kind --- not then collapse because of rouge traders or something. Then this indirectly benefits their customers. And many of these customers directly actually benefit from these kinds of investments that increase liquidity.

So we're not talking here about just moms and dads investors. We're talking about large businesses that have lots and lots of different relationships with banks. And when these large businesses need intervention to improve liquidity, they would like the bank to step in and take the other side of their orders through a principle kind of transaction. This requires the banks to operate using their house accounts so that the customers directly, the depositors, aren't at risk.

Dobbie: What about this other plan within Obama's vision that banks shouldn't get too big? I guess here what he's saying is that if we limit your ability to grow in size or take more market share, then you're going to take less risks because there's less reward at the end of the day. That makes a bit of sense doesn't it?
Swan: Actually, it wasn't deposit taking institutions at all that was associated with the sub cost. And it wasn't so much that Lehman's became too big or they were too big, but because they were making investments and taking on huge levels of debt, which were massively understated in their books.

They were too big and the regulators did the right thing in letting the shareholders of Lehman's take the can. But unfortunately, they didn't for the largest insurer and for Citibank and these other institutions. And once you start bailing out the shareholders, why don't you dictate all banks being minuscule in size so that if there is a failure, it'll be very, very small. So you go down this slippery slope of trying to control every aspect of the bank, in other words you are forced to become basically something along the lines of the Soviet Union. Which isn't the way that part of the shareholders and the depositors are going to benefit.
Dobbie: But 20 banks will be less of a risk to the economy than 10 banks though, wouldn't it?
Swan: You can look at Australia. Australia has a much more concentrated system than any other country in the world, we've basically only got four banks under the four pillars. And these four banks actually have the highest safety rankings in the world. And they also pursue many of these policies based around principle trades and investments which aren't directly customer focused. And they do it very successfully on the whole. So there's nothing wrong with size per se. What's important is that these banks be well run and monitored by shareholders.

Dobbie: So what do you think? Clearly you think the bailout was a bad idea. You think some of the banks should have gone to the wall, there should've been some hurt felt? If that had happened, do you think there'd be less need for Obama to be looking at any intervention at all?
Swan: If he'd let AIG, one of the world's most regulated insurers, not even a bank, go to the wall or if he'd let Citibank or any of these other banks go to the wall, he wouldn't have to be intervening now at all because shareholders would've learnt their lesson. There would have been a natural splitting up of the size. But the assets would have gone to debt holders and other forms of deposits as they should have. And we wouldn't have the existing, very bad management in place. So none of what Obama is attempting to do would be necessary. In other words, all these problems are of his own making and those of his predecessors. But once you've gone down the path of taking over the role of shareholder, where do you stop.

Dobbie: He did before, who's to say he won't do it again for us, thank you very much Mister President.
Swan: Shareholders now expect to be bailed out on all occasions. So they will be saying to management, take risks and become as big and profitable as you can because we're not worried, we don't care what you do, we're not even going to read your ludicrous annual reports because we don't believe them. Because we know that the tax payer will step in to bail us out, so this is a situation of capitalising your profits and socialising your losses. Something that third-world countries have done for a millennium and that's why they are third world and third rate because of these kinds of policies. But it doesn't mean that the world's most successful capitalistic nation has to turn itself into a third-world nation.

Dobbie: The share marketing took a bit of a hit obviously, the banking chairs, but the broader share market took a hit with the announcement of the news --- that's obviously a reaction. Is there likely to be a more far-reaching impact if the bank's ability to trade is restricted so heavily?
Swan: Yes, there will be an enormous reaction. The combination of less shareholder monitoring, the implicit subsidy to high risk taking and the inability of banks to intervene to provide liquidity where they take the risk, they take the risk when they take the other side of large client trade. So they aren't concerned with the individual profitability of these deals. They're concerned with their whole of business operations. So if your client's generating what's lots of fee income, for example, then when the customers are really in need, when the liquidity is lacking, when trades can't go through because of fears of collapse or something like that, then the bank uses its own capital to take the other side and make markets operate in periods when they wouldn't otherwise operate. So basically Obama's operating on every lever he can to make another world crisis, but 10 times greater than the one we've experienced, happen in future.

Dobbie: That trade, as I said earlier, will still be able to happen, won't it? It's just banks not taking deposits. I'd assume that banks are just going to restructure themselves aren't they?
Swan: I agree. The one reaction to all this is that banks will restructure. But none of these losses have been due to banks trading on their own accounts. As far as I'm aware, none of the losses of the retail banks or collapse of retail banks are due to that. Their losses are due to providing huge mortgages on real estate when those real estate prices have collapsed. In other words they're entirely customer focused. And so this is just a reaction to the loss of the unlosable Teddy Kennedy seat, the collapse of these policies on global warming and he's increasingly weak hold on the Senate. It's purely a populist poliy.

Dobbie: Right, that's what I was going to say, just a bit of populism. So the fact that this being a reaction from the banking sector and politicians in Europe who seem to say they welcome it. Do you think there's a bit of self interest from Europe? They're saying because of course in Europe they did a lot of bailing out for the banks themselves. But do you think there's a bit of self interest there? They're just saying, sure limit the size of your banks, no problem, all the more opportunity for us?
Swan: As long as they aren't stupid enough to copy these regulations. Because once you're part of the deposit-taking banks, if that's a successful popularist move to restore Obama's hopeless rankings in the poll, then he'll extend it to the non-depositing-taking banks. And then extend it to every business in America. You'll say well I know better than you in what's your customers' interest and I'll regulate you to force you to operate in what my view of what your customers' interest and not what the shareholders and the customers themselves think. So certainly as long as Mister Rudd doesn't copy his policies here, it's a great opportunity for the Australian banks, which are now some of the largest in the world and the safest because we've had a very good regulatory system here in this country. And so once again, Europe might become a lot more competitive if Obama could successfully kill off American enterprise.

That would be some self interest. Just as the Europeans are very determined to impose controls on carbon because Europe is very carbon poor, countries like Australia and the US are very carbon rich. Our success depends on carbon. So they are very self-interested policies to wipe out their economies.

Dobbie: You've got a lot of mistrust for politicians, Peter Swan. But I think that's something you've got in common with the rest of us. Appreciate your time today, thank you for talking to us.
Swan: OK, thanks Phil.

Dobbie: Professor Peter Swan. Now no one can accuse him of sitting on the fence, can they? Obama's bank path, nil poi as far as he's concerned.