The Royal Commission into Banking Final Report (RC Report) which was released by the Federal Government this week was a complete whitewash.
The report, submitted by Commissioner Kenneth Hayne to the Governor-General, offered the Morrison Government 76 recommendations that sought to address issues ranging from criminal misconduct to flawed operational practices spanning:
institutional culture, governance and remuneration; as well as
the conduct of key financial market and banking regulators – i.e. the Australian Securities and Investments Commission (ASIC) and the Australian Prudential Regulation Authority (APRA).
As noted by many stakeholder groups ranging from bank victims, consumer groups and the media, the RC Report’s recommendations were very underwhelming as they did not seek to address underlying problems in the banking and financial sector or their root causes through fundamental reform.
From an economic perspective, the RC Report made no recognition that bank lending practices have played a crucial role in inflating asset prices such as property prices to astronomical levels by allowing Australian households to obtain loans without proper scrutiny of the customer’s circumstances, such as their income and living expenses.
In several instances, Australian households who were awarded a mortgage, did not have the sufficient financial capacity to meet their mortgage obligations as well as existing living expenses, given their income levels.
Moreover, the RC Report did not acknowledge that these practices combined with other bank innovations and public policy measures such as:
record low official interest rates (set the Reserve Bank of Australia and other international central banks); and
generous tax and cash incentives (such as the negative gearing and the first home owners’ grant)
have been pivotal to the build-up of the biggest financial debt bubble in Australian history.
The failure to acknowledge the macroeconomic impact of existing bank and financial institutional practices is material.
In several historical examples of financial debt bubbles that have led to catastrophic economic outcomes such as the 1931 Great Depression, the 2001 Dot-Com Crash and the 2007-2008 Global Financial Crisis, one recurring factor was the existence of financial fraud.
Therefore, the RC Report’s recommendations should have been crafted with the view to acknowledging and addressing the macroeconomic structural imbalances that bank lending practices assisted in creating, rather than just purely from a legal compliance and community expectation perspective.
The RC Report Did Not Change Anything
In the context of Australia’s debt and property market bubble, several aspects of the RC Report were both baffling and concerning. These included:
1. Household Expenditure Measurement (HEM) – The RC Report did not provide any strong recommendations about the use of the benchmarks such as the HEM, which have been instrumental in banks significantly underestimating the living expenses of loan applicants and therefore awarding loans to customers that did not meet the legal criteria for responsible lending.
The Commissioner noted that in light of the Royal Commission hearings, Australian banks were reducing the use of the HEM (including its fraudulent application) as part of amendments to their loan verification practices.
However, given the lack of strong recommendations on such benchmarks, how can the public have confidence that banks and financial institutions don’t go back to their old practices when the dust settles and the pressure of generating shareholder returns come back?
2. Mortgage Brokers – The RC Report called for the ending of trailing and upfront commissions for mortgage brokers, however from an economic perspective, mortgage brokers are only one distribution channel for the issuance of credit into the economy.
If the RC Report is effective in shutting this distribution channel off, economic policy makers such as the Reserve Bank of Australia (RBA) as well as financial institutions (i.e. banks and non-bank financial institutions (i.e. shadow banks)) will still be able to increase the amount of credit flowing in the economy through other channels such as the traditional bank branch model.
Given that bank employees are still required to meet aggressive mortgage and other debt product sales targets, the issuance of credit and therefore the growth of the debt bubble can continue unabated.
3. New Regulatory Oversight Body – the RC Report recommended that the Federal Government establish a new regulatory oversight body to oversee the performance of ASIC and APRA given their poor performance in regulatory enforcement that facilitated criminal misconduct and poor operational practices to flourish.
However, the key question to ask regarding this new oversight body is who will staff such an organisation? Who will have the requisite expertise? It is likely that a former bank/financial institution executive (i.e. a member of the banker club) will be appointed to lead such a body on the grounds that they have a deep understanding of the issues that ASIC and APRA are seeking to regulate.
In such an instance, there is a high risk that such an oversight body may fall victim to ‘regulatory capture’ similar to what has already happened with ASIC and APRA.
4. Structural Separation – Despite ample evidence that the Big 4 banks, in particular, are ‘too big to fail’ (resulting from horizontal and vertical integration), the RC Report rejected any suggestion that financial institutions should be broken up along product or advice categories.
In doing so, the RC Report has reinforced ‘moral hazard’ within Australia’s large banks as the risk of failure has effectively been eliminated given that Parliament, the RBA and APRA will seek to rescue ‘too big to fail’ financial institutions under any circumstances in order to prevent a systemic economic collapse from occurring.
Knowing this means that the industry will be immune from market discipline likely resulting in greater financial risks being taken in chasing profits, including possibly ignoring (again) existing legal requirements and community expectations.
This will, in turn, increase Australian systemic macroeconomic risk.
Economic Impact of the RC Report
Given these issues raised above, the macroeconomic impact of the final RC Report will be minimal and therefore the flow of credit into the Australian economy will continue largely unabated.
The Royal Commission hearings process was effective in reducing the growth of credit during 2018 as lending practices such as the HEM were exposed, however, the lack of strong recommendations around the HEM and other lending decision making criteria has effectively opened the door for old practices to eventually come back.
My predictions that Australia is headed towards an economic crisis haven’t changed in the wake of this report, rather the report confirms my original thesis.
Australia’s Authorised Deposit-taking Institutions (ADIs) and other lending institutions (i.e. non-ADIs or shadow banks) will continue to grow their loan and mortgage book and the debt bubble will expand.
Australia’s financial system will become more fragile as the pressure for banks to generate robust rates of return for shareholders provide little incentive for meaningful changes to institutional governance and culture.
Failure to overhaul the approach and culture of the regulators ASIC and APRA means that Australia’s financial institutions are likely to exhibit, perhaps over time, new instances of non-compliance with existing laws, prudential and other standards including industry codes of conduct.
This will inevitably increase the level of systemic macroeconomic risk throughout the Australian economy, especially given the context that the world has the biggest global debt bubble on record. This will continue until existing macroeconomic risks become realised (i.e. a domestic or global economic shock) and Economic Armageddon becomes a reality.
At this point, Australians and key stakeholders will attribute greater blame on the RC Report for its lack of meaningful reform.
If a domestic or international economic shock were to eventuate, the Government, RBA and APRA will come to save the banks and the economy, through exotic monetary and fiscal stimulus policies of zero or negative interest rates, quantitative easing and greater government deficit spending.
The consequences of these actions will destroy international confidence in the Australian economy to meet its foreign debt obligations as well as the purchasing power of the Australian dollar.
How Did the System Go Largely Untouched?
History will record the Hayne Royal Commission as a failure to address systemic issues within Australia’s banking industry and financial system.
Questions will be asked as to why did the Commissioner not attempt to take steps which would have stopped the debt bubble from growing into the future as well as the build-up of systemic risk in Australia.
Did Item K in the Royal Commission’s Terms of Reference that required the Commissioner to consider the potential impacts of his recommendations on the Australian economy and the stability of the financial system prevent him from putting forward meaningful reform?
Or was the Commissioner pressured by vested political or commercial interests that any significant recommendations could lead to financial instability or trigger a massive downturn in the Australian economy (i.e. was he a victim of ‘project fear’)?
What private conversations did the Commissioner have with government and economic officials during the RC process? What was he told and were they accurate and legitimate? Or were claims that he could trigger an economic meltdown exaggerated to avoid changes to existing vested interests?
Australia, perhaps, needs a new Royal Commission to get to the bottom of what really
happened in the production of the RC Report and why it failed to dismantle the heart of Australia’s economic and financial power structure.
John Adams is the Chief Economist for As Good As Gold Australia
 Regulatory capture is a form of government failure which occurs when a regulatory agency, created to act in the public interest, instead advances the commercial or political concerns of special interest groups that dominate the industry or sector it is charged with regulating.