Are Australian Banks Too Big to Fail?

SYDNEY -- If banks are too big to fail, then they are simply too big. So say Mervyn King, governor of the Bank of England, and Alan Greenspan, former chairman of the U.S. Federal Reserve.

Citigroup creator and U.S. banking legend Sandy Weill weighed into the debate when he told CNBC television that U.S. investment banks should be broken up into their separate commercial and investment banking parts.

The commercial banks would take deposits and make commercial and real-estate loans -- something that will not risk taxpayers' or depositors' money -- and would not be too big to fail.

The investment side, comprised of activities such as proprietary trading (trading on their own behalf), asset management, institutional banking, mergers and acquisitions, broking, and wealth management could then do whatever it wanted, only putting at risk shareholders' and lenders' money -- not depositors' or taxpayers'.

Weill also told CNBC that the smaller resulting banks would be more profitable, as the "too big to fail" banks are required to carry more capital and are subject to stricter regulation, which has seen their share prices marked down by investors.

The impetus comes after the most recent scandals, such as the London Interbank Offered Rate fixing scandal and JPMorgan Chase's multibillion-dollar hedging losses. The public perception of Wall Street investment banks is that they haven't suffered enough for their sins, and recent Dodd-Frank reforms are widely seen as entrenching, rather than eliminating, "too big to fail" banks.

Weill argues that splitting up the banks could help rebuild banking's shattered reputation.

Australia's situation
Since the global financial crisis, St. George, BankWest, Bendigo Bank, Aussie, Adelaide Bank, RAMS, Wizard, and Challenger have either disappeared as independent companies, having been wholly or partly acquired by the majors, or joined forces, as in the case of Bendigo and Adelaide Banks.

Today we have four majors -- Westpac Banking Corporation (ASX: WBC.AX), Australian and New Zealand Banking Group (ASX: ANZ.AX), Commonwealth Bank of Australia (ASX: CBA.AX) and National Australia Bank (ASX: NAB.AX) -- that control around 90% of all Australian financial transactions, with a combined market capitalization of $267 billion. The problem with our banks is that because they have been deemed "too big to fail" by the ratings agencies, they have acquired higher credit ratings on the basis that they can depend on government support in a crisis, unlike any of the smaller banks. Higher credit ratings mean they can borrow funds at lower rates than their smaller rivals, meaning it's almost impossible to compete against them. Size begets more size.

It's unlikely that our banks will be broken up, as our government probably believes that they have the controls and regulation in place that make them unlikely to fail. But perhaps they should be broken up, given that our big four participate in some fairly risky activities and have exposure to potentially shaky global banks. The other issue is that with the four major banks controlling so much of the financial system, real competition has disappeared.

What would bank failure in Australia look like?
Should any of our banks fail, it would likely wipe out shareholders, as the federal government would probably nationalize the failed bank. Depositors should be OK, as the government would likely guarantee their deposits. The problem with even one bank failing is that it would shatter the confidence in the rest of our financial system.

We could see runs on the banks as depositors withdrew their funds. Their asset management arms could likely see funds removed as well, and the whole Australian financial system could come to a screaming halt. In a worst-case scenario, the government -- i.e., we taxpayers -- could be forced to bail out all four major banks.

The Greens said in June that they see the "too big to fail" issue as major and have introduced a bill into parliament that imposes a levy on the big banks to recognize the benefit they receive from having a "too big to fail" label and the implied government support.

They would also like to see changes to the law to stop the "big four" from acquiring any more second-tier financial institutions.

Foolish takeaway
The complexity of our banks and the difficulty of understanding all of their operations have made me shy away from becoming a shareholder. Yes, the dividend yield is very attractive, but for me the risks are too high.

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Motley Fool writer/analyst Mike King doesn't own shares in any companies mentioned. The Motley Fool's purpose is to help the world invest, better.The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.Take Stock is The Motley Fool's free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, while it's still available. This article contains general investment advice only (under AFSL 400691). Authorized by Bruce Jackson.

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