As a young banker in the 1970s, I was puzzled when the head of my employer’s consumer credit subsidiary announced that loans to large-scale property developers would now be favoured. Doesn’t a move away from consumer lending imply a huge increase in credit risk, I asked. “No,” the banker said. “You simply don’t understand modern corporate finance.”
Years later, as a reporter at a press conference held by a 1980s entrepreneur, I noted that his company’s finance division had recorded a huge increase in assets but only a tiny improvement in profit. Surely, I asked, the two figures should move roughly in sync? “No,” the entrepreneur said. “You simply don’t understand modern corporate finance.”
In both instances, fashions in finance did nothing to avoid disaster. The bank’s consumer lending division blew up, taking the bank down with it. The entrepreneur’s glorious career collapsed under a mountain of debt, dragging some of Australia’s largest businesses into a deep hole.
On another occasion I asked Nobby Clark, chief executive of NAB — and a reassuringly plain-talking human — why his bank had loaned money in the 1980s to the same people whose reckless antics in the 1970s had given him the opportunity to take over my employer on very favourable terms. Nobby made two remarks. One: almost two decades later, NAB still owned some of the property associated with the dud loans of my 1970s bosses. Two: the key to banking is “active forgetting.” Then he laughed, acknowledging the absurdity of it all.
Finance is not what it once was. After the 1930s Depression and through the postwar boom, tight regulation in most of the world made the industry “boring” (to again quote Nobby Clark). In those days, Australia’s economy was parochial and closely managed. Bank lending was heavily influenced by central government agencies that could loosen or tighten the flow of money. Big businesses — breweries, banks, media, energy suppliers — tended to hold state-based franchises with limited interstate competition. Tariffs protected a wide range of industry from imports, with high rates of union membership and centralised wage-fixing being the other side of the coin.
When the postwar economic consensus unravelled in the 1980s, finance was the big winner. As Nobby Clark lamented, banking became exciting. Merchant bankers, those lobotomised sharks of finance, became Medici-like, their new social status built on their cunning extraction of profits from other people’s assets. Along the way, princes of finance profited from mergers of competitive businesses. So much so that, just this month, the Productivity Commission described its recent tax proposal as a response to an economy in which “a small number of big firms exercise market power to the detriment of consumers.”
From the fundamental banking reforms of the early 1980s to the introduction of compulsory superannuation in the early 1990s, a one-way trend has driven an ever-larger share of the Australian economy towards finance. Australia’s GDP growth — fivefold since 1990 — has been outpaced by an explosion in finance-sector assets, which grew from 170 per cent of annual GDP in 1990 to about 450 per cent today. Over the period, finance’s share of GDP has grown from roughly 5.8 per cent to around 7.5 per cent (a similar trajectory to that of the United States).
Compulsory superannuation has certainly contributed, but the most obvious driver has been the growth in bank assets. The banks’ outstanding housing loans have grown twenty-five-fold from around $156 billion (in current prices) in 1990 to $1.6 trillion today. And house prices have risen in tandem, driving up debt’s share of household incomes. As we know, the burden of mortgage payments on incomes has become heavy.
Naturally enough, concern about the financial sector’s role in Australia has tended to focus on the growth of debt, and especially household debt. Regulators have remained relatively sanguine because the national aggregates show a high overall level of household assets. In other words, people can afford to borrow because they have — on average — a savings buffer.
Another reason to be cheerful is that a lot of smaller, inexperienced and sometimes incompetent financiers were driven out of the system in the wave of growth that followed deregulation. During the sharp upturn in financial assets in Australia after 1981, the large banks’ share grew slightly. But from 1990, in the wake of a sharemarket crash and a burst property bubble, the large banks took an increasingly large share of total assets as the smaller and less capable financiers were driven out. Lessons were learned when large banks like Westpac were forced through a very public humiliation; meanwhile, smaller players like Pyramid and virtually all of new banks — local and foreign — were proven to be lightweights (or worse).
Like much of the Australian corporate scene, finance is now dominated by a small number of players. Size is certainly a factor in their profitability, but the evidence suggests that this level of concentration has been fundamentally unhealthy and, in serious respects, a hazard to customers and the community.
Kenneth Hayne’s royal commission produced an admirably principles-driven report in 2019 challenging the notion that banks, super funds and others took seriously their duty of care to customers and the wider community. He made four observations, each of which was alarming. First: sales were the overriding objective and sales incentives were the driver of behaviour — regardless of whether that behaviour was illegal or contrary to client interests. His second and third observations highlighted the complexity of financial transactions, the disadvantages consumers face in understanding their choices, and the fact that agents and advisers were often conflicted. Fourth: big financial institutions must be penalised for law-breaking.
Hayne’s report attracted appropriate attention, and some legislation, but very little follow-up of the punitive kind. Anyone dealing with a bank or large financial institution would be well aware of bureaucratic tweaks designed to avoid liability but won’t have seen much evidence of a culture balanced, at least a little, by the need to deliver value and a duty of care to the client. Lately, a couple of newly appointed bank CEOs have announced themselves with “culture” shakeups that seem at once trite and somewhat mindlessly focused on profitability. (One spruiked the advantages of working over Christmas while the other demanded shorter PowerPoint presentations.)
In other words, it seems entirely possible that bankers (and others who sell financial services) remain entirely focused on personal incentives and corporate profit. Is that a problem?
Australia has experienced a remarkably stable, positive economic environment for a very long time. Putting aside Covid’s impact in 2020, the country hasn’t fallen into recession since 1991. Having moved away from protectionism and intrusive regulation in the 1980s, the economy benefited enormously from a global trend towards open markets and trade, and the remarkable rise of China, South Korea and India.
But the leading proponent of open trade, the United States, now seems intent on undoing all the progress and imposing its own conditions on trade and security partners. China, our largest trading partner, is a prime target of US trade restrictions but must also manage a complex and potentially disruptive transition in its own economy. All this means that a comfortable, prosperous experience that has lasted more than thirty-five years may well be disrupted, though you wouldn’t know it from the behaviour of the financial markets.
The Commonwealth Bank is undoubtedly well managed. As Australia’s highest-valued company, its almost matches Elon Musk’s on-paper fortune. Yet the average market analyst shaves a third, or $100 billion, from its sharemarket value, and the least confident would halve the figure. CBA’s earnings are valued at almost three times those of BHP, perhaps implying that BHP will face stormy international weather while CBA’s domestic earnings remain firmly on a growth path. But is unusual for sharemarket analysts to discount the market price of a prominent company, especially the largest in Australia, and the implication that CBA’s listed value is much higher than it should be is itself a red flag for the industry.
CBA’s hot valuation isn’t an outlier. On the contrary, global markets today are dominated by a country, the United States, whose sharemarket is effectively driven by a handful of hugely overpriced stocks. Confidence has grown year by year since the end of the cold war, and with that has come an increasing tendency to invest an expanded pool of savings in higher-yielding — and riskier — investments. Bets on currency, commodities, shares, private debt and a very wide range of “hedge” options have become a large part of global finance.
It’s more than thirty years since Hyman Minsky, a US economist, published his observation that long periods of prosperity breed financial instability. Minsky is cited when things go wrong at the end of a long period of asset inflation and credit growth, the abrupt version of which is known as a “Minsky moment.” The sudden withdrawal of credit from core global financial institutions in New York in 2008 was one such moment, and its context was examined in John Kay’s Other People’s Money, published in 2015.
Kay, a distinguished British economist, explains the evolution of finance from the “boring” environment that Nobby Clark preferred to a sector massively larger in every sense and layered with esoteric transactions largely conducted among the players themselves. A memorable contributor to the 2008 crisis was the trade in “collateralised debt obligations,” a form of security traded originally entirely within the market for corporate bonds.
In the 2000s, CDO trading funded a rapid expansion of American home mortgages, notably in the riskier “sub-prime” category. CDOs bundled mortgages in investment securities that provided investors with the interest and principal repayment of mortgage borrowers. Slices of a mortgage pool were sold in “tranches” according to varying risks of potential default, with those risks determined by S&P Global Ratings and other rating agencies. And then, to close the loop, insurance companies provided default insurance in the form of credit default swaps and “synthetic CDOs,” which were even more artificial than the name implies.
Sales-driven mortgage lenders turned out to be careless about maintaining high credit standards. When the bubble burst between 2007 and 2009, about US$1 trillion was lost by financiers, roughly half of which evaporated in the CDO trade. Major banks failed, requiring massive interventions by governments. And not much has really changed since then.
Kay’s theme is simplicity. Financiers who take public deposits should be limited to conservative, low-risk lending on solid home mortgages and government debt. The whole sector should be regulated by function, so that the obscure and often opaque market for derivatives and things like CDOs is confined to those who knowingly choose to take the associated risks. The finance sector has grown too big, says Kay. It is largely self-serving and presents too many points of conflicted interest.
We know that some astute investors take a dim view of today’s financial markets. Warren Buffet, famously, has been accumulating huge piles of cash for some years in the face of what he sees as unrealistic asset prices. In Australia, the difference between the price of those Commonwealth Bank shares (thirty times the company’s earnings) and BHP shares (twelve times) seems like a sign of trouble. BHP is effectively a proxy for Australia’s primary exports. CBA is our largest domestic bank. One of the numbers is seriously wrong, and informed observers think it is the bank’s. But it might be both.
Among the points made in the Productivity Commission’s tax reform proposal is that Australia’s economy is dominated by companies that have neutralised competition by buying their competitors. One possibility, boosted by the flow of money into superannuation, is that our savings have promoted reduced competition and inflated the share prices of the dominant companies. Index funds are popular with superannuation investors because they are often low cost and allow non-expert investors access to fairly dispersed risk across stocks in, say, the top 20 or 50 or 100 companies. Companies valued highly enough to get into those categories get an immediate share price boost from the index weighting, so there is a significant incentive for managements to try to achieve that result. Buying another company is the short route. The Productivity Commission’s proposal to change the tax rules to encourage smaller companies suggests that informed people see the need to reverse the concentrations of financial power that have grown up over recent decades.
In Australia’s case, overvalued assets — notably houses — are entering a more risky environment. The global trading system is being dismantled and China’s economy is undergoing a difficult transition of its own. Inflation could easily spread out from the United States if its proposed tariff strategy remains in place. It seems wise to follow Commissioner Hayne and John Kay in asking whether our financial settings and structures are robust enough to deal with the risks ahead. •
