Risk and reward need balance

26/11/2008 - 22:00


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I have been reading extensively this month about the deep problems in the US financial system and it has left me with one overriding conclusion.

I have been reading extensively this month about the deep problems in the US financial system and it has left me with one overriding conclusion.

Australia has a remarkably well managed financial system and we need to be careful not no over-react to international problems with misguided domestic policy responses.

The state of Western Australia is a mere spectator in the dramatic financial and economic events unfolding around the world, yet it is still valuable to analyse these events, to learn lessons, to reflect on what works well in our own country and assess what we could do better.

In the US, the latest stunning development was the second bail-out of banking giant Citgroup in as many months.

Just a few months ago, Citigroup was the most valuable banking group in that country, yet the US government has been forced to invest more than $US45 billion to prop it up.

The consensus among commentators seems to be that Citigroup is too big to fail and that the US government has no choice but to support it.

However, what is the lesson that governments send when they bail out companies on the brink of failure?

It simply encourages more risk taking during the next boom, because company directors know they can turn to government if things turn pear shaped again.

The commentary surrounding this banking crisis has involved a lot of talk about fancy financial securities in which Citigroup invested heavily, like collateralised debt obligations and credit default swaps.

Peel away the jargon and the technical complexity and it becomes clear that the root cause of Citigroup's problems - and of most other struggling US financiers - was appalling lending practices in the US housing market.

The sub-prime mortgage market collapsed months ago but the after effects are cascading through the US financial system.

What a crazy world when banks can make loans to people who can't afford them, package the loans into fancy financial securities, sell these securities to investors, and keep some on their own balance sheet - and make money every step of the way.

Similar developments occurred in Australia but without the extremes of the US. Why is that?

One reason is that the US government contributed directly to the problem.

Two government-sponsored but privately owned companies - get your head around that muddled mix for starters - known as Fannie Mae and Freddie Mac, are the biggest mortgage lenders in the US.

Part of their mandate was to widen home ownership by providing housing loans to people who traditionally could not afford them. Therefore, they stood behind sub-prime loans.

It worked well for several years, helped by record low interest rates and rising asset values, so it was little wonder that private lenders started chasing the same market.

The activities of Fannie Mae and Freddie Mac, which were effectively taken over by the US government in September, were based on a fatal confusion between social policy and economic policy.

If governments want to achieve social outcomes, they should be explicit about their objectives and transparent about the policy tools they are using.

They should not distort commercial markets in the process.

Reserve Bank governor Glenn Stevens nailed the policy issue last week when he said governments could spend more and potentially go into deficit, so long as their policy was good policy.

Some of the Rudd government's responses do not pass that test.

Guaranteeing all bank deposits in Australia has created huge distortions in investment markets. Clearly, this initiative was not carefully planned.

Providing large one-off cash handouts to low-income families, with no strings attached, is another very questionable response.

There has, quite rightly, been a lot of focus on what governments should be doing about the state of financial markets, but individual investors and business managers need to think about their actions as well.

It is impossible, indeed undesirable, to regulate or legislate away all risk.

It is risk that creates opportunity, for entrepreneurship and for reward.

What is needed is to restore the right balance between risk and reward.


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