Are Australian banks too big to fail?

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

Citigroup creator and US banking legend, Sandy Weill, has weighed into the debate when he told CNBC television that US 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 is not going to risk taxpayers’ or depositors’ money, and would not be too big to fail.

The investment side, comprising 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 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 been marked down by investors.

The impetus comes after the most recent scandals such as the London Interbank Offered Rate (LIBOR) fixing scandal and JP Morgan Chase’s multi-billion 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 disappeared as independent companies, either wholly or partly acquired by the majors, or have joined forces in the case of Bendigo and Adelaide Banks.

Today we have four majors, Westpac Banking Corporation (ASX: WBC)Australian and New Zealand Banking Group (ASX: ANZ)Commonwealth Bank of Australia (ASX: CBA) and National Australia Bank (ASX: NAB) that control around 90% of all Australian financial transactions, with a combined market capitalisation 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 its almost impossible to compete against them. Size begets more size.

Its unlikely that our banks will be broken up, as our government probably believes that they have the controls and regulation in place, making them unlikely to fail.

But perhaps they should be broken up, given our big four participate in some fairly risky activities and have exposure to potentially risky 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 likely nationalise the failed bank. Depositors should be ok, with the government likely to 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 – that’s us 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 recognise the benefit they receive from having a “too big to fail” label attached to them, and the inferred 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 in understanding all of their operations, has made me shy away from becoming a shareholder. Yes the dividend yield is very attractive, but for me, the risks are too high.

In fact, we’ve identified three companies we believe are better candidates for an income portfolio. If you’re in the market for some high yielding ASX shares, look no further than our ”Secure Your Future with 3 Rock-Solid Dividend Stocks” report. In this free report, we’ve put together our best ideas for investors who are looking for solid companies with high dividends and good growth potential. Click here now to find out the names of our three favourite income ideas. But hurry – the report is free for only a limited time.

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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. 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, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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