Twin Peaks – a glass half full

by Dr. Andy Schmulow

South Africa is well on its way to the adoption of a new financial system regime – the so-called ‘Twin Peaks’. This regime is modelled closely on Australia, and represents the most important financial system reforms since the Republic left the Gold Standard in 1932.

Twin Peaks is currently in vogue internationally. Credited as it is with Australia’s remarkable performance during the global financial crisis (GFC). Twin Peaks has been adopted in the Netherlands, New Zealand, the UK, variants in France and Germany, and is under consideration in China. Australia was first to implement it, fourteen years ago.

As the name suggests, two peak government bodies are created – one to enforce bank regulations – the Prudential Authority, and another to ensure market conduct and consumer protection – the Financial Sector Conduct Authority. Together with the Reserve Bank, these agencies will be charged with protecting South Africa from financial crises and international financial contagion, while ensuring that market participants behave, and do not abuse consumers.

Together with my colleagues in the Melbourne Law School – Australia’s premier research cluster investigating the strengths and weaknesses of Twin Peaks – we are firmly of the view that South Africa is headed down the right path, and that Twin Peaks is the optimal regime. The legal arguments are strong, and the empirical economic evidence supports that view.

However, Twin Peaks is not enough. This system has also recorded spectacular failures, and South Africa must be made fully aware of its shortcomings. During the GFC, three of the Netherland’s largest banks collapsed and were bailed-out by taxpayers. That cost approximately R 1 trillion. This was despite a Twin Peaks regime already well established in Holland.

In Australia, our market conduct authority – the Australian Securities and Investment Commission (ASIC) – has performed, at times, atrociously. Its performance in combatting the ever-expanding financial advice scandal has been so bad, that Australia’s Senate has recommended a Royal Commission. This has been market misconduct and consumer abuse writ large.

Market misconduct and consumer abuse should not be underestimated as a threat to financial system stability. Such malpractices in the US sub-prime industry gave the world such gems as ‘low-doc’, ‘no-doc’, ‘LIAR’ and ‘NINJA’ loans, and ultimately precipitated the sub-prime disaster. That disaster, in turn, metastasised into the GFC.

So the question is, what did cause Australia to fare so well during the financial crisis? What role did Twin Peaks play? Why did the Dutch fare so poorly? What else must South Africa have to ensure financial security, if Twin Peaks is not enough?

The answers are many, varied, and complex.

In Australia, we were lucky. Our banks were ‘vanilla’ – they were not heavily exposed to esoteric and opaque financial products. Our economy was strong, buoyed by the mining sector. When the crisis struck, the government spent heavily on infrastructure and cash hand-outs to taxpayers. In addition, all deposits up to AUD$ 1 million were guaranteed by the State.

What then are the lessons we can convey to South Africa?

First, the prudential regulator must be able and willing to enforce regulations. That will entail adequate resources and insulation from government and industry pressure. To this end we query the wisdom of locating this regulator within the Reserve Bank. While most other countries have located this regulator within their central bank, in Australia we have not. We think the latter is better.

Second, depositors must be protected by a formal depositor protection scheme – one that does not protect shareholders. Shareholders must suffer losses when a bank collapses, else they will have no incentive to exercise oversight over management. Currently this is lacking.

Third, the market conduct authority and the prudential regulator must not play second fiddle to one another. They must be independent and they must fulfil only their own remit. We are gratified that our advice in this regard has been followed.

Fourth, the Reserve Bank must be ferociously independent. South Africa has a stellar historical record in that regard, and the SARB’s independence is guaranteed by the Constitution.

Fifth, every effort must be made to inculcate a culture of fearlessness in both regulators, and this is much harder to achieve. We are of the view that South Africa lacks formal indemnity for the prudential regulator’s employees, and this should be addressed.

Sixth, co-ordination between the various agencies, the SARB and the Treasury, should be formalised – which it is – and strengthened wherever possible.

Last, we recommend that either the Council of Financial Regulators or the Financial Stability Oversight Committee be given the power to evaluate the performance of both regulators – similar to the proposed Financial Regulator Assessment Board in Australia. Such a panel, should include wise men and women who do not work for either regulator, and are therefore not susceptible to deficiencies within the culture of those organisations. They would act as an independent bulwark against regulatory capture or bureaucratic hubris.

If all of those measures are in place, in addition to a formal Twin Peaks arrangement, then South Africa has a fighting chance.

To paraphrase Churchill, Twin Peaks is not the beginning of the end. It is merely the end of the beginning.

Adv Dr Andrew Schmulow is a Senior Research Associate in the Law Schools of Melbourne and Witwatersrand, and is an Advocate of the High Court of South Africa. He resides in Melbourne, Australia.