A Funny Thing Happened On The Way From The GFC … We Lost Bank Competition
By Mike SeccombeMarch 1, 2012
Behind all the complicated argument about returns on equity, costs of funds and margins, here’s the real reason Australia’s big four banks have jacked up mortgage rates: because they can.
For banks almost everywhere else in the developed world, the 2007 global financial crisis was a disaster, from which they still are struggling to recover. For Australia's big four banks, though, it has proved to be a great thing.
It largely rid them of the curse — from their point of view — of competition for home mortgages, which make up about 60 per cent of their loan business. It brought them government (read taxpayer) guarantees against failure, which in turn won them higher credit ratings and therefore cheaper access to money. It provided them with not just a short-term boon, but a continuing competitive advantage.
Consider some statistical history, compiled from Australian Bureau of Statistics housing finance data.
Up until the early 1980s banks had about half the housing finance market, with the other half shared between building societies and other non-bank lenders. Then, courtesy of financial deregulation and other factors — foreign banks were allowed in, and some building societies became banks — things changed, radically. Just a decade later, in 1993-94, the banks' market share peaked at around 90 per cent.
Then it shrank again, and through most of this decade, it bobbled along, pretty constant at 75 to 80 per cent.
That's still a very big share, of course, but that 20 to 25 per cent of mortgage finance sourced from other lenders provided at least a measure of constraint.
Then came the global financial crisis (GFC), and things changed dramatically again.
Over a very short time — about 18 months — the non-bank share plunged by two-thirds. The most recent figures, last October, showed banks had 92.5 per cent of the market.
That's not just the big four, of course, but they control the lion's share of it.
But first, a look at how it came to this.
Professor Kevin Davis, Research Director of the Australian Centre for Financial Studies, University of Melbourne, takes us back to the 1990s, when the banks' share shrank.
At that time, he says, "we saw bank loan rates and interest margins come down quite dramatically, [because] there was suddenly alternative sources of funding."
Those alternative funding sources were the likes of Aussie, Wizard and RAMS, which grew rapidly through the second half of the 1990s and first half of the 2000s. Smaller banks and building societies also made inroads.
The driver was securitisation, an American innovation, described in Bethany McLean and Joe Nocera's definitive book on the GFC, All the Devils Are Here, as "a shiny new financial vehicle… [which] allowed Wall Street firms to scoop up loans made to people who were buying homes, bundle them together by the thousands, and then resell the bundle, in bits and pieces, to investors."
As Kevin Davis further explains, a lender had to "build up a pool of say $500 million, to do an issue into the marketplace of mortgage-backed securities. So you originate the mortgages somehow … then you go to the capital markets. But you have to fund those mortgages short-term, until you do the issue."
Of course, we all know what happened in America: mortgage borrowers were encouraged into a monstrous spending spree, based on the notion that house prices would go up forever, and in 2007 the whole thing came crashing down. But it needs to be said that the problem was not with the concept of securitisation per se, but with the fact that sub-prime lenders and greedy banks stuffed those securities with junk.
That was not the issue in Australia, where lending standards remained relatively high.
Nonetheless, Australian securitisers were caught up in the storm.
For one thing, there was a flight of customers to the major banks, because of their greater perceived security. Secondly, investors, particularly overseas, were suddenly very wary of buying mortgage-backed securities. Thirdly, the availability of funding declined and the costs of funding went up sharply, relative to banks'.
"The problem they faced in the GFC was that while previously there had been little change in the structure of interest rates [and] they had been able to compete with the banks pretty well, suddenly they found 'Whoops! We've got to pay 200 basis points more for our funding to create new mortgages'," says Davis. The securitisers' "cost of funding jumped immediately, whereas for the banks it gradually increased".
That was because the banks, with their much larger financial mass, priced their loans off their long-term average cost of funds.
"But if you're a securitiser, effectively you are taking a lump of new mortgages and funding them with money that you raise today in the capital markets," continues Davis. "Basically that business model suddenly became non-competitive."
With offshore funding harder to get, the Australian securitisers might have turned to domestic banks for funds; their products, after all, were not like the risky American ones.
But, notes Davis: "One of the things the securitisers argued during the financial crisis was that the banks just made it very hard for them to get that short-term funding they needed if they were ever going to put together a package of loans."
Now, there could have been a couple of reasons for this: either the banks were themselves worried about the state of affairs, and pulled back, or they saw a commercial opportunity and pressed their advantage.
"It depends who you ask," says Davis.
Ask yourself, then: Why would the banks want to engage in wholesale lending to competitors who would then use the funds to undercut the banks' retail mortgage operations? Especially in such an uncertain time.
So to the consequences.
"It's certainly true that the competitive position of the four major banks has strengthened as a result of events during and flowing from the financial crisis," says Saul Eslake, chief economist, Bank of America Merrill Lynch Australia (which is not in the home mortgage market in Australia, although it got badly burned in America).
"They include the demise or capture of securitisers like RAMS, for example. And the absorption of two of the more vigorous regional competitors, in Bankwest and St George. And the ongoing higher funding costs faced by some of the other ongoing competitors, in the form of the smaller regional banks."
Eslake notes in particular the absorption of Bankwest and St George.
"Now, Bankwest probably had to be allowed to drop into someone's arms, because its owner was the RBS [Royal Bank of Scotland, which fared very badly in the GFC] and they were going out the back door at a rate of knots. So CBA got them at a bargain basement price."
Westpac was allowed to swallow St George, even though it was not in trouble. "That catapulted Westpac into being almost equal to the Commonwealth in size, but it deprived the market of what had been a fairly vigorous and not insubstantial competitor," Eslake says.
Meanwhile, the remaining smaller banks — Bank of Queensland, Bendigo and Adelaide, Suncorp, et cetra — were left more dependent on wholesale funding, which became more expensive.
Why did this impact them more than the big banks?
"Because," says Eslake, "they have smaller deposit bases. They had grown their mortgage books faster than their deposit bases, and were more dependent on wholesale funding, which became more expensive."
And there's more. The banks also benefitted from the GFC in another way.
Recognising them as too big to fail, the government guaranteed them.
Economist Christopher Joye, a director of YBR Funds Management and Rismark International, and consistent critic of the big banks, argues this has further buttressed an "oligopoly".
(Joye, incidentally is the person who dug out all those statistics, mentioned at the top of this piece, on the banks' market share.)
"Before the GFC," he says, "they were never government guaranteed. Before the GFC, official policy was that the taxpayer would not bail out banks.
"My argument is that because the banks are now government guaranteed they're intrinsically lower-risk organisations.
They actually got their credit ratings upgraded by Standard & Poor's two notches, because of S&P's assumption that they're too big to fail, that they will be beneficiaries of 'extraordinary government support' during a crisis. So they got higher credit ratings because of the taxpayer, they're paying lower costs," he says.
Recently, of course, we saw all the big banks, one after another, break with the custom of following the official rate of the Reserve Bank; the banks increased their mortgage rates even though the RBA had left rates on hold.
The banks cited increased cost of funds.
In the weeks since, the arguments about costs have become increasingly of the "he said/she said" kind. The Reserve Bank accepts that costs have risen, but others question it. Notably, the head of interest rate strategy for Société Générale Asia, Christian Carrillo, told ABC radio recently that the evidence he'd seen indicated the banks' cost of funds had actually declined over the past six months. Choice magazine, which is engaged in a "Move Your Money" campaign, cited the research as further evidence that consumers were "getting a raw deal" from the big banks.
Christopher Joye, though, says it's a little more nuanced than that. "The Société Générale report … showed the cost of funds in percentage or dollar terms has fallen, unequivocally. Indisputably. If they were paying, for argument's sake, eight per cent at the beginning of last year, they're now paying about 5.4 [per cent]. However, the RBA cash rate has fallen further than that.
"So let's be clear, what they're talking about is their margins, that have been falling. And the margin contraction's been pretty trivial."
The bigger point is how fat those margins were to begin with. "Their margins are as wide as they've ever been over the past 10 years. Their returns are as high as they've ever been over the last 10 years," he says. "They have a choice: they can either deliver lower-cost products or they can deliver higher returns to their shareholders. And they're choosing the latter."
So the question is, how much is a fair thing?
There's been a great deal more he said/she said on that one too, mostly concentrated on the big four banks' returns to equity (RoEs), which average around 15 per cent.
Kevin Davis suggests those returns are not out of line with most big companies in Australia. If you look at what the banks pay shareholders, he says: "Over the course of that last four or five years there has been a return of 9 to 11 per cent, which is not excessive. It's what you expect to see on the stock market."
Nonetheless, he notes that the big four are returning far more than their smaller competitors, due to their market dominance. And the competition between them is less than vigorous.
"What I'm saying … is that banks' CEOs keep saying they've got this strong competition going on. And they are competing, but they're competing subject to this constraint that they have a target ROE of 15 per cent or more," says Davis.
If the contest between the big banks were a horse race, in other words, they each would want to be in front, but only by a nose, not by the length of the straight.
"If you had really strong competition you would expect to see that force them to push down their prices," he says.
Christopher Joye passes a much harsher judgment. In a piece co-written with Mark Bouris for The Drum in February, arguing for major change in the way banks and other lenders are regulated, he referred to "a worrying oligarchy" between Australia's major banks and their regulators. In properly-functioning financial markets, they argued, higher rewards usually went with higher risks. But in Australia now, this had been inverted — the biggest banks, with the highest credit ratings, gave the biggest returns to shareholders, while the smaller lenders, with lower credit ratings, returned less.
This reversal, they wrote, was "the purest possible illustration" that taxpayer subsidies were being used to benefit an oligarchy.
Joye continues to work on ways to expose the advantage being conferred on the big banks by the GFC. The next step, he says, is to try to establish just how much that taxpayer guarantee is worth to them.
To that end, he has been asking some pointed questions of the Treasury and Reserve Bank: "I'm asking them whether they've ever tried to price the taxpayer guarantee that we've provided the banks."
Joye noted that when Reserve Bank Governor Glenn Stevens was asked during an appearance before the House of Representatives Economics Committee on February 24, he said the guarantee might be worth "several basis points".
"He was implying that it was small, but in fact several basis points on $800 billion is about $500 million per annum," said Joye.
He is pursuing more exact numbers, via Freedom of Information requests.
"So there will be a very big story in the next three to four weeks, where Treasury and the RBA are going publish a huge amount of information basically saying how much they think the taxpayers are subsidising the banking system," he says.
Next question: "Why aren't the banks paying for these forms of taxpayer insurance?" Joye says.
No doubt the smaller mortgage providers would wish Joye well in his quest, and in his calls for broader reforms which would place them on a more equal footing.
But for the time being, the big four banks continue to enjoy an extraordinary dominance of the mortgage market, putting an ever tighter squeeze on other competitors.
So long as that continues, the answer to why they are charging their customers as much as they do is, at bottom, very simple.
Because they can.