I will range across a few subjects today, including the Westpac kafuffle and Glenn Stevens’s recent speech on financial regulation.
Westpac’s Woes
Following my article last week assaulting the commentariat’s blind defence of the major banks’ rate hikes beyond RBA-induced changes to the target cash rate based on simplistic net interest margin analysis, there appears to have been a change in the tone of the popular rhetoric. Ross Gittins, for example, picked up this line of thinking and acknowledged that one cannot evaluate the banks’ actions in the context of funding costs alone.
For those that did not read the original piece, allow me to recap. I have no problem with the banks boosting rates above and beyond RBA changes. I do have an issue with these decisions being blithely defended by the commentariat on the basis purely of net interest margin analysis, as has been the case to date.
The simple fact is that the only way to credibly interrogate the banks’ actions is by reference to the marginal profitability, or return on equity, associated with their home lending activities. Curiously, however, a discussion of return on equity, which is quite different from net interest margins, has been missing from the debate.
This argument is perhaps better understood through a ‘reinterpretation’ of Westpac’s much-maligned advertorial…
Once upon a time there was, say, a major car manufacturer. Now imagine that this car company suddenly faced higher aluminium costs (think funding costs) due to a surge in commodity prices (or, in the original Westpac story, the now infamous storm that drove up banana prices). Applying Westpac’s logic, this must lead to higher product prices.
But you see this car company operates in a much more complex world than the original analysis implies. At the same time that it experienced higher input costs, the company discovered that most of its competitors were going out of business, or unable to effectively compete (think non-bank lenders and smaller banks). It found that notwithstanding the challenging economic conditions, consumer demand for its product had soared through the roof because the number of viable suppliers had been reduced to just a handful (think the huge growth in Westpac’s home loan book during the GFC). It naturally capitalised on this market power by slashing its product distribution costs (in mortgage land this was analogous to a 30 per cent plus reduction in broker commissions). And since all of its factories are highly scalable (as home loans are), the growth in car volumes drove down unit costs. Finally, the evaporation of competitive pressures in turn helped cut the incremental marketing dollars spent to sell each new product – customers were now chasing it.
On the revenue side of the equation, the car company no longer had to give away the 'optional extras' on its vehicles (think banks waiving fees and charges on loan products).
There was one other important dynamic at play here. In the middle of this crisis, the car company was suddenly able to significantly reduce the equity capital required to fund each new automobile and replace this with much cheaper debt capital. Precisely the same advantage was bequeathed to the major banks (and only the majors) when they shifted to a new ‘risk-weighting’ system under Basel II, which slashed more than half the amount of equity they had to hold against residential mortgages. This mechanically boosted by a significant degree the profitability of this activity.
So there you have it. Our car company didn’t have to increase its product prices at all. Indeed, it ended up with an even more profitable product despite the higher input costs.
Now, until we evaluate the change in the major banks’ return on equity from residential lending, we cannot really say whether they are justified or otherwise in their rate-setting decisions. What I did show last week is that the available evidence indicates that the major banks are deriving a large share of their profits from home lending. In absolute terms, the profitability of residential mortgage lending has increased strongly and is subsidising weaker business lending profits, which is the exact opposite of what the commentariat would have us believe. And if one looks at the way they have been allocating capital throughout the crisis in favour of home lending, one has to assume that they are doing so to the highest return on equity opportunities (all other things being equal).
Dissecting Glenn Stevens
The Governor of the RBA, Glenn Stevens, has delivered an excellent speech summarising key regulatory failures during the GFC, the response of policymakers, and his own opinions on the strengths and weaknesses of different initiatives that are under way. In contrast to some overseas economic institutions, the RBA leadership generally write their own speeches, which presents their own opinions, and can on occasion make for more colourful fodder than the drier productions delivered elsewhere. So here are a few quick thoughts on Stevens’ commentary (in no particular order):
1) In the Q&A after the speech, Stevens was asked, unsurprisingly, what he thought about Westpac’s rate hike. I am guessing here that Westpac were looking for an RBA-inspired defence. It was not forthcoming. In a witty riposte, the Governor remarked:
“I’m interested to see Westpac asking this question…We’ve actually published some analysis of how to think about [lending margins], and we’ll probably update that at some point next year to at least give people a framework within which to debate these question…”
What was most noteworthy, however, was the Governor’s portentous observation that, “What the framework showed…up to a few months ago [ie, well before the Westpac decision] was that, overall, margins had declined initially…and then recovered all that ground since. It will be interesting to see what that shows in a few months’ time.”
2) Still in the Q&A, the journalist David Uren asked whether the RBA had ‘strengthened its position’ regarding the need to fight asset price bubbles, and whether this is something that ‘should be incorporated into our way of thinking about monetary policy.’ Regular readers will know I have written a great deal about this in the past. When I heard the question, I actually felt sorry for the Governor, as he has been hammered on this subject pretty relentlessly ever since the politician Scott Morrison carefully lifted the lid on precisely where he stood on the subject, which, unfortunately for the media, slayed a few myths that they’d been gleefully advancing about he RBA’s desire to run down asset prices. Anyway, the Governor rightly gave the question short shrift:
“Well, I am not sure I can advance, David, any further than the answers I’ve given on that question at length, which I suppose you could interpret as remaining constructively ambiguous for the time being. I suppose my position is that I’m not anxious to go chasing asset prices, but, equally, I would never say never…”
Now I have adjusted my own views on this subject somewhat. In short, it is perhaps more apparent to me that the RBA can play a useful role in jawboning asset markets in the event that there is demonstrable evidence that there is too much credit-fuelled ebullience driving returns. Given the obsessive following of the media, these statements can have quite an impact (and for the same reasons, must be used carefully and sparingly). The more I think about it, there will also be some unusual contingencies when markets are behaving hysterically and there is a (rare) case for the central bank to—in combination with other ‘macro-prudential tools’—marginally change the gradient of the interest rate trajectory (in a positive or negative fashion), although I don’t believe that there should be materially different ‘levels’ set to combat asset price inflation given the well-documented collateral damage that this would impose of the rest of the economy.
But let’s also not beat around the bush: this would represent a considerable expansion of the RBA’s existing powers. Contrary to what some might believe, this is not a decision for the Governor of the RBA to make. These are unelected officials overseen by a weak Board that wield tremendous influence over one of our most important economic levers. And so, I would repeat my call for the RBA leadership to consider pro-active governance reforms, such as strengthening the membership of the Board with semi-permanent macroeconomic experts (as former RBA Board members, like Professor Adrian Pagan, have called for).
Here the Governor made some intriguing remarks in a footnote to the speech when discussing the evolving course of monetary policy in Australia (my emphasis):
“We ended up with a form of constrained discretion: a reasonably clear medium-term objective combined with short-term operational flexibility, and independence of the decision maker from the day-to-day political process (with accountability to legislatures). The counterpart framework for counter-cyclical capital management will, if it is to be successful, require similar elements, including the independence of the relevant decision-maker – from both the political process and the markets and institutions affected by the decisions.”
Now this may just be artefact of the tendency in economic theory to use the words ‘decision maker’ in an abstract mathematical framework. But keen central bank watchers will know that there has throughout the RBA’s history been a tension between the decision-making authority of the Governor, which at times has been vested unilaterally, and the authority of the Board, which at various points has been enhanced explicitly to place a check on the autocratic powers of the Governor. I guess my point is that in an environment where quite a few are concerned about the integrity of the RBA’s governance controls, it is not especially comforting to hear references to the RBA’s powers as being held by a single ‘decision-maker’. In fairness to the Governor, he has gone to great lengths to defend the integrity of the Board, and the interrogations to which it subjects the RBA executive. Yet the cynical would suggest that this is no different to Rupert Murdoch defending the independence of News Limited’s directors.
There is further nuance here. One leading economic commentator remarked to me recently that he had no beef with the Board having little-to-no influence because, after all, the Governor was by far the best person qualified to make these decisions. A similarly sympathetic economist opined that we want the executive setting policy because they are the guys with all the analytical know-how. Both of these views are fine in the ‘base-case’ when everything always goes according to plan.
But the reason we have governance protections is to control for those rare adverse events when the base-case system fails us. Think of a rogue Governor, or a major analytical mistake the executive has made. While these events are clearly going to be exceptional, they are nonetheless tail probabilities that we should provision against. History tells us that all institutions can fail no matter how well prepared they may appear to be.
3) This brings me to another important comment the Governor made. On the subject of financial regulation, he averred (my emphasis):
“Yet some jurisdictions ended up with very serious problems, while others did not, even though they were all, more or less, operating on the same internationally agreed framework for bank supervision. Why that was so remains a question of interest.”
I have written a lot about the future of financial regulation (see here). The Governor raises a key point, which was interpreted by some in the media as meaning that perhaps Australia does not need to be subject to the same regulatory changes given that we came through the crisis relatively unscathed. For what it is worth, here is my response:
* The traditional banks are effectively public-private utilities, with taxpayers now guaranteeing their deposits (around 60% of their funding) and their wholesale debt (another 40 per cent of their funding) while our publicly-owned bank, the RBA, lends to them every day of the week on terms that are often substantially below market (particularly during times of crisis). No other private companies get the benefit of all these taxpayer subsidies;
* The absolutely critical premise of the 1997 Wallis Inquiry was that the government (and APRA) would never, under any circumstances, guarantee any part of the financial system for fear of inducing permanent, and irreversible, moral hazard risks. This system failed the first serious test it faced: the 2007-09 GFC. So claims that Australia’s prudential system has withstood the GFC are quite misplaced;
* All the Australian banks now benefit from both explicit taxpayer guarantees, and forever and a day henceforth, implicit guarantees that they are “too big to fail” (given the explicit guarantees were deployed at the first sight of crisis). This is exactly the same moral hazard risk that was a key explanatory variable for the demise of Fannie Mae and Freddie Mac;
* So critical policy questions that few people are asking are not when will the guarantees be withdrawn, but rather (1) what new policy protocols will govern how they will be used in the future, and (2) what new policy measures will minimise the significant moral hazard risks that we have introduced into the system?
* It is hypocritical for commentators to sing the praises of the major banks for not having had any material overseas exposures, which was submitted as one of the main reasons why they were able to withstand the worst of the GFC, while also applauding the major banks now rushing to buy other banks overseas (in Asia, the UK and possibly the US). Do we not learn from history?
* I have long been of the belief that the next major financial crisis Australia faces will originate in Asia, and quite possibly China. The economic, legal, and political risks in China and Asia are orders of magnitude greater than those that many believed triggered the US crisis. And yet some of our major banks are seeking to reinvent themselves as pan-Asian institutions, which seems little different to the UK and European banks whose US activities served as the delivery devices for contagion during the recent calamity.
In conclusion, there are at least four key lessons from financial history:
1) The banking business model, which involves banks borrowing short from customers with ‘at-call’ deposits, and lending long via 25 year home loans, is inherently frail because of this intrinsic asset-liability mismatch, and has always required direct and indirect public support (for banks to survive in the long-run). The reason we originally established central banks was precisely to act as a lender of last resort and bail out private banks during times of crisis;
2) Banks should stick to their knitting of taking in savings and conservatively redistributing that capital as loans throughout the economy (ie, forget equities trading, investment banking, private equity, and any other non-core activities that induce excessive risk-taking);
3) Banks have a terrible track-record of expanding beyond their home territories, which is normally the harbinger of future disaster. They should, therefore, focus, in a institutional sense, on their domestic economies (ie, it is one thing to lend on a case-by-case basis to foreign companies, but quite another to establish major banking operations in, say, China); and
4) There is an ineluctable, but nonetheless very important, conflict between the interests of CEOs and shareholders, who are trying to maximise short- to medium-term “growth”, and the objectives of taxpayers and policymakers, who want to vouchsafe the long-term durability of these organisations, which often means lower but more stable growth.
