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Monday, February 20, 2012
Op-ed in The Australian: Puzzling over big bank myths
Why Australia's big four banks rule the roost
BY:CHRISTOPHER JOYE AND MARK BOURIS
February 20, 2012 12:00AM
Today we’ll address three key puzzles in the emotive banking debate.
First, Australia has 128 savings and loan institutions competing with one another, but a powerful quartet control 80-90 per cent of the market. Why?
Second, despite complaints about ‘funding costs’, the big four banks continue to yield very high shareholder returns that are fifty to 100 per cent above their competitors. And yet these smaller rivals still manage to survive. Why?
Finally, the major banks claim that the RBA’s cash rate has only a minor influence on their funding costs, and that they should be able to set lending rates independently of it. At the same time, the RBA argues it controls the level of lending rates via its cash rate. What gives?
In the business of banking, the company with the lowest credit risk can generally source the largest amount of funding at the cheapest rates. This bequeaths them with tremendous profitability benefits.
In the US, there were two giant institutions with the highest possible, ‘AAA’ credit rating: Fannie Mae and Freddie Mac. Both were private companies listed on stock exchanges, like the majors. Both were regarded by investors as ‘too-big-to-fail’, and implicitly government-guaranteed, like the majors. Because of their funding advantages, both companies ended up accounting for nearly half of all home loans written in the US. Nobody could compete with the scale or cost of their capital, much like the majors.
Unlike Fannie and Freddie, which were only implicitly government-backed, Australia’s majors get explicit taxpayer guarantees of their retail deposits, which make up 60 per cent of their funding, and have used government-guarantees for their wholesale debts, which make up much of the remainder.
And let there be no doubt, they expect this insurance to be rolled-out again in the next calamity. To quote CBA’s former CEO, Ralph Norris, on the question: “Obviously in the future, if there was ever a situation that was similar, you would expect to see a similar sort of approach.”
When Standard and Poor’s rates the big four, it lifts their credit ratings two notches higher than local competitors because it believes that only the majors can be certain to receive ‘extraordinary government support’ in an emergency. Why? Because in Standard and Poor’s opinion, the majors are too big to be permitted to fail.
The reason Australia has such a concentrated financial system is that the ‘fortunate four’ possess an immense yet simple comparative advantage: access to larger quantities of cheaper money. And this translates into strikingly different rates of return, which some economists contend is a form of fiscal subsidy.
According to APRA, the majors have delivered an average 15.3 per cent return on equity since 2007. All other domestic banks produced returns that were, on average, 41 per cent lower.
The gap is even wider when one considers ‘profit margins’. APRA estimates that the majors have generated an average 30.1 per cent profit margin since 2007. In comparison, all other Australian banks have subsisted on profit margins of less than half this level, at just 13.6 per cent.
A third sign of the too-big-to-fail subsidy is found in net interest margins. The RBA reports that regional banks get by with an average net interest margin of 1.6 per cent. The major banks, by way of contrast, capture net interest margins that are fifty per cent wider at circa 2.4 per cent.
The fortunate four do have a choice. They can take their fund-raising advantages and pass these cost savings on to customers. Or they can maintain their margins and generate superior returns for shareholders. Analysis from both APRA and the RBA suggests they choose the latter.
The big banks’ rhetoric about ‘funding costs’ has nothing to do with competing with Australia’s 124 other savings and loan institutions. It has everything to do with protecting oligopoly profits.
Terry McCrann argues that the majors need to manufacture higher ‘equity’ returns because they are so heavily leveraged. Having a lot of debt is only a risk to equity investors if there is a chance you will default on that debt. Yet taxpayers have explicitly resolved that they will not allow the majors to default on their liabilities. Of course, there always remains residual equity cash-flow risk. But this is quite different from the additional risk induced by leverage.
Smart observers know that taxpayers’ insurance goes further than this. The RBA recently announced that it will offer all Australian banks a “committed liquidity facility” that they can draw on if they ever look like defaulting on their debts. For a price of 0.15% per annum, they will have access to a direct line-of-credit with the central bank.
There are few alternatives to taxpayers acting as insurers of last resort like this. Centuries of credit crunches have taught us that to safely convert short-term savings into long-term loans banks inevitably need government guarantees.
We believe that the best way for taxpayers to back-stop the financial system while maximising product competition is via guarantees of highly-rated ‘assets’, rather than insuring lower-rated ‘institutions’. This is a model the Canadians have successfully adopted, and would radically reduce the barriers to entry. Levelling the competitive playing field would also eat-into oligopoly profits.
You often hear regulators say that a more concentrated system is a safer system. We’ve argued that this logic is flawed: a chair with ten legs is stronger than one that rests on four. The CBA’s former CEO, David Murray, agrees: “Taxpayers are better off…if they are not exposed to highly concentrated banking industries. Ideally, there should be a large number of smaller banks.”
But only our political leaders can actually make this happen. And it will only come through fundamental changes to the rules of the game.
The final puzzle is whether banks should set rates independently of the RBA.
The RBA’s former head of domestic markets, John Broadbent, notes that, “Funding costs are not entirely determined by the [RBA’s] cash rate, but the major determinant is either the present level of the cash rate or expected changes in the cash rate.”
The other main driver of costs is the margin banks pay above the government bond rate for their funding. This spread reflects the risk of a bank defaulting on its debts. Much of the time these credit spreads are relatively stable. Every couple of decades, however, a credit crisis comes along and the markets reprice bank risk.
The highest-frequency influence on funding costs is the RBA’s monthly board meeting, which sets the overnight cash rate. The RBA’s goal is to work out whether the banks’ lending rates are at the ‘right’ levels to keep inflation within its target band. If they are not, the RBA adjusts its cash rate.
Millions of Australians with variable rate loans have been conditioned to this convention. While banks are right to highlight other influences on the price of money, they are wrong to create an artificial disconnect with monetary policy.
Mark Bouris is executive chairman of Yellow Brick Road and sits on the Treasurer's Advisory Council. Christopher Joye is a director of YBR Funds Management