Dr Malcolm Edey, one of the RBA’s Assistant Governors, gave a speech on Wednesday where he sought to explain why the Australian banking system had fared so well in comparison to its peers overseas.
In short, Dr Edey pins it on – surprise, surprise – the integrity of Australia’s housing market and the conservatism of our lending practices, which has led to extremely low default rates (well known explanations for regular readers of this blog).
As the RBA has noted recently while puzzling over the persistent illiquidity in Australia’s securitisation market (which it erroneously described in early 2008 as just a “cyclical” blip that would quickly pass with few long-term ramifications):
“No investor in a rated tranche of an Australian [residential mortgage backed security] has suffered a loss of principal stemming from default on the underlying mortgages.”
Indeed, Dr Edey posited that Australian banks’ much higher balance-sheet exposures to residential mortgage lending (60 per cent) was a source of their comparative strength vis-ŕ-vis banks in the US and UK, where home loans account for only around 35 per cent of all lending.
Dr Edey was predictably far weaker in his assessment of the impact of the evaporation of Australia’s securitisation market.
It is well known that since all the RBA cares about is its formal “system stability” mandate, it does not give two hoots about competition. This explains its apparent indifference to, amongst other things, Westpac and CBA buying St. George and BankWest, the closure of the securitisation market (over which it has no control) and the ensuing demise of almost all non-bank lenders including Aussie, RAMS, Wizard, Challenger, Bluestone etc (again, over which it had no control), its apathy to proposals made here—and supported by the likes of the Bank of Queensland, Bendigo & Adelaide Bank, Suncorp and Challenger (too late)—for the government to offer commercial guarantees of AAA-rated RMBS and CMBS to level the competitive playing field along the lines of the Canadian model (Canada’s securitisation markets have remained fully functional throughout the GFC), and its repeated efforts to defend the major banks in its public pronouncements.
As one example of this final point, the RBA recently brought attention to the fact the banks’ net interest margins on their residential lending had fallen, which was presumed to excuse them for hiking up rates in 2008 beyond RBA rate changes and then subsequently failing to pass on the full extent of the RBA rate cuts. Yet the truth is that banks’ return on equity appears to not have been materially affected – at least judging by the way they are allocating vast volumes of capital towards residential lending – since they have captured large cost savings through slashing mortgage broker commissions, harnessing scale economies care of huge market share increases (the same system is servicing a much higher number of loans), and generating new revenue opportunities as a result of not having to offer fee waivers (see also the chart below).
Perhaps the most bizarre defence the RBA has offered to conceal the weak state of competition in the banking and finance sectors is that home loan volumes have been rising. That’s akin to telling people back in the early 1990s that the telecommunications market was competitive because Telstra’s landline connections were increasing.
The problem here is that the RBA confronts an essential trade-off: competition is great for consumers but potentially bad for underlying system stability.
Using the lens through which the RBA looks at the world, the stronger the core of the financial system – that is, the more profitable and stable the four major banks – the better a place the world is.
On this basis, competition is bad because it reduces the profitability and hence intrinsic health of the major institutions that constitute the core.
Competition is also bad because it erodes margins in safe commoditised sectors like residential lending, and therefore compels the incumbents to seek out other higher risk sources of return, such as business lending.
In the RBA’s worldview, securitisation is particularly undesirable because it affords an alternative source of funding to the competitors to the core that do not need to make the latter’s massive investments in high fixed cost branch networks.
The irony of the debate surrounding securitisation is that insofar as it supplies funding to “match” the exact term of 30 year home loans, it is actually a far safer medium than using at-call deposits and 3-5 year wholesale debt to underwrite such assets. It is precisely because of the risks inherent in conventional sources of bank funding that the RBA was established to provide emergency liquidity support and prevent bank “runs”.
So from the RBA’s perspective, the closure of the ostensibly robust securitisation markets, which has needlessly killed off the non-banks and severely hindered the ability of smaller banks and building societies to compete with the majors, is actually a net positive outcome because it has at the same time massively enhanced the revenues, market power, and longer-term profitability of the core financial system – that is, the big banks – over which the RBA has indirect regulatory responsibility (ie, through its liquidity and lending facilities that the banks get exclusive access to).
Here it is sobering to quote Dominic Stevens, the CEO of Challenger, in an outstanding submission that he made to the Senate Economics Committee outlining the significant subsidies that banks realise via the RBA’s liquidity facilities:
“The profile of liquidity risk within the global financial system has been a central issue as those institutions that have ignored the true cost of financing have learnt to their detriment. Global risk free government yield curves are more often than not normally shaped which means the cost of longer term finance is higher than short term finance. The cost of money for riskier institutions will also have an even higher cost in the long term than the short term.
As a result there is always a propensity to lend for longer terms and borrow for shorter terms at lower rates than would be required to match fund a transaction. The price of liquidity to term is the long term borrowing cost of an institution. If that institution decides to borrow shorter and take the risk that rates might rise in the future the institution is taking liquidity risk.
Because the major banks had access to the RBA’s repo window they were able to take liquidity risk at an out of market level which they were not required to mark to market in their books.
Non-bank mortgage lenders are much more constrained in their ability to tolerate liquidity risk. They can only lend with any scale at prices which closely reflect the true market cost of funding their assets to the term of those assets.
As a result of the credit crisis, until the wholesale funding guarantee was introduced, the major banks had to rely much more heavily on RBA open market operations to obtain the liquidity that they needed to fund lending. The cost of such borrowing is determined by the bidding process which is used by the RBA to maintain the overnight cash rate as close as possible to its target rate. Access to liquidity through RBA open market operations gives the banks a pricing advantage and underpins a significant part of their profitability.
Extensive use of the RBA’s repurchase arrangements therefore gave the banks two advantages relative to their non-bank competitors:
1. Access to liquidity; and
2. A pricing advantage.
Banks also provide the warehouses for non-banks, but the pricing now charged for these warehouses does not reflect either the price at which the banks are originating mortgages on their own books, or the value that they receive from taking similar pools of securities to the RBA repo window, which both make non-banks less competitive.”
And enclosed below are the relevant excerpts from Dr Edey’s speech:
“Throughout the crisis period, the Australian banking system has proven to be much more resilient than its counterparts abroad. One obvious point of comparison is bank profitability. This is not always a popular point to make, but it’s a great advantage during an economic downturn to have a banking system that remains profitable and is able to continue lending. In 2008 the major banks in the US and Europe moved sharply into loss, though some have returned to profit this year. Australian banks, in contrast, have so far experienced only a small decline in their aggregate profitability, and they continue to earn a high rate of return on shareholders’ equity overall.
It seems clear that Australian banks generally had stronger balance sheets coming into the crisis period, and less exposure to high-risk assets, than many of their international counterparts.
This has been particularly evident in banks’ lending for housing. Although there has been some pick-up in housing loan arrears for Australian banks, the overall impairment rate remains very low. It currently stands at just over 0.6 per cent. This is likely to rise further in the current environment, but it is well below comparable figures in many other countries. In the United States, for example, the legacy of high-risk lending has contributed to a build-up in non-performing housing loans from less than one per cent of the banks’ loan book to 5 per cent. In the UK the figure is around 3 per cent.
Structural features of the Australian housing market have probably helped to make both borrowers and lenders more conservative than they are in some other countries. Unlike in parts of the United States, for example, housing loans in Australia are full-recourse, both in law and in practice, so borrowers have a stronger incentive to avoid over-committing themselves as well as to avoid default. In addition, the Uniform Consumer Credit Code puts some responsibility on the lender to avoid putting borrowers in a position of over-commitment. A further point is that the prudential regulator took steps in recent years to increase capital requirements on riskier types of mortgages.
It’s hard to be definitive about the relative contributions of these factors. What does seem clear, though, is that the combination of legal, regulatory and structural characteristics of the Australian mortgage sector made it much more conservative in its behaviour than some of its overseas counterparts. Low-doc and non-conforming loans, for example, were always a very small part of the market in Australia, particularly in comparison with sub-prime mortgages in the US.
Another important factor has been the timing of the Australian housing cycle. Australia experienced its last major housing boom in the 2002–2003 period. For a number of years after that, the market went through a period of correction, when house prices were mostly either falling or were rising more slowly than incomes. This was also a period when construction of new housing was fairly subdued. Hence, the twin problems of over-priced housing and overbuilding that occurred in the United States in the run-up to the crisis were avoided in Australia.
A further point here is that, as well as having smaller loss rates than in some other countries, housing lending in Australia forms a relatively big part of banks’ overall loan portfolio. Currently housing loans account for around 60 per cent of Australian banks’ on-balance-sheet loans, compared to figures of around 35 per cent in the United States and the UK.”
