Beware the Unintended Consequences of Increased Bank Competition

The Federal Treasurer, Wayne Swan, is due to announce the Australian Government’s reforms to increase competition in the banking sector on Sunday 12 December. In anticipation of this announcement, I want to take readers through some of the key proposals put forward in submissions to the Senate Inquiry into Competition in the Banking Sector, which is due to report on 31 March 2011, as well as the reasons why I think increasing competition for mortgage lending is a stupid idea that risks Australia’s financial stability.

As an aside, the fact that the Treasurer is planning to hand down reforms prior to the completion of this Inquiry – or even better, a full scale Financial System Inquiry – beggars belief and is indicative of the poor state of governance and policy making in this country.

Anyway, back to the topic at hand.

Competition: the phony war:

The whole issue of banking sector competition has slowly bubbled its way to the surface following the demise of many non-bank lenders, and securitisation more generally, after the onset of the Global Financial Crisis (GFC).

In the early-1990s, these non-bank lenders entered the Australian mortgage market and began raising funds via securitisation on wholesale debt markets. The rise of these non-bank lenders in the mid-1990s caused an intensification of competition amongst mortgage lenders. With no formal regulator and no rules outside of regular trade practices and corporations law, they led the decline in Australian credit standards by introducing ‘innovative’ loan products like low-doc loans in 1997, then ‘no-doc’ loans in 1999, and more recently they were beginning to issue ‘non-conforming’ (sub-prime) loans just before the GFC intervened.

Faced with this new competitive threat, Australia’s banks responded in kind by reducing their deposit requirements and tapping new sources of funding offshore, much of it short-term. Gone were the days of requiring a minimum 20% housing deposit and restricting home loans to an amount that could be repaid with 30% of a household’s gross earnings. Instead, banks accepted 5% housing deposits and lent households an amout that, after loan repayments, left them with just enough money to ensure that they stayed above the Henderson poverty line.

The massive increase in the availability of credit sporn from this increased competition, combined with unresponsive housing supply, has resulted in the housing bubble that Australia experiences today. The problem is, this increased competition in the mortgage lending market has not improved housing affordability. If anything, it has helped make affordability worse as evident by the below chart showing the amount of total household disposable income (HDI) required to service mortgage interest repayments.

Despite the significant reduction of mortgage interest rates over the past 20 years, the ratio of total mortgage interest payments to HDI has increased from around 6% in 2000 to 10% as at June 2010 (after peaking at around 11.5% in 2008). Whilst this ratio may look benign on the surface, only 35% of households in Australia have a mortgage. Further, since only interest payments are shown, this chart does not show the extra repayment burden arising from higher mortgage principal. So the actual repayment burden on indebted households is much larger than that implied by this chart.

System failure:

The funding models used by the banks and non-bank lenders alike to fund housing were found to be unsustainable after the GFC. Both the banks and non-banks had a dangerously high reliance on short-term wholesale funding, which seized-up amid heightened risk aversion during the GFC. The non-banks and many smaller APRA-regulated institutions were also heavy users of securitised debt markets, which similarly froze-up post GFC. As such, the Government was called upon to guarantee banks’ wholesale funding and buy up to $16 billion of residential mortgage-backed securities (RMBS) in order to ensure that credit continued to flow into Australia’s housing markets, thus keeping the housing ponzi alive.

But after the big four banks raised their mortgage interest rates above the RBA official cash rate in November 2010, and the Shadow Treasurer, Joe Hockey, ridiculed the Government for not taking action to reign-in the banks for their ‘blatent gouging of consumers’, the Senate Inquiry into Competition into the Banking Sector was formed. Amid growing pressure, the Treasurer also vowed to release his reforms to enhance banking competition prior to Christmas.

The key proposals:

To date, over 100 submissions have been provided to the Senate Inquiry into Competition in the Banking Sector. From the cross-section of submissions that I have read, there appears to be two main proposals being put forward by the industry:

  1. increased Government support to the RMBS market; and
  2. amending the Banking Act to allow the issuance of covered bonds.

On the first point, the overwhelming majority of industry submissions strongly encourage the Government to step-up its support of the domestic RMBS market, either via increasing its direct purchases of RMBS or by guaranteeing the performance of the underlying mortgage security, as is the case in Canada.

The Credit Union Australia (CUA) submission is indicative of the type of argument being put forward by the industry:

Currently, one of the major factors restricting competition within the Australian banking sector is the difficulty CUA and other customer-owned financial institutions have in accessing reasonably priced funding from both domestic and overseas markets…

The Australian Office of Financial Management (AOFM) has supported us in our endeavours to continue using securitisation as part of our funding strategy; however this support has been restricted due to the AOFM’s current investment mandate that only allows it to invest in A rated notes.

While investors have been returning to the higher rated notes, lower rated notes in securitisation issues remain difficult to sell at reasonable margins and it would greatly assist if the investment mandate was expanded to provide the AOFM with the ability to invest in these notes. In addition, this would free up capital that CUA and other customer-owned financial institutions would have to hold against the securitised assets thus providing increased capacity to undertake greater levels of home lending

In order for smaller lenders to retain support in accessing securitisation markets, CUA urges the Government to introduce a new, wider mandate for the AOFM to enable it to provide continued support…

CUA believes these actions would significantly enhance the ability of customer-owned financial institutions to compete with the major banks and ultimately provide greater competition in terms of products and services for consumers.

The second proposal – amending the Banking Act to allow the issuance of covered bonds – is being put forward predominantly by Australia’s major banks. Covered bonds are senior debt instruments issued by a bank, usually of five-to-ten year durations, and backed by a dedicated group of home loans known as a “cover pool.” If the issuing bank becomes insolvent, the assets in the cover pool are carved off from the issuer’s other assets solely for the benefit of the covered bond holders. This ‘ring fencing’ of a portion of a bank’s loan book for the benefit of covered bond holders is why covered bonds are currently banned in Australia under the Banking Act (1959), which requires that depositors get paid-out before all other creditors in the event of default by a bank.

The banks are keen to have covered bonds introduced into Australia as they would enable them to raise funds more easily and cheaply from offshore, thereby enabling them to issue more loans and earn higher profits.

Covered bonds are currently all the rage in the USA, where they are seen as a ready alternative to securitisation, which has lost favour following its key role in the GFC. Covered bonds are considered safer than securitisation since the loans are kept on the bank’s balance sheet, thereby ensuring greater care is taken by the issuer in assessing a borrower’s borrowing capacity as well as requiring capital to be held against potential losses.

The Reserve Bank of New Zealand (RBNZ) is looking to introduce legislation that enshrines the rights of foreign covered bond investors to mortgages written by New Zealand banks ahead of local bank depositors, and gives the banks the ability to issue covered bonds worth up to 10% of their total assets, based on the value of assets securitised. This limit would be an increase from its previous guideline of 5%. The Bank of New Zealand (owned by Australia’s NAB) became the first New Zealand bank to issue covered bonds, issuing NZ$425 million worth to domestic institutional investors in June 2010. Westpac New Zealand also recently issued its first covered bonds.

Why proposals to increase bank competition are a bad idea:

I oppose these measures to increase bank competition for three main reasons:

(i). they are unlikely to lower interest rates on mortgages:

Even if these measures are successful in lowering bank funding margins, they will do little to lower interest rates on variable rate mortgages. This is because the RBA sets the cash rate based on end-user borrowing costs. Had the gap between the RBA cash rate and standard mortgage rates not widened as they did following the GFC, there is a high probability that the RBA would have raised the cash rate by more than it has over the past 12 months.

Put simply, variable mortgage rates are unlikely to be significantly affected by changes in the level of competition.

(ii) they are likely to further increase the availability of credit:

As indicated by the above chart, previous measures to increase competition have led to a significant loosening of credit standards and a substantial increase in the amounts that households could borrow for housing. The resulting increase in debt levels has been capitalised into house prices, thereby reducing housing affordability.

Increased government support of the RMBS market, or further offshore borrowing by the banks via covered bonds, will increase the overall amount of funds available to be lent for housing. In turn, this increased availability of credit and competition is likely to: further erode credit standards; increase household debt levels and house prices; and reduce housing affordability.

(iii) they place taxpayer funds at risk and reduce financial stability:

Increasing government support of RMBS and covered bonds would further push the risks of mortgage lending onto the Australian taxpayer.

In the case of RMBS, the taxpayer would be required to absorb any losses incurred on non-performing loans. And given the AOFM’s ridiculously generous eligibility criteria on RMBS – 95% Loan-to-value-ratio; $750,000 loan size; 10-year interest only – the risk of loss in the case of a housing market correction is beyond hypothetical. The risk of default would be even higher if the Government decides to become an investor and price leader in subordinated tranches (i.e. lower quality / higher risk) of RMBS, rather than restricting itself to AAA-rated senior debt, as it does now.

In the case of covered bonds, with bank assets ring-fenced and covered bond holders ranking ahead of depositors, Australian taxpayers would likely be called upon to cover any depositor losses in the event of a bank’s failure. So the increased protections afforded to investors under covered bonds would come at the direct expense of the taxpayer.

Reflating the housing ponzi:

It is clear to this blogger that the Government’s focus on banking competition is a distraction from the real issue at hand: that Australia’s housing market has become highly unaffordable due to: easy credit funded, to a large extent, from offshore; investor speculation; and supply-side constraints. And now that house prices are correcting, thanks mainly to households reaching ‘peak debt’ as well as the banks finding it increasingly difficult to expand credit by borrowing offshore, the Government is once again looking to intervene in the market to reflate the credit/housing bubble.

What you, the reader, needs to ask yourself is whether this is how you want our banking system to operate: borrowing large sums from foreigners and channelling lending towards housing in place of productive enterprises, with the taxpayers picking up the tab if things go wrong? Is such an approach to banking in our national interest?

It’s a shame that our political leaders and mainstream commentators are not asking these important questions.

Cheers Leith

Leith van Onselen

Leith van Onselen is Chief Economist at the MB Fund and MB Super. Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.


  1. Can't agree with you on this one sorry. I'm no supporter of making it easier to borrow to continue the housing ponzi scheme but I think having 4 increasingly dominant banks is not without social and economic cost.

    Point 1 – what you seem to be arguing is that monetary policy should be allowed become permanently less effective by allowing the 4 banks to control their margin spread to the cash rate. While the net effect might be the same ie: variable rates do not change as the rba increases more to offset margin decreases – the monetary policy transfer mechanism improves as should the outcome to consumers with further choice

    Points 2 & 3 – I agree with you there was no doubt Australia had some dodgy asset backed markets and it is questionable whether the market as a whole can sustain more asset backed, this is not an argument for less competition. It was poor regulation that caused the easy credit conditions – something the world is slowly coming to terms with. With favourable government assistance, it should be possible for small banks to access traditional funding sources. Yes this could impact tax payer's funds but this comes at the benefit of decreasing the dominance – and associated lack of control that comes with it – of the major banks.

  2. Gillard,Swan & Co are determined to keep the bubble inflated at whatever cost to the nation in the longer term.

    We would need comprehensive psychiatric examinations of these people to determine their motives.Plainly,that is not possible.

    I will stick to my default explanation and put it down to the SIA Syndrome – Stupidity,Ignorance,Arrogance. This condition has a poor prognosis.

  3. Is there any reason that we can't have variable loans Indexed to the RBA rate? Most other countries with variable loans have them from what I gather. I also wonder if covered bonds could create an increased risk for banks if depositors make a run for the door.

  4. Oh god all smoke and mirrors live on ABC 24 right now watching Swan… I know your right Leith.

    No one is asking the hard questions here.

    No cheap capital to re-inflate this will all end in tears on day and i will be a massive correction.

    We need to pay ff the debt why can the average Australian not see what they are doing?

    Does no one read anymore?

  5. Another timely reminder that no real problems are identified or rectified with this superficial response…..

    Shoppers, if illinformed,may persue this so called competitive measure by re-financing only to discover that the, often, massive break fees apply as they always have and will.

    The measures are aimed partly at exit fees that have allready ceased or reduced.

    ANY measure that adds to our current plight, ie. madnitude of debt to a falling "price..MUST be counterproductive…

    Snake oil men like Swan are Very dangerous…

    This is, a Swan dive if ever I saw one…

    NB -Adelaide Sunday mail article today..Page 30 features headline of HOUSE PRICES HIT- BOOM IS OVER AS VALUES FALL….
    Leith perhaps that theory of a bubble Prick….- WEST to EAST in Our great land is looking more likely…

  6. Leith

    you are on the boil with this one … but we're in the back seat of the bus waiting for the crash, and all we can do is assume the position.

    While you're on the boil, why not take a peek at the prices of commercial property and consider how that (and the extortionate pricing of retail space by places like Westfield) leads to consumers paying way way more for items just to fuel the prices of commercial property. This perhaps in-turn feeds the cycle of why people don't see 750,000 as being expensive for a 3br fibro house

  7. Leith van Onselen

    All. As usual, great comments. I'll try to read through the Government's "reforms" this week and write a follow-up piece.

    [email protected] – I agree that Australia's system whereby variable mortgages rates are determined by the banks, rather than against some kind of reference rate (e.g. the RBA cash rate or BBSW), is perculiar. Kevin Davis recently wrote an excellent article on BS addressing this matter. He has also provided a submission to the Senate Inquiry along these lines.

    Obakesan – I might tackle the commercial property angle down the track. I've got some other issues to tackle first.

  8. Evan,

    I believe this is a false choice.

    Banking reform does not have to mean increasing irresponsible credit.

    Consider if the proposed RMBS carried a tax incentive, or simply the guarantee, and were limited to loans under 65% LVR. This would be a much more productive alignment of incentives. As Leith has shown, the terms of support for the proposed RMBS extend to 95% LVRs so there is no doubt taxpayer funds will be called upon in a downturn.

    I think this is deliberate. I think the big banks are working hand in glove with the government (and opposition) to create this new funding source to replace the overseas wholesale funding which I believe is now closed to them. Rather than this cause a credit crunch and market crash I believe the banks are using this ploy to de-risk their portfolio at taxpayer expense.

    The big banks response seems too muted, and it could even be said they encouraged this "competition" by increasing their rates in excess of the RBAs rate increase.

    I smell a rat.

  9. Do you if there will be a way to find out which bank/deposit taking institutions will be offering covered bonds so that I can avoid them?

  10. Nic,

    I don't disagree (nor do I disagree with Leith's underlying sentiments). It is more a case of me favouring the Japanese philosophy of any improvement is a good improvement.

    That doesn't mean this is the best solution by any means nor is it likely that the bank's haven't had a strong political influence. But I think at least everyone is fearful of too much dominance. I'd like to hope it was because they'd learnt from the horrible actions during the crisis (blank deposit guarantee, screwing people on margins to maintain profits, buying / swapping each other's paper, self-securitisation etc.) but the reality might be that they only care because the general public is upset by bank's profits at the moment.

    However, funding issues aside, banning exit fees and taking your bank account number with you like your mobile phone are great ideas. Too bad it looks like the latter is one that bank's will scream so loudly about it won't get implemented.