Too-big-to-fail banks are crushing competition

Cross-posted from the MARQ Services Blog

Since the global financial crisis, the Basel Committee on Banking Supervision has devised numerous reforms to ensure that taxpayers will never again have to rescue banks teetering on the brink of collapse. Yet despite these moves, explicit and implicit government exposures to banks are substantial and are distorting competition.

Professor Deborah Lucas, distinguished professor of finance at the Massachusetts Institute of Technology’s Sloan Business School notes that explicit and implicit government exposures to banks are huge so the prospective costs and risks are high. She believes that policymaking is distorted because governments fail to recognise those potential costs and risks.

Speaking at the Australasian Finance and Banking conference on systemic risk in Sydney last December, Lucas said US mortgage market risk is still held almost entirely by the government. Early in the crisis, the US government took over The Federal National Mortgage Association, FNMA, commonly known as Fannie Mae, and The Federal Home Loan Mortgage Corporation, known as Freddie Mac, in 2008. In doing so, the government converted two government-sponsored enterprises from private companies with implicit government guarantees into entities that are fully owned by the government and whose losses the government has a legal obligation to absorb, said Lucas.

For those with a deep interest in the subject, the book “Measuring and Managing Federal Financial Risk” from the National Bureau of Economic Research and the University of Chicago Press, edited by Professor Deborah Lucas, contains a number of relevant papers on the topic from highly acclaimed academics.

The underlying concern is that governments, including Australia’s, are not assigning any costs to these call option style guarantees which are not only at great cost to the taxpayer but also at the increase of systemic risk.

In Australia, APRA has recently recognised the existence of Domestic Systematically Important Banks (D-SIBs) in their release of its Information Paper of December 23 2013. This paper perhaps puts the spotlight on assessing the costs and risks of both implied and explicit government guarantees that Australia’s D-SIBs enjoy.

Mòrgij Analytics commissioned research on the topic from John Watson of Margate Financial Research Solutions. The full paper can be found here, but the following is a summary:

• The introduction of the Financial Claims Scheme, that provides a government guarantee of deposits held in $A with ADIs incorporated in Australia per deposit-holder up to $250,000 as well as to policyholders of general insurance companies, is distorting the structure of household financial decision-making in regard to the relative competitive position of authorised deposit-taking institutions versus other financial market participants in the savings, lending and investment markets.
• The RBA and APRA have agreed to allow participating Australian ADI’s to partly fulfil the incoming Basel III Liquidity Coverage Ratio by paying a 15 basis point fee for a Reserve Bank committed liquidity facility (CLF) based primarily on the repo of AAA RMBS rather than requiring ADI’s to hold larger amounts of government bonds. The RBA is clearly viewing the CLF as a liquidity facility only and pricing it accordingly with no margin for credit risk. However, as there is no liquid market for RMBS where, an ADI or the RBA can safely and quickly sell RMBS, the facility is really a credit facility and therefore should be priced as such. With the tax-payer subsidised cost advantage to the banks (of taking advantage of the CLF rather than purchasing government bonds) of up to 150 basis points based on current market yields, the annual cost of the subsidy to taxpayers amounts to $4.5Billion.
• D-SIBs do not pay for the benefits they derive from the market-perceived implicit government support which, as the IMF noted in its report on Australia’s 2012 Financial Sector Assessment Program, include lower funding costs than their competitors. In contrast to their smaller rivals (2nd tier banks, regional banks and the mutual sector), the D-SIBs are now regarded by credit rating agencies and investors alike as “too-big-to-fail”. The D-SIBs get the benefit of credit ratings that have been explicitly lifted two notches higher than would otherwise be the case.
• In addition to the direct funding cost benefit enjoyed by the D-SIBs because of the implied government guarantee, those banks are particularly aggressive on their internal ratings-based approach (IRB) models for calculating risk weighted assets for residential mortgages. The implied guarantee does not just support the credit rating agencies opinions but also allows the market to ignore the low rate of actual capital held against residential mortgages. Risk weighted assets (RWA) for residential mortgages averages around 16% for the D-SIBs. The implied government guarantee support allows the D-SIBs to improve their return on capital whilst maintaining profit levels.
  
• On 23 December 2013, APRA released a framework for D-SIBs, belatedly recognising that there is a market perception that the D-SIBs are too big to fail and that this should not be the reality. Unfortunately the APRA determined 1% higher loss absorbency (rather than 3% adopted by many other regulators) capital requirement effective from 1st January 2016 that must be met from common equity tier 1 capital for D-SIBs does not sufficiently level out the competitive landscape.
  
• The following table provides a high level $ estimate of the annual advantages enjoyed by the D-SIBs at the cost to the taxpayer:

We make no claims as to the exactness of John Watson’s assessment and neither does he, but the research does highlight the significant annual dollar benefits enjoyed by D-SIBs over their smaller rivals, organisations which may provide equal services and have high quality loan books.

As residential mortgages generally represent the majority of assets of the non D-SIB ADIs, MARQ Services can be used to provide detailed transparent analysis and management of those mortgages so that an organisation can prove to regulators, investors and lenders the high quality of its assets. At the very least could this transparent analysis help us to recognise that Australia’s financial system’s future does not just lie with D-SIBs?

Is this something for the Murray Financial System Inquiry to look at in detail?