More competition or less debt?
As usual, I’ll be putting an argument that is contrary to popular opinion on the need for more competition I the banking sector. So to clarify the issue, here’s a quick poll: who thinks that Australia doesn’t have enough debt?
Nobody? OK, now let’s discuss the “need” for more competition in the banking sector.
The raging debate is missing the point–Hockey and the Coalition are right to go after the banks, but they’ve made a mistake in suggesting that the sector’s ills would be cured by more competition. In fact, we allowed too much competition in the 1980s, and again in the 1990s. The outcome, both times, was too much debt—firstly for businesses, and then for households. That’s the sector’s real problem, and adding a third dose of competition won’t fix it.
One of Paul Keating’s monumental ‘achievements’ when he was playing the role of the ‘world’s greatest Treasurer’ was to let virtually unlimited competition into Australia in the form of foreign banks. The initial proposal was to let four in, but Keating’s ‘triumph’ was to successfully argue to allow sixteen to set up shop here. I thought nobody would forget what happened next, but since competition is once again being suggested as a panacea, maybe everyone has forgotten. Cut-throat competition for market share poured money into the hands of Ponzi merchants like Alan Bond and Christopher Skase. That “Bondy” went bust trying to sell beer to Queenslanders just about says it all about the people willing to lend him money.
The end of that era of excess saw most of the foreign banking capacity in Australia collapse, leaving the market pretty much in the hands of the Big Four – not forgetting that one of the them, Westpac, came close to making it the ‘big three’ when it too nearly collapsed in 1992 with a then record $1.6 billion loss.
After the collapse of Bond Corp, Qintex and others, Australia had virtually nothing to show for it beyond a string of expensive hotels along our shorelines and a mountain of business debt—the unwinding of which gave us “the recession we had to have”. The Business sector, which had gone from a debt ratio of 22% to 55% in just over a decade, began to rapidly delever to 40% of GDP by the mid-1990s.
But that is starting to look like ancient history. The contemporary debate on banks is squarely focused on mortgage lending which, we are told, is uncompetitive.
Give me a break. After the Wallis Inquiry in 1996, non-bank lenders were set free by their new ability to raise funds through the securitisation market. Aussie John Symonds and a throng of others began cutting margins on home loans to build volume, starting a race to the bottom that the banks, to a large extent, were forced to join.
Back when “the recession we had to have” began, mortgage debt was a mere 17% of GDP. It began to rise right from that time—even though unemployment was exploding from under 6 to over 11 percent—and kept on rising to its pre-First Home Vendors Boost (FHVB) peak of 81% of GDP. Courtesy of the FHVB, it rose again to again to 87%, from where it is now falling.
A large reason for this blowout was the competition for market share driven by the growth of the non-bank securitized lenders like Aussie Home Loans, Wizard, etc.
I made a submission to the Wallis Committee in 1996, and walked away stunned when they told me that one of their key recommendations would be to allow securitized lenders into the Australian market. Shocked at how blithely the Committee was considering this, I wrote a supplementary letter to it the next day (July 12 1996), which in part stated that:
The securitisation of debt documents such as residential mortgages does not alter the key issue, which is the ability of borrowers to commit themselves to debt on the basis of “euphoric” expectations during an asset price boom. The ability of such borrowers to repay their debt is dependent upon the maintenance of the boom…
Should a substantial proportion of eligible assets (e.g., residential houses during a real estate boom like that of 87-89) be financed by securitised instruments, the inability of borrowers to pay their debts on a large scale… will be felt by those who purchased the securities, or by insurance firms who underwrote the repayment…
there would obviously be a collapse in the tradeable price, and, potentially, the bankrupting of many of the investors…
Of course, my warnings were ignored in the general euphoria for “more competition”, and the rest is history: lending standards dropped as the old and new competitors fought it out for market share, debt to households ballooned, the bust in lending arrived, the securitizers failed and these new competitors were taken over by the big Four once more.
Yet here we are again with people arguing that more competition will improve things. The numbers from the past decade and a half tell a completely different story. Even if you accept the general economics mantra that more competition is always good thing in product markets—which I don’t—the usual basis for that is the belief that more competition will mean higher output at lower prices. But the output of the banking sector is debt-based money: we may want debt to have a lower price, but do we really want more debt?
Be careful also about wanting a lower price—in terms of the margin between the RBA’s base rate and the variable mortgage rate. One way price can be driven down in competition is by offering a lower quality product, and that’s certainly what happened as competition in the post-Wallis Committee era. Lenders replaced careful valuations with drive-by checks to see that there was a building on the block, and careful assessment of capacity to pay with “liar loans” and 30-minute online loan applications (see page 34 of this report by the Home loan lending practices and processes House of Representatives hearing back in 2007):
CHAIR—We will ask Mr Warner for a comment on that. Also we would be interested in knowing is there an issue with the valuations of properties.
Mr WARNER: … We do not have valuers going out doing asset tests on all loans that are undertaken by financial institutions. Some banks get their own either ex-managers to drive by to see if the actual house exists or we have a lower form of valuation being undertaken.
These days it is getting to the point where you actually have the valuer who would not actually even see if the house or asset existed in the first place. You have a drive-by which is at best a cursory glance to see if there is a property on the lot that has been purchased.
With lower quality valuations and many other cost cutting measures like this, the interest rate margin dropped. RBA figures show that headline variable mortgage rates which in the 1980s had been 400 basis points over the RBA cash rate, came down to less than 200bps through the period 2000 to 2008.
So the big paradox for the dominant “we need more competition” argument in the current debate is why, if the banks have lent on much tighter margins, are they so profitable? The answer is to be found the rising volumes of credit extended from the mid-1990s to the present.
Lending volumes are now 400 per cent of what they were in 1992. That would make sense if the economy and population had increased in equal measure, but they have not. The banks kept lending through the GFC, and Australian homebuyers kept up their frenzy of borrowing until March of this year, when the mortgage debt to GDP ratio peaked at 87 per cent. That figure is now coming down as householders deleverage.
You might think that the banks should turn next to business lending, where there have been valid complaints that money for working capital needs is too hard to obtain. However this is add odds with the aggregate lending data for business – it peaked at 63 per cent of GDP in 2008, and has been coming down quicker than homelending.
This is why Joe Hockey’s attack on the lack of competition is flawed—what we need is not more lending but less, and not a lower price but a higher quality. This is where both the opposition and government should be looking. Instead, Treasurer Wayne Swan is trying to kick along more lending by buying up RMBS issues, thereby playing the game both the banks and the non-banks want – to keep volumes growing.
Further cut throat completion to grow volumes would be madness—we are saturated with housing debt and the long delayed deleveraging cycle will go on, whatever Wayne Swan does to give it a boost.
What we need are methods to regulate the volumes of debt offered by the banks to stop this happening again, without putting upward pressure on the cost of households have to pay for it. That may sound like an economic impossibility, and it would be if “free competition” between banks were expanded.
In fact there is nothing ‘free market’ about banking in the first place. Our big four banks are raising covering their shortfall between loans and deposits by borrowing vast sums abroad—equivalent to 40 per cent of mortgages in Australia—exposing the economy to future credit shocks, and all on the back of actual, and implied deposit guarantees provided willingly by the government.
That is massive regulation of a positive kind for banks. It’s time to balance that with some less positive regulation—policies that regulate and control the volumes these state-underwritten entities can lend.