The RBA has not been rendered impotent by the Big Four (updated)

The bank debate now seems officially out of control. Increasingly foolish notions about banking are being served up day after day. One example: the developing meme that claims the banks have decided they will no longer be bound by official interest rate policy.

One morning last week I listened to ABC’s Melbourne local radio presenter, Jon Faine, beat up the banking industry’s official spokesman, Steven Münchenberg, on radio (audio here). Münchenberg could well be Australia’s King Of Making Difficult Arguments Sound Reasonable, but Faine is fast turning into Australia’s One And Only Left-Wing Shock-Jock, and the whole thing quickly became pretty awful to listen to. Its worst awfulness was that Faine kept insisting that the banks were now rendering government and Reserve Bank policy impotent. By deciding to react to rising overseas funding costs by raising their rates, he claimed, the banks were saying: “we will decide what’s best for the Australian economy; we won’t let the Reserve Bank decide what’s best for the Australian economy”. “It nobbles the government’s main strategy for trying to in some ways address inflation and therefore control what goes on in parts of Australia”s economic activity,” Faine declared, in a tone that suggested he knew exactly what he was talking about.

If Faine were right, this would be a huge problem for macroeconomic management in Australia. Thankfully, it’s populist blather. As a couple of Faine’s phrases disclose, he has little idea about how or why the Reserve Bank conducts monetary policy. If Faine really believes it …

… let him wait until the Reserve moves rates and then see how far the banks have decoupled from official monetary settings.

The not-very-complicated truth is that the banks’s pricing is influenced by more than one thing, just like prices in most business. My local greengrocer’s prices are mostly dictated by wholesalers’ prices, but if you doubled their wage costs tomorrow, I’d end up paying more for tomatoes and apples. In the same way, official rates matter a lot to the banks, but rates on global markets matter too – because banks borrow a lot of money offshore, and in the process effectively fund Australia’s current account deficit.  Banks are now moving rates up because they are paying noticeably more for money, in a global market which is currently nervous about who it lends to.

But the rises are hardly enormous: ANZ’s much-criticised increase amounted to six basis points on mortgages – that is, six hundredths of one per cent.

And of course, if the Reserve wants to nullify the effect of such a rise, all they have to do is make an offsetting change of a few basis points when next they move rates. Reserve governor Glenn Stevens has made this point himself, though I couldn’t quickly find the precise reference. (Münchenberg made this point to Faine too; Faine simply ignored it.)

What’s particularly interesting about the current moment is that Faine is just one of many people talking up strange ideas about banking. I opened up the Business Spectator website a few days after hearing Faine, and found the much-admired Robert Gottliebsen, founder of modern Australian business journalism, arguing a similar point: that the Reserve Bank’s independence is “crumbling” because the advent of overseas funding has weakened its power over rates. I could have missed it, I suppose, but this is not a view of monetary policy that has cropped up in any of the monetary policy or central banking literature that I’ve seen. If it is a problem, it’s been a problem for a while, because the banks have been going overseas for money for at least a quarter-century now.

The dilemma that the Big Four banks really pose, it seems to me, is that they’re a highly profitable oligopoly which has actually boosted its margin in the past few years as banks elsewhere in the world have plunged into chaos. This was, of course, not the way Steven Münchenberg wanted to put it. But crudely benchmarking the Big Four’s long-run profitability against their Australian peers, as Ian Harper did for Banking Day a year ago, suggests that their returns are consistently a few per cent higher than they would be in a more competitive environment. (Note: Ian Harper, who is no fool,  disagrees with this reading, arguing bank profits are broadly where they should be. He  could be right. There is no simple right way to decide what a company’s long-run profitability should be.)

The Big Four banks’ profitability is a genuine issue for discussion – though maybe not our biggest national problem right now, if only because the banks’ profits are mostly paid out to Australian superannuation funds. But it’s in a way just one version of a broader national issue: Australia tends to have highly profitable oligopolies in key network industries like groceries, banking, energy distribution and telecommunications. The banks get more attention than most because some of us pay them more, and we pay them more because we like to borrow.

A debate on how to deal better with highly profitable companies would be a good thing to have. There are policies available to address that issue. The national temper tantrum we’re having right now about banks reflects little credit on some of the participants.

Update: The Reserve’s Guy Debelle has now addressed this issue in comments made after his most recent speech.  As well as confirming that the Reserve agrees with the reasoning above, he makes the point that to the extent the banks’ mortgage rates react to factors other than “official” rate changes, the Reserve’s management gets slightly less precise. But he also makes the point that mortgage rates are just one of many transmission mechanisms for monetary policy (anyone remember business lending? or bank savings?), and there’s always imprecision in the process. Debelle also notes the US circumstance, where most mortgages are written at a 30-year rate. That really might make US monetary policy less effective than Australian monetary policy.

So have the Australian banks’ recent changes to their processes influenced the effects of monetary policy? “I don’t think that has changed materially at all,” Debelle said.

Update 2: Faine followed up at the end of last week by verballing Wayne Swan with the same ill-researched argument. His first question: “Has a Treasurer ever been so impotent, in Australia, in the face of international and other forces?” Swan reacted relatively coolly, saying he “certainly rejected that characterisation” and pointing out that the economy was in fairly reasonable shape.

About David Walker

David Walker runs publishing consultancy Shorewalker DMS (shorewalker.net) and is commissioning editor of Acuity magazine. David has previously edited the award-winning INTHEBLACK business magazine, been chief operating officer of online publisher WorkDay Media, held policy and communications roles at the Committee for Economic Development of Australia and the Business Council of Australia, and run the website for online finance start-up eChoice. He has written professionally on economics, business and public policy since 1987 and spent three years in the Canberra Press Gallery for News Limited and The Age.
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37 Responses to The RBA has not been rendered impotent by the Big Four (updated)

  1. Nicholas Gruen says:

    The “much admired Robert Gottliebsen” indeed. You saw that halo drop first on Troppo.

  2. conrad says:

    One thing that might cause a bit of excitement for the RBA (and certainly the shock jocks) would be if people started taking out foreign currency loans for housing. This already happens commonly in some places in Euroland (for better and often worse), although curiously it seems almost unheard of with the local population here, and no banks seem to aggressively market it. However, if it did happen en masse, it’s not clear to me what the RBA could do about it.

  3. David Walker says:

    Conrad, if organisations here started marketing foreign currency loans for housing, I’m willing to bet that they would be targeted very aggressively by the ACCC. The reason is that most consumers do not understand the risks of such loans – and Australia has comparatively recent experience of this fact.

    Here’s the history, with apologies if you know it already. In the 1980s, after the float of the $A, some or all of the Big Four aggressively marketed foreign-currency loans with low interest rates. The main target was farmers. Swiss franc loans were the most common. Westpac was, from memory, the most agressive marketer.

    When the $A collapsed the farmers ended up with much higher $A capital and higher $A interest payments too. There were many suggestions that the banks did not provide appropriate advice to the relatively financially naive customers who took out the loans. The banks started foreclosing, though my recollection is that they ended up settling a lot of these cases and taking their losses.

    The whole affair became the subject of a very unsatisfactory Senate inquiry – unsatisfactory because from memory, the senators prosecuting the case against the banks most aggressively made spectacular claims of fraud that they were unable to back up. The stronger case was almost certainly that the banks had simply been incompetent and many of their staff ill-trained.

    Given this history, anyone wanting to market such loans today would quickly be made to show that they were setting out in great detail all the risks of such a loan. It’s essentially an interest-rate bet, and the ACCC would probably take legal action if you presented it as anything else. The only exception would be where you had foreign-currency income, which would make a loan in the same currency a legitimate natural hedge.

  4. Nicholas Gruen says:

    People should be able to take out foreign loans. But they should 1) be informed properly of the risks and 2) insulated from the sales and marketing process, by having the issues explained to them by an independent intermediary.

    I think it’s very unfortunate that instead, we just ban the things because they’re financially dangerous. They’re also potentially highly beneficial. I could certainly do with a share of our mortgage in Euros or $US or even better, Yen!

  5. Paul Montgomery says:

    And of course, if the Reserve wants to nullify the effect of such a rise, all they have to do is make an offsetting change of a few basis points when next they move rates.

    And what happens if the banks refuse to pass that on, as they surely would be encouraged to by the business press? The Oz in particular has been baying for the banks to stare Swan down. Chatter before the recent RBA decision was that they would lower rates but the banks wouldn’t pass it all on, if any.

    I think you’re being a bit naive, David. The RBA only provides 25% of the funding for Australian bank loans, a figure that has been going down steadily. Why should the banks continue to pass on 100% of the RBA’s rate movements when it only affects 25% of their funding sources?

  6. David Walker says:

    Nick, I agree that foreign currency loans should not be banned. The full explanation of the risks is what the ACCC would and should insist on. I don’t want cyanide banned either, but I would want retailers discouraged from selling it in litre bottles on supermarket shelves. In the wrong hands, foreign currency loans are poison.

    Just out of interest, would you be happy to cop the rise in payments from a Euro/Yen/$US housing loan if commodity prices cratered and the $A went back to $US0.60? Is it a natural hedge for you? Do you just like living dangerously?

    Now, anyone up for defending Jon Faine?

  7. David Walker says:

    Paul, I don’t think the banks should necessarily continue to pass on 100 per cent of every RBA rate movement. In fact, in my ideal world they would be free to make whatever commercial decisions they like within a competitive framework. If the framework isn’t competitive enough, I think it’s the framework that policy should first target. Though that’s easier said than done – there’s something about the structure of the Australian economy that just promotes oligopolies.

    But I repeat: if the RBA thinks the banks are going to keep their rates up if the Reserve pushes official rates down by 25 basis points, the RBA will quite happily drop official rates by 50 basis points – or whatever other number it thinks is necessary to get the end result it wants. At some point, the market will force the banks to react, and the Reserve will get the movement in the cost of money that it deems necessary.

    I’m sorry I can’t point you to the speech or presentation where the RBA set all this out itself, but unless I am mistaken it has been quite explicit.

    On the issue of the banks’ term structure – it hasn’t changed that much. Short-term wholesale funding now makes up something less than 20 per cent of the Big Four’s funding, but retail deposits are about 50 per cent of their funding, and have a short weighted average term, so they are influenced by official rates. The banks’ equity has risen and its term profile has lengthened in recent years, but not that far.

    Just to be clear, the RBA does not in the normal course “provide funding” for Australian banks. It targets the overnight cash rate, thereby heavily influencing the price of all short-term rates in the market.

  8. Pedro says:

    I should have thought there is a reasonable prospect the RBA left the cash rate on hold knowing that a bit of tightening would flow through and for once it would not get the blame. The warnings were certainly coming in the days before.

    I don’t ever hear Faine, but a couple of other dopes have had lots of dumb things to say about the banks on radio national.

  9. JB Cairns says:

    THE RBA does not target the cash rate, it targets retail rates.
    Rick Battelino said this eons ago.

    The cash rate influences the BBSW rate and this affects some of the bank’s funding cost.

    Retail deposits cost banks a lot more in these post GFC days and probably always will.

  10. Paul Montgomery says:

    David: it seems to me that the banks are coming to the decision that their most important and/or needy stakeholder is not the RBA, it’s their shareholders, and by proxy the hedge fund managers who set expectations for profitability. If the hedge fund managers say the banks should be making x% profit margin and the RBA wants them to make x-2% due to setting interest rates at a certain point, then the banks are making noises to the effect that they will follow instructions from the hedge fund managers.

    In that circumstance, the RBA has a much more difficult time of it. Consider the scenario of the RBA getting wedged by a simultaneous jump in domestic inflation and a second GFC. Stevens would have a couple of hot potatoes to juggle there. Nationalisation might not seem so crazy under those conditions.

  11. Patrick says:

    Hedge funds set profitability expectations at the Australian big four banks?

    I also hadn’t previously realised that the RBA was targeting bank profitability, as this isn’t obvious from its website.

  12. Nicholas Gruen says:

    David @6.

    I do like living dangerously, but try to do it with a margin for safety.

    So I’d just have some of my loan in foreign currency, although I probably wouldn’t do it now. I’d do it when the dollar had fallen. (Just as I’m trying to buy foreign assets right now because I presume there’s not a lot of upside in the Aussie – though of course I may be wrong).

  13. Ross says:

    Why is it that we have Canada with a similar economy to us having rates 4% lower than us? The Global Central Banks are again milking this country and will bring on a massive recession.

  14. JC says:

    One thing that might cause a bit of excitement for the RBA (and certainly the shock jocks) would be if people started taking out foreign currency loans for housing. This already happens commonly in some places in Euroland (for better and often worse), although curiously it seems almost unheard of with the local population here, and no banks seem to aggressively market it. However, if it did happen en masse, it’s not clear to me what the RBA could do about it.

    Conrad, that was widely popular in the 80’s, adopted by lots of people and a disturbing number ended up as equivalent road statistics. Secondly the banks spent several years defending themselves against lawsuits (having actually lost some) and having the bad publicity of bankrupting far too many people. They won’t go near them as a product.

    However a foreign currency loan is actually pretty easy to replicate if that is what you wish to do. Take out a loan and go buy an Aussie Dollar/US or whichever currency contract to equal the sum borrowed. Give or take fees etc it gets you to the interest rate of the currency you wish to borrow in.

    My recommendation though is don’t do it. Carry trades, which is what it actually are, is a really silly way to try and make make or save some money.

  15. Ross says:

    How is it that Canada with a similar economy to ours has rates 4-5% lower
    than ours? We are not been told the truth.Our banks are buying their money
    at the same rate of Canadian Banks.We are not that stupid.

  16. David Walker says:

    Ross, you’re right to look at Canada, but there’s no cover-up here. The cost of wholesale money for Australian and Canadian banks is very well known, and Australian banks are paying much more.

    Any explanation of short-term rate differences between countries is complicated. In the case of Canada, the simplest fact to point to is jobs: Canadian unemployment spiked above 8 per cent during the GFC, and the Canadian authorities cut the official short-term rate from Australian levels to bugger-all. And since Canadian official unemployment is still 7.6 per cent, short-term rates Canadian official rates have stayed low. (The difference between the two nations’ rates at the long end of the curve is much smaller – about 1.9 per cent for ten-year government money.)

    The broader point is that in economies with inflation-targeting central banks, low interest rates tend to be a sign of weakness, not strength. Australia is booming. Canada is not.

  17. Dan says:

    Sorry if this is a dumb question, but why aren’t Australian banks borrowing where it’s dead cheap, ie. overseas?

  18. Ken Parish says:

    Speaking of the Canada/Australia comparison, it might also be instructive for the Coalition groupies who religiously swallow Abbott’s propaganda line that Labor’s GFC stimulus was larger than it needed to be (although he’s mostly now adopted a strategy of implicitly denying that the GFC ever even happened).

    Canada implemented a smaller GFC stimulus package than Australia, indeed around the size that Abbott (and before him Turnbull) now argue Australia should have done. Coincidentally or otherwise, Australia’s unemployment rate peaked at just on 6% around July 2009 whereas Canada’s peaked at 8.7% only a month or two later. As David points out, Canada’s unemployment rate remains at around 7.6% while Australia’s is at 5.1%.

    Not coincidentally one might suspect, as at 2010 (CIA World Fact Book per Wikipedia, Canada’s ratio of public debt to annual GDP stood at 83.95% whereas Australia’s was at 20%.

    Those who make Australia/Canada comparisons and draw conclusions in Canada’s favour are largely merely making themselves examples of cognitive bias in general and confirmation bias in particular.

  19. Patrick says:

    Canada is coupled to the US we are coupled to China. But the current government will bring down rates soon enough.

    Dan, it isn’t a stupid question. But the main answer is that bank debt is not cheap anywhere! There is always a margin over the base rates and for banks lenders demand both high margins and high security.

    Second reason is that they lend AUD and so if they borrow foreign money they need to swap into AUD and the difference usually catches up to them in what they pay on the swap rates.

  20. Tel says:

    Ken I just checked the CIA World Factbook figures. There’s a note against Canada saying that it’s gross government debt, and I’d guess that Australia’s number looks also like gross government debt based on the size of it (but no note listed), so I’d say those figures are comparable. What was that about confirmation bias? We are talking about that GFC in 2008 yes? A single event… not the entire history of Canada up to and including that event.

    Canada, Public Debt:

    65.4% of GDP (2006 est.)
    — GFC —
    84.0% of GDP (2010 est.)
    83.5% of GDP (2011 est.)

    Australia, Public Debt:

    14.1% of GDP (2006 est.)
    — GFC —
    28.8% of GDP (2010 est.)
    30.3% of GDP (2011 est.)

  21. JC says:

    Ken

    Canada was whacked because of what Patrick pointed out. For instance all the American car and car component makers have assembly plants across border on that iceberg and it was pretty significant to the economy, so when the industry got hit in the US, the iceberg also took it on the chin.

    The Canadian dollar is very peculiar to trade because you also have to have a partial view on what is happening in the US on a macro level to figure out where that thing is heading. A general unscientific rough rule of thumb that traders use is that you need to take about a 1/3 of one’s view in terms of what is happening in the US if you’re looking to trade Canadian stocks or the Can dollar.

    Dan:

    Sorry if this is a dumb question, but why aren’t Australian banks borrowing where it’s dead cheap, ie. overseas?

    Banks don’t borrow straight US dollars, Euros or Yen convert them to Aussie dollars and lend it out as the currency exposure is far too big.

    So in order to get around that there are several ways of hedging the currency exposure and converting the proceeds in Aussie Dollars.

    If the exposure is short term, say, either side of 12 months, a bank will borrow US dollars and cover the exposure forward through the currency forward market.

    If it’s longer than that they will use the currency swap market which is little more difficult as it uses up a larger amount of notional credit limits with other banks.

    But there is no free lunch if that is what you’re thinking as the interest differential is always factored in that it will gross up the cost of borrowing at the prevailing rates in the domestic market. In other words you can’t borrow US dollars without a currency risk and if you don’t want the currency risk, you end up paying the Aussie dollar interest rates.

    Generally obtaining funding through overseas borrowings is always more expensive than either the domestic terms markets or straight out deposits which is the least costly.

    This index shows a little of what went on last year. It went from 20 basis points to 60 as the European crisis was raging. It’s the spread between US t-bills and the 90 day libor/Euribor.

    This is also a good index to look at along with it US counterpart.

    It tells you how stressed the capital markets are.

  22. Ken Parish says:

    JC etc

    I was responding to Ross who asserted that Canada had a “a similar economy” to Australia (and that therefore their lower interest rates were somehow an indictment of Rudd/Gillard govt policy. You’ve now argued (quite persuasively) that Canada’s economy is very different from Australia’s i.e. much more exposed to the US.

    BTW If the figures I cited are gross public debt I agree with Tel that they’re probably not very useful. The net public debt figures appear to be as follows:

    Australia – zero net debt prior to GFC rising to an estimated peak of a miniscule 6% of GDP in 2012-13 (despite putative small federal surplus);

    Canada – apparently around 14.9% of GDP shortly prior to GFC (2007) rising to an estimated 44% of GDP in 2011-12. Not horrendous but much inferior to Australia.

    Now Canada’s demonstrably much worse performance than Australia on both unemployment and net debt (and no doubt just about any other measure) might well be due at least as much to its greater exposure to the US economy than Australia than to the fact that it implemented a much smaller GFC stimulus package. I guess it depends on one’s ideological predilections. I simply don’t know. What I do know is that it is nonsense to point to Canada’s lower interest rates as proof that its economic policies are/have been superior to Australia’s over to last 5 years or so. The figures if anything suggest the opposite.

  23. JB Cairns says:

    One thing also to note that although having a much smaller stimulus , brought on by parliament not the government , their fiscal consolidation is taking much much longer.

    Those Catallaxy folk might cogitate on why Canada has taken sooo long for their recovery to gain strength and consequently very slow fiscal consolidation.

  24. Dan says:

    Patrick, JC – thanks. That kind of opens up more questions than answers for me, but I’ll go and try and figure out some stuff on my own.

  25. Patrick says:

    Nah shoot Dan, I’m not far off over-reaching and exposing the limits of my own knowledge so I might learn sth too!

  26. Fyodor says:

    There’s no mystery about Canada: the USA takes 70-75% of its exports, so the two economies are umbilically connected, resulting in a similar monetary environment. The long-term correlation between money market rates in CAD and USD is around 81%. It’s only around 58% for AUD-USD. End of fucking story.

  27. Dan says:

    Okay – I accept that as JC puts it, the interest differential is always factored in; that there are no free lunches; that you can’t borrow low overseas and lend high here. But this is not an intrinsic relationship, an identity, is it? Therefore, could a combination of exchange rates and overseas interest rates (bearing in mind that overseas lenders want safe borrowers, and Aust has a surfeit of those compared to the rest of the world) force the RBA to alter domestic interest rates?

    Or am I wrong – will the exchange rates automatically move to close, or more than close, that differential? If so, why?

  28. conrad says:

    “that you can’t borrow low overseas and lend high here”

    You can Dan as JC notes, you just have to take the risk or spend even more insuring yourself against it, which the average person probably isn’t up to (or game to). Despite this, you are probably essentially already taking a currency risk through a proxy if you are investing in geared companies that have done it or in companies whose earnings are not mainly in Aus dollars. This is bound to be the case if you have stocks in your superannuation.

  29. Pedro says:

    So Ken, if only everyone in the world had done a stimulus as big as us, the recession would be over every where? We “Abbott groupies” must have missed something.

  30. JB Cairns says:

    Yes Pedro, never a truer statement was made.

    Except the libs stimulus would have been smaller and later

  31. Dan says:

    Fyodor – thanks, so I was kind of right – there are arbitrage opportunities during some short period following a change in rates, but those windows rapidly close (and render the spreads during those windows null).

  32. Fyodor says:

    Yes, but extremely few “true” (i.e. riskless) arbitrage opportunities due to “covered” interest rate parity. There’s an army of professional FX traders out there who are paid a lot of money to exploit those opportunities into oblivion whenever they arise.

  33. JC says:

    Fyodor – thanks, so I was kind of right – there are arbitrage opportunities during some short period following a change in rates, but those windows rapidly close (and render the spreads during those windows null).

    It’s still speculation though and not a clear arbitrage if I can be pedantic, Dan. If there is a sudden move in a market you will likely have to favor a side first and then later cover the other side.

    In other words if you think a sudden hypothetical action by the RBA will cause rates to move more than the market thinks for a point in time you still have to buy/sell that side and cover later.

    Clear arb opportunities in this day and age don’t really exist per se, especially with a global price being available for trades contracts.

    We used to call it specutrage.

    Morgan Stanley had the biggest desk in the country arbing currencies, with a bunch of people arbing the currency futures contracts vs the interbank market. They were stilted human beings. Everyone outside despised them. They were a despicable desk. And you know, there wasn’t a lot in it. The biggest arb was the Euro and the arber made around $3 million a year for the bank in doing just that. That wasn’t really a whole lot of money in the scheme of things showing that arb opportunities aren’t around a lot. Keep in mind that the markets have become more technologically driven too.

  34. Dan says:

    Yeah, I guess the technology would lead those windows to close more instantaneously than in the past.

  35. Ross says:

    David Walker has the audacity to say Australia is booming.Only the mining industry backed by Chinese production is booming.The rest of our economy languishes in desperation and looming poverty.

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