Sunday bank-bashing at Troppo

Troppo co-host Nicholas Gruen made an impressively well-groomed appearance on Alan Kohler’s Inside Business program on ABC TV this morning.

Nicholas canvassed a really interesting idea I don’t immediately recall his having yet ventilated here at Troppo.  It’s the concept of portable mortgage insurance to replace the current government guarantee of the Big 4 Banks.  The lenders would pay something for the insurance and it would cover bank and non-bank lenders alike.

Together with banning or capping exit fees at a low rate (although Nicholas suggested that this might be a mixed blessing),  this would certainly enhance competition in the home loan market by assisting the redevelopment of viable non-bank lenders in the wake of the Big 4 having taken advantage of the GFC to obliterate or absorb Aussie Home Loans etc.

However, I can’t help wondering whether it would be enough.  The banks have achieved a level of maket dominance that may prove difficult to overcome.  They seem to be elevating the techniques of the Claytons (unprovable) cartel to an art form.

One of the advantages of being a self-confessed economics nincompoop is that I can unblushingly canvas ideas that may well be extraordinarily stupid, if only so the economic gurus can gently explain to me why they’re silly.

Why should we not also consider creating a publicly owned non-bank lender, taking advantage of the lower interest rate at which governments can borrow to on-lend to home buyers at reasonably affordable rates?  Mortgage rates would need to to be high enough so that they keep the banks honest rather than crowding them out of the market, but that shouldn’t be impossible to achieve.  Why not legislate to require the new affordable lender (Wayne and Julia’s Awesome Home Loans) to lend at a minimum interest rate of (say) 1.5% above the cash rate for the time being, with some independent review mechanism to ensure that the margin above the cash rate remains at a level that would allow the private banks to maintain a reasonable profit margin in the home loans market?

Wayne and Julia’s Awesome Home Loans would not be a deposit-taking institution (so it wouldn’t compete with the banks in that respect and would miss out on that potentially cheaper source of loan funds) and would not maintain a branch structure (thereby giving it a compensating advantage over the banks).  It would utilise existing private sector mortgage brokers (including Nicholas’s Peach Home Loans).

Of course, all this assumes that the banks really are acting as a cartel to a sufficient extent to justify what is a fairly radical intervention in the mortgage marketplace.  Perhaps the evidence of market failure and excessive oligopoly profits isn’t yet persistent enough to provide sufficient justification.  However, subject to the advice of economically literate Troppists, I think it’s an idea worth keeping in mind.

Update – I must say I find Michael Pascoe’s article in this morning’s SMH a pretty persuasive rebuttal of my proposal, and possibly of Nicholas’s as well.

About Ken Parish

Ken Parish is a legal academic, with research areas in public law (constitutional and administrative law), civil procedure and teaching & learning theory and practice. He has been a legal academic for almost 20 years. Before that he ran a legal practice in Darwin for 15 years and was a Member of the NT Legislative Assembly for almost 4 years in the early 1990s.
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Patrick
Patrick
11 years ago

I think the US tried something similar, with Fannie and Freddie basically underwriting mortgages to keep rates down and encourage banks to lend to higher-risk customers.

That I think this sounds similar should tell you what my at-least-equally-non-economically-talented opinion of this idea is!

Douglas
Douglas
11 years ago

Re Mortgage Insurance. This is offered by the lender thus, “Would you like Mortgage Insurance with this loan?”
This is often taken up by the borrower.
I believe it gives comfort to the lender while the borrower pays the premium. Can someone confirm that this is a bad deal for the borrower.
While the exit fees may be waived there is still the considerable expense of re-stamping the mortgage documents. Now if the Government waived these fees it would make changing Banks far more likely and therefore more competitive. Can someone say if this is correct?

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
11 years ago

They could do that Ken. And it would be sensible if done sensibly. But they’re too gutless. In the meantime they may be more attracted by the idea I floated on Inside Business. I’m writing a paper on it which should be out in a week or two.

I don’t agree with you that the banks could stave off non-bank competition if it was cheaper. They didn’t when Aussie turned up. The thing is with home-loans, you’ve got the lenders’ money, so the risk is with the lender, not the borrower.

That’s why defaults are probably necessary to remove overpricing from investment, where people tend to be more impressed with a nice add with people talking to you from Hong Kong, Dubai and London rather than a well researched track record (seems fair enough to me, those ads are very expensive to make), but price competition really works in lending, as we’ve seen.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
11 years ago

Douglas,

Yes, if a lender asks you to pay insurance for them – it’s a bad idea for you to do so if they give you the choice. Indeed, it’s as bad an idea as for you to pay your neighbour’s fire insurance.

But lenders usually require you to pay LMI. Then you can take the loan – with LMI, or not take the loan.

Ken Miles
11 years ago

The New Zealand government started Kiwibank operating out of the Post Office at the urging of a minor left wing coalitation partner. Apparently it is very popular in NZ and the current National government has promised not to privatise it.

Tel
Tel
11 years ago

I know at least one fellow who took the mortgage insurance (at the bank’s insistence, because it was the only way anyone would lend to him) and after a year or so, lost his job. The insurance did actually chip in a bit with the repayments providing some time to search for a new job. After finally getting a new job he went back to making payments and it seems to have been a very good situation for all concerned. I’m fuzzy about details, because it gets a bit uncomfortable to pry too closely.

Numerically, of course the bank owned the house so the bank had more to lose but trying to look for a job while at the same time getting booted out of your house is quite stressful. Getting a rental while you are unemployed is pretty much impossible, so I’d say the insurance protected both the bank and the home owner.

In the bigger picture, this sort of insurance is nothing more than hiking up rates to cover additional risk (the reason given for high credit card rates is the huge default rate and you can secretly add to that huge fraud rate as well). While the insurance companies do an excellent job of amortizing many small sporadic risks (such as the chance of fire next door, of the chance of one man being out of work), they have no defense against systemic highly correlated risks (such as a market downturn and many people out of work).

Jacques Chester
Jacques Chester
11 years ago

I suggest its lending rules should be jut as rigorous as the prvate banks.

Initially it may be so, but such a thing would never last. Eventually Today Tonight would run non-stop stories about ordinary Mums n Dads who couldn’t get a loan from Our Bank. Those bloody shinybums, asking about bad debts and the repayments on the V8. This checkout-and-shelf-stacking couple are saints – saints! – and by god the government practically owes them the $800,000 they want to borrow.

Paul Frijters
Paul Frijters
11 years ago

I am with Jacques on the political dynamics of a state mortgage bank. It wouldn’t be long before political imperatives would start to dominate economic ones.

MikeM
MikeM
11 years ago

The NZ Post Office had a long history in running its own bank, the Post Office Savings Bank, which was eventually sold off to ANZ. That made it a more likely candidate to re-enter the banking market than is the case with Australia Post.

The fact that Fannie Mae and Freddie Mac were presumptively guaranteed by the US federal government enabled them to raise funds at a lower price than commercial banks. That was supposed to provide a benefit for borrowers but a fair chunk of the savings went into lobbying and election campaign contributions – supposedly nearly $200 million in the decade up to 2008. The main objective of the lobbying was to ensure that US bank regulators were kept well away from them.

If those institutions had been adequately regulated (which would have included a requirement to hold adequate capital) then they need not have been at the centre of the market collapse. The fact that Ken’s idea reminds Patrick of Fannie and Freddie has is irrelevant to the worth of the idea as long as Australia’s strong regulatory regime is maintained.

Eventually Today Tonight would run non-stop stories about ordinary Mums n Dads who couldn’t get a loan from Our Bank. Those bloody shinybums, asking about bad debts and the repayments on the V8.

Vanishingly unlikely, so long as APRA is not captured by the industry that it regulates.

John B
John B
11 years ago

Does anybody remember the Commonwealth Bank window at their post office. Yes, I know – I’m showing my age.

I’m pretty sure that it was a non-lending arrangement. Deposits and withdrawals, a few bank cheques perhaps.

Besides this, my concern is not so much the banks’ lending policies, but the risk profile which comes with also running a few gambling casinos with other people’s money – so-called wealth management, brokerages, house dealings in shares and other securities, linked insurance subsidiaries and so forth. I don’t like the Commonwealth (Gov’t, not Bank) lending our AAA rating to this kind of outfit at any price. Perhaps the biggest risks are the foreign operations and the type of CEO required to drive into these markets.

For an example of just what kind of CV a potential CEO needs these days, check out via Google the current CEO of ANZ, paying particular attention to where he was during the collapse of the Argentine banking system only a decade or so ago. I, for one, wouldn’t give him the time of day, let alone a share of my wallet. What would a Canadian-born ex-boss of a US bank operating in Argentina and subsequently Asia who now finds himself in Australia trying again to get into Asia using Aussie Gov’t S&P ratings care about a little thing such as Australian Government sovereign risk? There must be limits.

Jacques Chester
Jacques Chester
11 years ago

Vanishingly unlikely, so long as APRA is not captured by the industry that it regulates.

It is exceedingly likely. If not in the short term, then in the longer term.

Australia’s third largest political party is talking about directly setting interest rates. Its two largest political parties are playing a game of policy chicken, seeing who will be prepared to push for the most destructive intervention.

Once such a constituency is formed it will take enormous pain to remove it, if such a thing is even possible.

Jacques Chester
Jacques Chester
11 years ago

The other problem with a publicly-owned savings institution is that it provides an attractive source of funds for government spending. All things being equal, it is politically easier to mandate that a public bank buys government debt as an ‘investment’ than to raise taxes or get funding on the free market. Thus life savings are converted into IOUs reliant on the financial discipline of politicians.

In a reasonably well-run country like Australia this sovereign risk is not particularly acute; but nevertheless it exists when it needn’t. As you noted, Ken, the systemic problems are not about unregulated interest rates but over-regulated land release.

Jacques Chester
Jacques Chester
11 years ago

For an example of the risk of such banks, look into the storied history of Japan’s postal savings system, which has had trillions of dollars equivalent on deposit. A lot of it was ‘borrowed’ for the endless parade of costly white elephants the Japanese are struggling with now.

Nicholas Gruen
Admin
Nicholas Gruen(@nicholas-gruen)
11 years ago

Tel,

You seem to be talking about MI not LMI. LMI stands for “Lender’s Mortgage Insurance”. It doesn’t insure the borrower at all. It insures the lender against borrower default.

Tel
Tel
11 years ago

There’s a page here explaining:

http://www.insurancecompared.com.au/explained/in-the-home/mortgage-ins.php

Borrowers in the “high risk” category (e.g. blue-collar worker w/ 5% deposit) usually have to pay both MI and LMI as a package deal (take it or leave it), but strictly speaking on day #1 the bank pays the LMI (the bank has the money to pay), then tacks it on top of the loan, so the whole package just translates to higher payments for the same house.

If the insurance company in question happens to be a subsidiary of the bank (or closely related somehow) then the combined corporate entity gets to pay itself for the LMI (later paid in installments by the borrower), and also the MI (paid continuously by the borrower) and also gets interest on the loan — the upshot being that it gets paid three times, for what is essentially only taking one risk.

Or you can just see it as a complex mechanism for charging higher interest to high-risk borrowers. Some might see this as ripping off poor people, but there is a small reward in the little bit of slack offered if you lose your job, get sick, etc. From the combined bank/insurance POV, a system to salvage what can be salvaged is more profitable than a slash and burn approach (i.e. having the MI pay a little avoids the LMI paying a lot).

… the banks’ profits are certainly very healthy indeed and at a very early stage of the economic cycle (although I wonder whether Sinclair accepts that such a thing exists). Nevertheless it may well be that ROE alone doesn’t provide conclusive evidence of lack of competition.

I have a bit of a simulation demonstrating why nonlinear prices and costs can easily result in high markups even with four or five genuinely competing players in the game. Comes with pictures for people who just want to scan it quickly, and source code for the truly bored who might want to try it at home.

http://lnx-bsp.net/news/2010/07/19/

Jacques Chester
Jacques Chester
11 years ago

Your link seems broken, Tel.

trackback

[…] Over at Club Troppo Ken Parish raises two issues about banks. First that the majors are all raised their interest rates by a similar amount in excess of the RBA rise. To my mind that doesn’t suggest monopoly power. The majors all have more or less the same business model, face more or less the same market for customers and raise finance in more or less the same financial markets. On that basis I expect them to behave more or less in the same way. That behaviour is due to them facing more or less the same competitive pressures. Why do they raise their rates at more or less the same time? Because they get their cue from the RBA. So what looks like coordinated behaviour is, to my mind, competitive behaviour. (Think of the Hotelling theorem – two icecream sellers on a beach will locate at the centre standing back-to-back rather than locate at the quarter and three-quarter mark). […]

Sinclair Davidson
Sinclair Davidson
11 years ago

Ken – thanks for that. I was doing a quick answer to your questions that became a much longer answer. So I’ve posted the whole thing here.

I have no intellectual problem with the existance of a business cycle or even that some organisational forms are relatively advantaged or disadvantaged at different stages of the cycle.

Julia
Julia
11 years ago

My own stupid non economist idea that came to mind this morning when listening to the parliamentary debate about whether and how to regulate bank fees was that regulating, say, exit fees will just squish fee increases across to other existing or new “services” (like breathing bank air, for instance).
How dumb is it to entertain the idea of regulating for an inverse % relationship between the totality of bank fees a given bank may charge and their profits? Banks may eventually reach a position where the fees are close to zero if the bank is extremely profitable, but on face value the idea appeals to me.
Tell me its dreadful.

The Beverage Curve
The Beverage Curve
11 years ago

there is no doubt that banking is now an oligoploy however at the time of the GFC the thinking was merely to save banks.

now that is over we have the problem of trying to get competition in the sector.

given that foreign banks have had the dickens of a time trying to bed down in Asutralia we can safely assume the barriers to entry are far higher than anyone imagined.

Are the banks working in concert. of course they are. Anyone who had read anything to do with game theory knows what they are doing indeed one large Business school shows how game theory works by using the banks.

Their ROEs are very high.

Both Treasury and the RBA has stated increased rates ABOVE the rise in cash rates are not justified because their margins are soo high.
One reason for that are the margins on loans to small and medium businesses.
( talk to them about increased competition!)

I am all ears on how to increase competition in this sector but have yet to hear anything substantial. ( this also applies to the NBN as well).

Patrick
Patrick
11 years ago

Indeed there is a class action underway on that issue.

The Beverage Curve
The Beverage Curve
11 years ago

Just to make things quite clear what Treasury and the RBA are saying is that the Banks have already recovered the higher borrowing costs.

What they are doing now is increasing their interest margins when they are already quite high.

Moreover Banks have form on being mischievous with reasons for doing things.

They had very high interest rates on credit cards ( because of risk) yet said at the same time almost all people always paid off the debts. In other words no sign of that risk in the rate offered.

They also charged more for money taken out of an ATM not owned by the bank you banked with despite NO extra cost in doing so.

Paul Frijters
Paul Frijters
11 years ago

Beverage,

yes, the question of how to increase competition in the banking sector is the crucial one.

If I was a regulator, I think I would like to see what the impediments are to borrowing money from overseas via the internet. The main issues are those of reputation and local assessments. The government has a traditional role in helping to accredit reputation and local assessments can be outsourced. I would for instance want to see if companies like Virgin wouldn’t like to give it a go, kick-started by managing a lot of mortgages on government buildings (i.e. time-limited preferred supplier status).

JC
JC
11 years ago

Nevertheless it may well be that ROE alone doesn’t provide conclusive evidence of lack of competition.

I chose two American banks latest ROE to compare to Australian banks average 10% ROE.

I chose what people think are the two large cap (relatively) healthy American banks: Wells Fargo and JPMorgan. Wells is a better comparison as JPMorgan has no large capital markets operations to speak of like our own large banks.

ROE was 9.59% and 9.41% respectively according to my data source- Morningstar.

These two banks (and nearly all Large cap banks) continue to write off significant GFC loss accruals and write offs and are still perhaps 4 quarters away from normalized earnings (ie when provisioning is expected to fall to Australian bank cycle level) and analysts expect ROE of 15% from then on.

If anything Australian banks ROE are pretty mediocre.

Another metric to measure potential gouging is Net interest margin. This is generally shown without writeoffs and provisioning impact.

Comparison of Large Cap US banks with two of ours.

BAC 2.72%

JP Morgan 3.01

PNC Fin. 3.96

US Banc 3.91

Wells 4.25
———————————-

CBA 2.01%

ANZ 2.43

IF there was any gouging it ought to be seen here particularly with the focus on the banks raising their rates.

Again the highlight is just how mediocre Aussie banks NIM actually is compared to the large US large caps.

JC
JC
11 years ago

oops screwed up: Should read

Wells is a better comparison, as JPMorgan has a large capital markets operations while Wells has none to speak of (like our own large banks).

David Walker
David Walker(@d-w-griffiths)
11 years ago

Australian banks are not at 10% pre-tex RoE any more. They had one bad quarter – September 2009 – but they put all that behind them very fast.

From the APRA quarterly summary released a few hours ago (http://www.apra.gov.au/Statistics/upload/Bank-Quarterly-Jun-10.pdf), which I use simply because I was just looking at it for another purpose:

Return on equity (after tax): Jun 2009 10.9%; Sep 2009 3.8%; Dec 2009 16.1%; Mar 2010 11.3%; Jun 2010 16.1%; Year end Jun 2009 13.4%; Year end Jun 2010 11.9%.

APRA doesn’t supply pre-tax numbers. It is also conservative in what it puts in the R and the E, so its figures are lower than some others I’ve seen.

And the September 2010 quarter has fairly clearly gone better than any recent quarter before it. Westpac’s own numbers suggested it got 18.8% RoE pre-tax in the September half.

All this is pretty much consistent with Nick’s 18% pre-tax number.

Bear in mind also that Wells Fargo and JP Morgan both had a terrific GFC, buying Wachovia and Washington Mutual respectively at fire-sale prices. And yet these two fall well short of the Australian banks’ RoE.

Other big firms make some even higher returns – Woolworths and Telstra chief among them. But there is certainly something interesting going on with banks’ RoE.

None of this on its own justifies the sudden imposition of a new layer of regulation, the creation of new government banks etc. Nick knows that, and is working his way to the nub of the question – how to improve competition in finance.

(The Pascoe piece is mostly aimed at a different question, housing affordability. Some people probably assume that lowering the Big Four’s RoE from 18% to 15% would make housing noticeably more affordable, but I doubt it’s true. Anybody got the maths on this?)

JC
JC
11 years ago

I went back now and followed Sinclair’s link and according to APRA it’s 10.6 for 2010.

I checked again to make sure it’s right and seems to be.

I really don’t get why people think the Aussie banks are so hugely profitable.

Their results overall could/should be classified as disappointing to middling. Top line revenue growth is a hardly on any steroids and a large part of their improving results is reduction in elevated provisions and hard arsed cost control.

Look it does a appear that we need some sort of competition in the mortgage market, but dear god let’s not have the government do a Fred and Fan here when by some reasonable measure we have close to the most expensive real estate markets in the world. There may be room for the government to coax and push some good ideas in the mortgage area which could allow the banks to focus on higher ended chunkier stuff and alleviate pressures from mortgage lending.

JC
JC
11 years ago

DW, Go look on page 11 of the APRA statement. 10.6% is in the June year end 2010 column.

JC
JC
11 years ago

APRA doesn’t supply pre-tax numbers. It is also conservative in what it puts in the R and the E, so its figures are lower than some others I’ve seen.

Would you mind explaining what they back out to reach that? Thanks.

Tel
Tel
11 years ago

Your link seems broken, Tel.

Turns out that an unclosed (title) tag in the html header makes google chrome attempt to push the entire web page into the little title part of the browser tab. IE7 and Apple’s browser seem similarly upset by the closed tag. Firefox just shrugs and works normally. Shows how many vendors use the same library under the hood huh?

Anyhow, the (title) tag is closed now.

Tel
Tel
11 years ago

I noticed Nicholas Gruen pop up on Lateline last night (yes I finally bought a digital flat-screen TV, with a Kogan badge as it turns out). Maybe I was tired and not paying sufficient attention, but Nick’s proposal came across to me as a more general purpose bank deposit insurance rather than specifically a mortgage insurance. This makes sense (better than setting up an Aussie version of Fannie Mae) because our government already offers general deposit guarantees for a selected set of financial institutions (seems only fair to make them pay for the privilege) and why not open it up to the general market whoever else wants to buy the same insurance.

What I missed was how to price said insurance, which requires the government (i.e. the insurance salesman) to correctly judge the risk — but judging risk is the bank’s job. Nick’s proposal merely shunts an existing problem to a different place, so it remains to be seen what makes some government department better at doing this than our current semi-private system.

I imagine the bank judges risk on a retail basis, while the insurer is working more at the wholesale level but does that really make things easier?