Australian politicians reacting to out of cycle mortgage re-pricing perceive a lack of banking competition as the reason. The more likely answer is a rising cost of capital and ongoing structural change in bank funding globally. The evidence is clear when you look at banking systems around the globe. We are not alone. In fact, Australian’s are experiencing mild structural changes in comparison to consumers in other major banking systems.
Australia being overweight investment opportunities, therefore requiring overseas investors, in a mostly intermediated financial system (i.e. funded by the banks), further compounds the impact of structural change, and is likely to equate to ongoing funding pressures.
While Australia’s financial system fared well through the GFC, the downturn was mild by historical standards due to the increasing ties with Asia (China in particular), as evidenced by the historically high terms of trade. At some point though, commodity income will wane and offshore investors will question the sustainability of the Australian economy, inevitably testing the true strength of Australia’s financial system. Australia’s ability to sustainability fund our economy through such a period is likely to be tested.
Poor lending on a large scale in the US (similar to the experience of Australian Banks in the early 1990s), is driving structural change in global wholesale funding markets. Investors are asking for higher returns to compensate for higher levels of risk. As a consequence the cost of capital globally has increased. Therefore, Australian banking which sources approximately 21% of total funding from offshore wholesale markets, is currently experiencing a predominantly liability driven crisis, as the higher cost of funding (i.e. higher returns to wholesale investors and deposit providers) is pushed through the system.
Australian banks have responded by changing prices for lending, deposits and raising capital. In particular, the record profits of 2010 for the Australian Major Banks need to be considered in the context of much larger capital bases post the GFC. Approximately $30bn of additional equity (over and above retained earnings) was raised over the 3 year period to 2010, resulting in capital bases expanding by some 65%, from $85bn in 2007 to $140bn in 2010. Therefore, while the $22bn in profits for 2010 is a record result in absolute terms, and $6bn or 38% higher than 2007, the Return on Equity (ROE) has actually fallen to 16%, approximately 2% points below the average ROE in the 10 years prior to the GFC.
Thus, Australian Major Banks to date, are yet to return to pre-GFC profitability, although this is also a reflection of where they are in the loan loss cycle. Looking forward, as bad debts move to more normal levels, the ROE for the Australian Major Banks is likely to move back to the averages for the 10 years prior to the GFC.
Market commentators have tended to credit higher net interest margins as the reason for record bank profits. However group net interest margins for the Australian Major Banks over the 3 years to 2010 have only increased by approximately 3% from 2.19% to 2.26%. The real driver of the 38% uplift in profit is a direct result of Australia’s Major Banks stepping into the void created by wholesale funding markets, thereby underwriting system credit for the past 3 years. Undeniably, a desirable outcome given the dislocations experienced in other financial systems around the globe, particularly wholesale dependent systems such as the US (in excess of 50% of system credit pre-GFC).
In response to the resurgence in re-intermediation (i.e. borrowing through the banking system), Australian depositors have benefited directly from the reassessment of risk globally through significantly higher deposit rates. A transfer from borrowers to depositors (as witnessed by effectively flat bank net interest margins) has occurred, to encourage depositors to invest: a clear illustration of how capital can be allocated rationally within a free market banking system. Understandably, we are hearing plenty of stories from mortgage holders who are bearing the cost, however little from depositors that are banking the gain (mind the pun). Keep in mind the banking system had outstanding mortgage balances of approximately $1 trillion, and deposit balances of $1.4 trillion at 31 October 2010.
The Federal Government guarantee on wholesale debt used by Australian Banks to raise approximately $166bn, is often cited as a handout (although Australian Banks are currently paying approximately $1bn pa for the use of the guarantee), and indicative of the implicit support mechanism underpinning the perennial moral hazard issue in the Government-banking relationship.
The Irish, for reasons that are now clear, dragged the vast majority of Governments worldwide into guaranteeing bank debt whether they required it or not. Once the Irish Government had credit enhanced bank debt, investors saw a low risk opportunity globally. Furthermore, the world’s highest rated banks, the Irish Banks, had the opportunity of tapping a new class of investor who invested only in Government paper. As asset classes globally were experiencing a flight to quality, the typical near term human response during a downturn, funds were relatively more available to investors in only the highest rate (or lowest risk) securities such as Government paper. Therefore, banks worldwide would face a material funding disadvantage, and therefore other Governments had to follow.
Australia, alongside other parts of the world, was also starting to experience a depositor flight to quality, prior to the introduction of the guarantees. Depositors were choosing the Major Banks, just as investors in the Australian share market were gravitating to large cap blue chip stocks in late 2008. Hence, the introduction of guarantees on bank deposits within the Australian Banking system to engender Confidence, the key ingredient in any system based on paper promises.
In Australia, the conservative risk based capital framework employed by the banking regulator has worked very well. The learnings from the asset-led banking crisis of the early 1990’s and subsequent financial system enquiry placed Australia in a strong position. In fact, global bank regulation on capital is moving to align more with Australian standards, a strong endorsement of APRA’s oversight.
We need to take the lessons from the current liability driven banking crisis Australia is experiencing, to develop a funding framework much like our well regarded capital framework. The GFC has highlighted, that in a far more integrated global financial system, the requirement for understanding, monitoring and regulating total system funding has become more important. This is particularly true for a small open economy, overweight investment opportunities, in a financial system funded mostly by bank intermediation that is becoming increasingly reliant on offshore funding (approximately $517bn at 31st October 2010).
Under the new Basel III regulations, the international banking regulator has already announced guidelines for banks on funding (such as the net stable funding ratio) and liquidity. However, Australia needs to be on the front foot in developing funding guidelines that may go further than international regulation is currently suggesting given the structure of our domestic financial system. Central to funding guidelines would be a clear understanding of the Character of Funding, which is critical for managing the asset-liability mismatch implicit in banking rather than the typical understanding implied by name i.e. securtisation, domestic wholesale, offshore wholesale, deposits etc.
It is unfortunate that wholesale funding, and securitisation markets in particular, have been tarnished due to the GFC. Wholesale funding markets are important conduits for competitive forces to drive change, as the Australian mortgage market experienced in the years prior to the GFC. Residential mortgage back securities exploited subsidies within the banking system, a clear market inefficiency. Australians are better off today as a result. The benefits are clear, so how do we develop domestic wholesale funding markets to be dependable and sustainable?
Australian listed companies quickly recapitalised during the GFC, raising $110bn in equity in addition to the $30bn raised by the banks, representing approximately 10% of the $1.4 trillion in Australia equity market capitalisation. Without our world leading superannuation system this outcome would be harder to replicate. But, what about our domestic debt markets, how did they perform during the GFC? To date more information, and debate has centred on developments in equity markets than Australian debt markets.
Furthermore, Australia’s domestic debt markets seem underdeveloped relative to other major economies as the domestic bond market is smaller ($1.15 trillion at 31st October 2010), than our equity market, whereas in most major economies it is the other way around. And given our growing reliance on offshore wholesale funding (increased from 16% at the time of the Wallis enquiry to 21% today), what risk does this present to our financial system? Also, does it make sense for $1 trillion in residential mortgages to be funded entirely through the banking system? Australia needs to form a view on these types of questions to address funding sustainability.
Stream Three, under the Governments announced reforms for Competitive and Sustainable Banking represents a good starting point, but more needs to be done. An enquiry into funding solutions for the Australian economy is required, with the aim of lowering Australia’s cost of capital, through the broadening, deepening and strengthening of Australia’s funding options. This will go a long way to improving economic resilience and prosperity, while generating sustainable economic growth and promoting bank competition.