Australia’s banks are certainly failing to meet their obligations as custodians of the public good to drive growth and to raise community welfare. This is a long term problem. Public confidence in Australia’s banks has been steadily eroding since financial deregulation in 1983 and now the brand of the Big 4 banks, especially CommBank, is at its nadir.
What has gone wrong?
It seems that Australian banks would rather earn a fast buck than support real longer term investment projects and jobs for the betterment of all Australians. Consider the loan book of major deposit taking institutions:
- Around 60 per cent of new lending is for housing.
- Around 80 per cent of all housing loans are for the purchase of existing property.
- Around 60 per cent of all new loans are made to investors for negatively geared investments.
- Around 40 per cent of housing loans are interest only.
Somewhere along the line successive Australian governments, the Reserve Bank of Australia (RBA), and the regulator, and the institutions themselves, have forgotten that banks do not exist to facilitate speculation by investors via the use of tax subsidised debt. Rather, banks have a broader social licence, the flip side of their regulated ‘public utility’ sinecure and too-big-to-fail status, requiring them and their executives to always act in the national interest.
Right now the banks business model is fairly simple. Make as much profit as you can, maximise short term shareholder value, achieved through incentivising executives with outrageous bonuses whilst telling Australian’s it will trickle down to them. Banks compete on both sides of their balance sheet. They offer their depositors and bond holders a sufficiently attractive rate of return to attract funds. They take these funds and turn each dollar into up to $7 dollars of loans (where regulated risk weights bias investors towards existing housing assets). They then offer clients ancillary services (investment advice, insurance, and retirement products) to clip the ticket multiple times before the customer passes GO.
Old style banking
Historically, the business model of Australian banks was very different. It was to prioritise the efficient intermediation of capital to businesses, prioritise first home-ownership and assist macroeconomic management via reaching liquidity objectives in times of crisis.
This old fashioned view of banking – as a provider of basic services - shares many of the same characteristics as a public utility – like energy, water, sewerage etc. that all households and businesses require, where quality is hard to observe, and some sort of regulatory control is often needed to prevent the abuse of power.
The banking system that arose from Federation emerged out of the tragedy of the 1890s property bust and depression. The newly formed Commonwealth financial system emerged via a highly regulated mix of state owned banks, building societies and mutual institutions, charged with broader development goals. The outcome was system stability, even if credit was effectively rationed. In this world the local bank manager was the most important and trusted person in town. Bank executives were paragons of virtue, albeit a boring sober type. The lessons of that episode seem eerily pertinent to the Australian economy in 2017.
The era of deregulation
When financial deregulation finally came in late 1983, no one was particularly sad to see the old regime fall. The Australian economy was stuck in a low productivity slump, hiding behind the tariff walls. Certainly some form of deregulation was necessary, but broader development goals were soon forgotten. The industry was handed over to the ‘money changers’. Whilst the housing loan book became the main game, it became useful to play up the ancillary services more directly. Vertical integration became a deliberate strategy to move the oligopolistic competition in loans, up and down the household value stream: i.e. into the payments system (credit cards), risk (life insurance and CCI), and funds management (super and trading). And where supply networks are captured (mortgage brokers, branch networks, financial advice) – a sales culture dominates, flogging product, regardless of the underlying needs of customers.
In this world the local bank branch become a shopfront with anonymous staff and bank executives were more like highly paid celebrities.
Bank executives have apparently revelled in raising short term shareholder value whilst maximising their own compensation. They have become oblivious to any notion of stewardship to their front-line employees, much less the community.
Bank shareholders have mostly had a wonderful run but may still live to regret the lack of oversight of current and past managers. The diverse nature of the major banks throws up internal efficiency issues. These banks are bureaucratic, slow, cumbersome, and have poor internal information and systems. They are rife with infighting around internal targets and staff performance measures and it leads to dysfunctional decision making – for example, limits on cash deposits on smart ATM machines, plus a poor anti money laundering control framework.
This ‘incentives’ driven mentality has also helped to exacerbate Australia’s boom bust property cycle and addiction to debt. Household debt to income ratios rose from 20 per cent in the early 1980s to 130 per cent before the GFC. Since the GFC, Australia’s household debt to GDP ratio has reached a record 190 per cent – much higher than the United States before the sub-prime crisis.
Risk of financial instability
Significant pockets of mortgage stress now exist all over the suburbs of Australian capital cities. Many are servicing loans in excess of six times household income. ME Bank are reporting that 9 per cent of all households think they cannot meet minimum required payments on their debt over the next 6 to 12 months.
Since the GFC, Australian banks have intermediated the build-up of private debt by investors chasing yield and short-term capital gains, or ‘making money with money’ in the face of ultra-low interest rates. Australia’s banks have profited at every step throughout the latest upswing in the property market since 2013, so much so that the regulator is still struggling to dampen activity. Now it seems the average yield on Melbourne residential property has fallen to 2.6 per cent, which represents a price to earnings ratio of 38 times. This is insane compared to average ASX 200 investment at more like 15 times.
Thomas Edison said genius is one per cent inspiration, ninety-nine per cent perspiration – now, thanks to Australia’s banks it is more like 100 per cent tax-leveraged speculation.
Is the answer foreign competition?
Former Treasurer Peter Costello wants to open up the “cocooned” banking “quadrapoly” and other sheltered workshop sectors: “Whether you split (them) up or encourage new entrants, I think we need more competition in the banking system”.
So when does more competition work for customers?
Real competition creates alternatives – or meaningful choices - which puts power in the hands of consumers and hence allows prices to adjust through market forces to reflect value for money.
But efforts to blindly implement competition when the wrong preconditions are in place leads to bad outcomes for mums and dads. It is almost certain that in those situations the market will provide the chimera of choice via product line proliferation. Consumers will be chiseled rather than resource allocated efficiently.
Most industries in Australia lay somewhere between ‘perfectly competitive’ fresh fruit and vegetable markets and a natural monopoly like electricity transmission with huge fixed costs. In most markets consumers lack information, expertise, and are limited by a myriad of cognitive short comings.
Whilst most of us know how to achieve value for money for the purchases of most smaller consumable goods, purchasing major capital goods and services like gas, electricity and phone contracts, health insurance, life insurance, tertiary training courses and certain specialised medical care often are completely incomprehensible. Indeed most of us are probably flying blind through the most important decisions of our lives and don’t even know it.
Alan Kohler from The Constant Investor says competition is especially bad when there is too much variety and choice in a service that is paid for now but delivered in decades, such as in superannuation. In these circumstances more information and competition doesn’t help human beings with limited brain power select between product options.
Bad decisions can be life altering. For example, choices between life insurance policies, health funds, retirement income products, tertiary education courses or institutions, when and where to buy a house and how much money to spend on it.
Into the muddy field of uncertainty tread commission driven sales-people, like snakes in long grass, who sing the praises of competition and more choice. Meanwhile, they push ever more product on uninformed and confused buyers.
Is the answer more product choice?
Most consumer-facing industries in Australia are now dominated by two to four main competitors. Many offer a bewildering array of complex, confusing and ever changing products, pricing schemes and/or plans; always watchful of competitors.
So when does competition and choice benefit or harm consumers?
Competition is good when customer’s desire bespoke goods and are best placed to exercise that choice for themselves.
Competition is bad when customers only want a basic product and perhaps cannot identify that choice for themselves.
From home loans to telephone contracts to superannuation products to power providers – most basic customer requirements would be better met by a more ‘wholesale’ market structure and streamline product line. For example, all electricity retailers buy from the same place and send electrons down a wire so the product can’t physically be differentiated. So like Costco and Aldi, let’s cut out the middle-man.
Policy options to address banking via regulation
According to new RBA Governor Phillip Lowe: “Banking, historically, has been a profession - a profession of stewardship, custodians, service, advisory, counsellor. It is not a marketing or product-distribution business; banking is a profession.”
Wayne Byres, Chairman at APRA, and Phillip Lowe are both talking up a culture problem. But is there a culture problem or are we making culture a proxy for that old time concept of stewardship that existed in a more regulated environment where a bank-based financial system was more intrinsically linked to sourcing capital for productive allocation.
Certainly, Australian authorities must deal with structural issues in foundation financial institutions like monopolies, economic rents, cross-subsidisation between industry segments and daily examples of corporate criminality, with the money laundering scandal at CommBank being the last straw. They must break the hold of connected dealer groups or advisory networks on relevant market shares. The priority must be to clean up the mess, refocus the sector back on core functions at least via the structural separation of various business lines.
A bold policy would be to establish a not-for-profit (public or mutual) bank, which provided home loans on a cost recovery basis, passing the benefits of scale on to the community. For example, Nick Gruen’s idea of a ‘people’s bank’ which morph’s the Post Office into a retail banking provider to anchor pricing. This model might point the way forward for the rest of the sector – both culturally and in terms of their business model.
Lessons for Australian economic management
In terms of economic management, perhaps it is already too late for reform to avoid a hard landing. New house sales in some major international capitals are falling fast as they are here. Elvis (or Asian investors) has left the building. Rate hikes in the US and elsewhere are likely to raise the wholesale cost of funds for our banks by upwards of 100bps by mid-2018 even if low inflation leaves the RBA is unlikely to hike in the near term. Prices for oversupplied market segments such as new units could take a big tumble, especially in Melbourne, further exposing highly indebted households.
The Australian economy is certainly stuck in a downward spiral of falling competitiveness and lower productivity, in part because most Australian governments have not achieved a major microeconomic reform since Humphrey B Bear was last on Australian television screens. But also some aspects of past regulatory changes are now strangling growth prospects.
The good news is that Treasurer Morrison seems to appreciate that the ultimate goal of policy should be the welfare of the community. There is no one-size-fits-all solution to competition policy and regulation but approaches should vary depending on the character of the commodity market in question.
The lesson of the last decade is that we must build consensus by avoiding faith based policy and focus back on the national interest by applying microeconomic reforms which grow incomes and create jobs.
Published in The Canberra Times, 3 October 2017.