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Competition and/or stability in banking?

As a Royal Commission into the financial system kicks off in Australia a newly released Productivity Commission report has argued the Australian system is skewed towards stability rather than competition.

It’s clearly an important argument – but not a new one. Nor is there an obvious answer.

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Without offering a view on the PC report or other commentators, there is inevitably a tension between these two forces. Again, not a new observation. Prudential regulators who preside over both competition and system stability face a potentially intractable dilemma because greater competition inevitably and by definition destabilises the system.

“In both the US and Australia an established market was disrupted by new competition, the former ultimately catastrophically, the latter to the benefit of the economy.”

The critical question is whether consumers – and taxpayers – are better served in the long run by a particular stance on that inevitable tension.

Some would argue – as did Christopher Joye in The AFR Weekend – it’s a “flawed regulatory paradigm that presumes competition always undermines financial stability when it can reinforce it by reducing our reliance on the oligarchy”.

That argument is open competition reduces reliance on incumbents, removes cross-subsidies and rents, makes the system more flexible and ultimately delivers greater resilience. It’s a cogent argument – in theory, in the long run.

But it’s the getting there which needs to be carefully managed.

Glaring

The most glaring demonstration of this is clearly the financial crisis of a decade ago. It was driven by new products, frantic competition and a lapse in risk management and prudential policy.

For years, would be borrowers benefited by receiving finance they previously would not have; mortgage originators and the creators of the debt products which funded them made money; various shareholders grew their wealth.

But the American sub-prime mortgage market was fatally flawed. Its collapse infected wider financial markets and taxpayers, borrowers and many organisations have been paying for it ever since. The global economy is only just recovering a decade later (although of course, some made money in the crisis - notably hedge funds which saw how fragile the whole contrived market was.)

In this case, innovation and competition went too far. Ultimately the broader costs to society were far greater than the initial cheap, readily available loans.

An Australian example also comes from the mortgage market which in the 90s was disrupted by a disaggregation of the sales, production and funding of mortgages.

Where banks had once dominated all three, mortgage originators and brokers entered the sales markets; investment banks like Macquarie Group the production; while investors funded the loans through securitisation.

In the process more than 2 percentage points were cut from mortgage prices. Cleary this was of aggregate benefit and system stability was preserved. However, as funding markets tightened and banks became more efficient, the new paradigm was undermined.

Indeed, investing in one of the original revolutionaries, RAMS, when it listed just prior to the financial crisis would have been catastrophic as the model crumbled. Aussie Home Loans, the highest profile new competitor, is now owned by Commonwealth Bank of Australia.

In both the US and Australian examples, an established market was disrupted by new competition, the former ultimately catastrophically, the latter to the benefit of the economy.

Stability

The PC report was explicit in arguing the Australian Prudential Regulation Authority, the banking supervisor, has erred on the side of system stability and taken actions which could actually lessen competition.

This too is not new. Indeed since the crisis APRA has consistently stressed its emphasis on system stability – in part because its own current incarnation is directly attributable to perceived failings, soon after it was formed, to prevent the collapse of Australian insurance giant HIH. A collapse which delivered enormous collateral damage to the Australian economy.

HIH was a poster child for new competition and price wars in the then staid Australian insurance and particularly indemnity market. Its collapse left thousands of businesses vulnerable and sporting or community organisations unable to hold events because they could no longer obtain public liability insurance.

APRA chairman Wayne Byres re-emphasised this attitude recently in response to suggestions from the Federal Treasurer APRA’s approach to restricting investor lending for property might be eased.

"We can modify our interventions as more permanent measures come into play," Byres said. "That will include, amongst other things, further strengthening of borrower serviceability assessments by lenders, strengthened capital requirements for mortgage lending imposed by us, and comprehensive credit reporting being mandated by the government."

That is, system stability takes precedence.

The PC however argued APRA’s macro-prudential measures designed to tamp down interest-only lending - primarily for investors and considered more risky - were anti-competitive and had delivered a $A1 billion annual profit windfall to the major banks.

This goes the heart of the dilemma: how do we gauge the short term/long term trade off in costs to society? The PC may be right in the short or mid-term but potentially not in the long term.

Reserve Bank of Australia governor Phillip Lowe has been clear in his view. He wants the macro-prudential measures made permanent and presumably sees systemic stability as taking priority.

“When I talk to my overseas peers and say more than 40 per cent of new loans in the country were to borrowers who didn't have to make a single dollar of principal repayment, they say, how?” he said during questions at a recent speech.  “Why would you allow that?

"It didn't feel right to me. It felt like it was building up risk in the system so that was addressed and I would hope there would be a permanent element of that."

Forgotten

Indeed, the timeframe over which crises run appears easily forgotten. In the US, particularly under the Trump administration, measures and institutions created to lessen the risk of a repeat of the worst financial crisis in half a century are already being unwound.

Yet as the Bank for International Settlements noted in its latest review, “while banks in the euro area, the United Kingdom and the United States suffered large losses at the height of the crisis, those in Australia, Canada and Sweden fared better and did not need government capital support.”

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Former Reserve Bank official Stephen Grenville has argued “memories of 2008 are still fresh enough to constrain management and stiffen regulators’ spines.”

“But the lessons of the 1930s bank failures lasted for more than half a century,” he said. “The lessons of 2008 look like they have already been forgotten, or erased.”

Grenville is particularly concerned about the loosening before the crisis of regulation which had restricted government (taxpayer) backing to simple banking functions. That loosening contributed to the carnage. The rule were tightened after the crisis but are already being loosened again.

Grenville too draws implicit attention to the tension between stability and competitive innovation. He notes a good financial sector provides funding even for risky ventures; provides risk management; participates in a full range of financial markets; and is innovative.

However system stability demands the riskier parts of this spectrum do not make the essential, more mundane parts more fragile – posing threats to consumers and taxpayers.

“Without an enforced separation, banks expand their activities into these more exciting activities and are then managed by hard-driving, risk-loving Masters of the Universe,” Grenville said. “Didn’t we learn this lesson in 2008?”

This tension between competition and stability – and implicitly which stakeholders might benefit – is a live discussion both globally and across multiple domains.

Open

Take so-called ‘open banking’ regimes, now coming into force which essentially oblige incumbent financial institutions to share data with rival institutions if the customer asks. This is designed to make it easier for new entrants to compete.

The tension here is whether the new entrants are genuinely competitive – which means they have sustainable business models and will add efficiencies to the economy – or whether they are simply opportunistic.

“An open banking regime is key to giving consumers more choice of financial services providers, a greater understanding of their financial standing and overall more control over their financial future,” FinTech Australia chair Stuart Stoyan siad.

“It is also vital to supporting greater fintech innovation – which creates increased competition, greater choice, more efficient delivery and lower price of financial services for consumers.”

The caveat is the difficulty in distinguishing creative destruction in the system through strong competition from mere destruction – which may only be evident over a longer time frame.

The PC in its report makes the recommendation the competitive spirits in the Australian financial system need to be monitored by an institution without APRA’s inherent divergent demands, either the Australian Competition and Consumer Commission – the competition regulator – or the Australian Securities and Investments Commission – the companies regulator.

That would solve that tension for APRA. But it doesn’t dissolve the ultimate conundrum for the economy: how to measure and choose between competition and stability. All three bodies form, together with the Federal Treasury, the Australian Council of Financial Regulators.

That’s as good a forum as any to have the argument. But it’s still one with no easy answers.

Andrew Cornell is Managing Editor at bluenotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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