If they haven’t already, the members of the Senate committee should ask RAMS Home Loans founder John Kinghorn to appear before it to explain why RAMS, followed subsequently by most of the non-bank lenders, hit a brick wall and effectively collapsed at the very onset of the financial crisis.
RAMS was the first of the big non-bank lenders to be overwhelmed by the crisis because it had an unusually high — dangerously high, it transpired — reliance on very short-term funding. To a lesser degree, most of the non-bank lenders were also borrowing short in wholesale markets and also accessing securitised debt markets.
In its submission to the inquiry, lodged on Friday, Commonwealth Bank admitted that the major banks were also sourcing a growing share of their funding from those same markets before the crisis — in CBA’s case almost 30% of its funding in October 2007 came from short term wholesale markets, compared with about 18% today.
“In effect banks were reducing their cost of funding by taking on unsustainable levels of liquidity and funding risk, a practice that has now reversed,” it said.
That’s a critical point that is almost always over-looked in discussions about the state of competition in banking markets. Pre-crisis credit generally was unsustainably cheap — risk was being badly mis-priced — and there was, therefore, a level of competition from non-banks that was also unsustainable, and self-evidently wasn’t sustained.
Efforts to recreate, with government/taxpayer assistance, the same intensity of competition that existed in the lead-up to the crisis are therefore misconceived and potentially threatening to the stability of the system.
Small banks and non-banks shouldn’t be able to borrow as cheaply as their larger and more diverse and, in the case of non-banks, generally far more heavily capitalised big bank competitors. That they could do so pre-crisis was an aberration rather than a norm.
While NAB’s submission has generated considerable attention because it urged the government to target exit fees — which meant it was encouraging the government to act against its rivals Westpac and CBA, which haven’t abolished their exit fees — the CBA submission contains some very useful insights because it has broken out the detail of its retail banking business. It is generally difficult to disaggregate bank retail margins and returns on assets from the rest of their domestic businesses.
Domestic net interest margins for the major banks, while slightly higher than their pre-crisis levels, are 100 basis points lower than they were in 2000. CBA’s retail banking net interest margin, however, is actually 15% lower than the pre-crisis levels — it was 251 basis points in the half-year to June 2007 but was 219 basis points in the six months to June this year and had fallen to 215 basis points in the September quarter.
The bank hasn’t recovered that lost margin by increasing fees. Retail fee income as a percentage of average interest earnings assets within the retail bank have fallen from 1% pre-crisis to less than 0.8%.
The margin compression is, as is now well understood, or at least should be, due to the continuing rise in funding costs that has occurred post-crisis and is still occurring as the banks roll-over cheap pre-crisis borrowings and also shift to a higher proportion of more expensive longer-term wholesale and deposit funding.
Given that it is home lending that has galvanised the politicians into this latest and fiercest bout of bank bashing, the detail of the CBA retail bank margins and returns undermines the argument that the sector is uncompetitive and profiteering.
The majors have repriced their lending to business, but that also reflects a return to more prudent pricing of risk. The history of bank collapses — and of the financial crisis — says that banks fail when they don’t properly price risk.
The Senate committee — and Wayne Swan and Joe Hockey — need to be reminded that while competition in banking is a good thing, too much competition can destabilise the system, particularly if it is driven by a cost of funding that under-prices risk or by incentives that unduly distort the normal functioning and competitive balance of the system.
That’s why they should talk to John Kinghorn, the veteran of the non-bank sector, or the shareholders in RAMS who saw their company implode only months after it floated.
This article was originally published on Business Spectator.