Banking concentration and policy

Christopher Joye had an op-ed in the AFR today talking about the recent IMF Financial System Stability Assessment for Australia. This bit caught my attention:

The IMF’s anxieties derive from the fact that Australia’s banking system has become “one of the most concentrated in the world”. The four majors “hold 80 per cent of banking assets and 88 per cent of residential mortgages”. They are “highly interconnected, as they are among each other’s largest counterparties”. This means that “their expected default frequencies are [also] highly correlated”.

The IMF’s findings contradict the Martin Place meme that there is an adverse trade-off between financial stability and banking competition. Indeed, it suggests, as I have, that Australia’s financial system would be safer with a larger number of smaller institutions.

So I hunted down the actual document – which is somewhat more muted that Chris Joye’s account. The IMF says:

The major banks are highly interconnected, as they are among each other’s largest counterparties, and their expected default frequencies (EDFs) from Moody’s KMV are highly correlated.

I’m not sure what the Moody KMV method is, but my interpretation of what the IMF are saying is that if one of the Big Four experienced a significant enough negative shock so as to cause financial distress some or all of the other Big Four would also experience financial distress. Yes – that doesn’t surprise me. Now the probability of such a large negative shock is not zero, nor should it be, but I can’t imagine it is large either.

I am not convinced that the IMF suggests “Australia’s financial system would be safer with a larger number of smaller institutions” or if they did that they are correct. In a 2006 analysis of sixty-nine economies over the period 1980 – 1997 (including Australia) Thorsten Beck, Asli Demirguc-Kunt and Ross Levine find that greater bank concentration is associated with a lower probability of a banking crisis. While James Barth, Gerard Caprio, and Ross Levine report restrictions on banking activities are associated with higher probabilities of banking crises and lower levels of efficiency.

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25 Responses to Banking concentration and policy

  1. Infidel Tiger

    Thorsten Beck, Asli Demirguc-Kunt and Ross Levine

    I’m not a fan of double barrelled names and for the life of me I can’t understand why the Demirquc family entertained that addition.

  2. Sinclair Davidson

    Turkish. That “K” is pronounced like a “G”.

  3. faust

    Moody’s KMV is a risk management analytical software

  4. Pedro

    Interesting question, you’d think smaller banks would be less of a counterparty risk to each other, but otherwise probably a higher internal default risk. On the other hand that could lead to more syndication.

    I recall Arnold Kling arguing for small banks as a risk management response to the GFC.

  5. tbh

    I read Chris’ blog quite a bit and think there might be an element of talking his own book here too. His mate Mark Bouris (of YBR fame) is setting up a deal with Macquarie to get into the mortgage market.

    http://www.smh.com.au/business/macquarie-group-takes-yellow-brick-road-into-home-loans-market-20121107-28ywl.html

  6. Alx

    I suppose it might be the case that a concentrated banking system leads to a lower overall probability of failure, but worse potential consequence.

    In OH&S risk management you always consider risk-ranking to be based on a combination of probability and likely consequence.

  7. H B Bear

    Shouldn’t the Australian banking system really be renamed the Australian building society system?

    Without wanting to understate the fiduciary oversight of the RBA, could it be the one of the strengths of the Australian banking system is the lack of domestic funding that largely constrained them from buying securitised American junk and CDOs in the first place? Coupled with a very comfortable oligopoly market structure with more than enough fat and margins in there for everybody, without chasing artificial yield put together by those financial geniuses on Wall Street.

  8. Tom

    As a consumer of an economic system, nothing bad ever happened as a result of competition. However, as a small capitalist economy in the smallest continent, Australia has always tended towards oligopolies, duopolies and monopolies that have got away with skinning their users because of a history of weak competition policy and the rewarding of scams. If you have a single-minded focus on making capitalism do what it does best – compete – you reward consumers while removing the scam syndrome, which has given Australia a corporate sector that behaves like a scag addict always looking for a cheap hit instead of doing the disciplined yards.

  9. Lysander Spooner

    Can I open a bank?

    I love other people’s money! :-)

  10. Driftforge

    Random question – how much of a drop in the Australian property market would it take to cause problems for our banks?

    From memory they run about 70% residential mortgage, and have about 3-4% in reserves.

    Systemic shocks are always only an interest rate rise or two away..

  11. Skuter

    I think the removal of depositor preference (due to the introduction of covered bonds) and in turn putting (free) deposit insurance is a more dangerous development for the stability of the Australian banking system. As far as depositors (with deposits of less than $250) are now concerned, banks are now effectively homogeneous save for the interest rates they offer, so they can just hunt for the highest yield in the knowledge that Swannie will ride in and save them. There is no need for a depositor to worry that a bank might be offering higher savings rates because they need to offer that to overcome some other perceived riskiness.

  12. Andrew Reynolds

    Sinclair,
    I would agree with the IMF on this. Having them all highly correlated in this way is not healthy. While the probability is low, as noted, the effect of the high correlation is that if any one of them experience trouble then all of them will – effectively quadrupling the chance of systemic trouble.
    While a lot of small institutions means that the likelihood of trouble occurring in one is higher, the chances of any one institution causing a systemic issue is greatly reduced.
    If the ideal is a largely stable system but with occasional bank failure so that the markets supply the discipline then you need a system with smaller banks with low risk correlation. If you want a system with a very low risk of bank failure but with a high likelihood that an individual bank can bring down the whole system so that the regulators are supplying the systemic control then you want the system the way it is in Australia at the moment.
    Personally, I would prefer smaller banks – which is why I agree with the IMF. I also believe that the effective oligopoly we have now is largely due to regulatory action to favour the bigger banks.

  13. Sleetmute

    Chris has a bad habit of self-aggrandisement and ignoring evidence that contradicts his oft-touted views. It’s a shame, because he makes good points from time to time.

  14. Jim Rose

    Usually stop reading at IMF. What is the IMF saying about Canada’s big five banks? They hold more than 85 percent of total bank assets, almost like Australia.

    I thought Canada was the model banking system that escaped the GFC?

    (IMF) Directors commended Canada’s strong financial regulation and supervision. This has resulted in a stable and resilient banking sector, which has resisted the international financial crisis well and remains well prepared to deal with most adverse scenarios.

  15. Bruce

    House prices here aren’t especially high relative to disposable income, given the barriers to development and continuing high immigration.

    Meanwhile the IMF is currently doing karmic contortions to avoid Greece defaulting on the politically inspired loans they made to that country, without the normal straightjacket rules.

    I suggest they go away and heal themselves before being sniffy about Oz banks.

  16. Alfonso

    Yawn….there is no liquidity risk for any big four bank, no matter what…..the RBA Xerox and road trains stand ready with new notes for delivery as required.

    They’ll opt to deal with the consequences of that later, punters.

  17. chris joye

    SD, thanks for bringing this to my attention. I have tweeted a link to it. Chris

  18. tbh

    Chris has a bad habit of self-aggrandisement and ignoring evidence that contradicts his oft-touted views. It’s a shame, because he makes good points from time to time.

    I enjoy his writing but you are right. One of the most shameless self-promoters and wise after the event guys in macro-punditry.

    He does bring the data though and is right on a regular basis. That keeps me going back there.

  19. There should only be a few players in a competitive market. The fact is the Australian banking market is an open market and the only reason that competitors will not line up is they see it as too competitive given the possible returns. One risk at the moment though is the no fee to change mortgage legislation as in theory this means an old loan at a low ratio is far more valuable and therefore can be a much lower interest rate meaning the opposite is true for someone trying to get into the market. There is also a possible risk of too much competition to get the old stable loans and the only thing worse than very profitable banks is non profitable banks (some politicians should get this into there heads as both sides of politics at the time said our banks are ripping us off).

    With Australias limited market size it should not be expected that there will be many players in businesses that require high capital. Examples of this could be supermarkets, airlines and mobile telephony. Before anyone says but groceries are more expensive than US or Europe, our basic wages are about double the US and many European countries so of course things are more expensive you idiot and we don’t even have much in the way of farm subsidies to lower the price.

  20. Driftforge

    Yawn….there is no liquidity risk for any big four bank, no matter what…..the RBA Xerox and road trains stand ready with new notes for delivery as required.

    Quite so.

  21. Alx

    Can anyone shed any light on why the “Commonwealth of Australia” would be required to lodge a prospectus with the SEC in the US in order to provide deposit insurance?

    http://www.sec.gov/Archives/edgar/data/805157/000134100409000792/scheduleb.htm

  22. Can anyone shed any light on why the “Commonwealth of Australia” would be required to lodge a prospectus with the SEC in the US in order to provide deposit insurance?

    I can shed a little bit of light the US does not allow US citizens to purchase shares in share offers made in overseas juridictions unless they have lodged with the SEC in the US. I am guessing it is to do with the same legislation. Basically they are not a free market country in respect to investment.

  23. faust

    Chris has a habit of beating a drum to promote whatever enterprise he is involved with at the time.

    I would add that largr banks in a small economy like Australia have greater access to cheap liquidity versus smaller banks.

    I know a lot of ibanks in the UK and US who went down the road Macquarie Bank did by buying a mortgage provider and then using this origination process to build up their securitisation arm. It didn’t work for them then so it would be interesting to see how Mac makes it work now.

  24. Nick

    Solvency concerns create liquidity issues. No doubt that the Australian banks will be back stopped (note AOFM actions to date) but this does not protect dividends and equity holders.

  25. chris joye

    So the RBA’s Glenn Stevens has entered the bank capital debate, backing what I said about the need for higher capital charges for local banks that are systematically important:

    http://afr.com/p/blogs/christopher_joye/rba_news_for_banks_and_currency_P2xtgRR3Lmu5JZREiqgdTJ

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