Banking competition II

Yesterday a comment by Richard Denniss in the AFR caught my eye:

“The No. 1 issue is: why has competition spectacularly failed in the banking sector. We don’t have a competitive banking system. We have an oligopoly,” says [Richard] Denniss, noting that the major lenders account for 90 per cent of the mortgage market. The lack of competition effectively puts a tax on financial products sold to consumers and small businesses, enabling the big banks to generate “super normal” profits, he says.

The argument that the Australian banking sector is not competitive is a progressive staple. The thing is that the empirical evidence simply doesn’t support that view.

A few years ago I made a submission to the Senate on this point – and posted on the issue – but it is well worth revisiting.

One way of evaluating competition in an industry is to make use of the well-known Structure-Conduct-Performance (SCP) model. This approach works on the principle that the structure of the industry (either concentrated or diffuse) leads to conduct (either monopolistic or competitive) which in turn leads to performance (monopoly profits or normal competitive returns). The SCP approach has been criticised by economists such as Harold Demsetz, nonetheless the approach itself is widely used and appears to be intuitively attractive to non-economists.

Jacob Bikker and Jaap Bos (2008) have investigated the SCP approach in a massive analysis of 7,266 banks across 46 countries spanning 1996 – 2005. Their Australian sample includes 36 financial institutions. In their analysis they make use of the well-known Herfindahl-Hirshman Index and various concentration ratios (in the empirical test of the SCP approach they employ a top-three bank concentration ratio). They are able to find no statistically significant relationship between concentration and profitability for Australia (pg. 87) and no statistically significant relationship between the Herfindahl-Hirshman Index and profitability for Australia (pg. 88). They interpret this result as follows, ‘for most countries the impact of market structure on performance is limited’.

Of course, the argument at present is that the banking industry has become more concentrated and less competitive since the global financial crisis. To be sure it does appear that the banking sector is more concentrated and some smaller financial institutions are struggling in the current environment. It is instructive to examine what Australian regulators and public officials were saying about bank competition at the time the crisis first began and to compare that to what they say now. In particular what was reported to the 2008 House of Representatives Standing Committee on Economics Inquiry into Competition in the Banking and Non-Banking Sectors. At that time The Treasury argued

Notwithstanding the prominence of the five major banks in the Australian banking sector, there is evidence that the sector is contestable. Australian banking customers are served by a wide range of banking providers, including: 13 domestic banks; 12 building societies; 139 credit unions; and a subset of Australia’s 10 foreign bank subsidiaries, 31 foreign bank branches, and more than 100 non-ADI financial institutions. According to financial services research firm CANNEX, there are currently around: 140 providers of over 2,400 mortgage products; 70 providers of over 300 different credit cards; and 130 providers of over 2,400 different types of deposit accounts.

Similarly the RBA argued, ‘By international standards, Australian borrowers are offered a wide range of mortgage products and are able to choose from a large number of different loan types, with many of these offering more flexibility than is available in other countries.’

The view of both the RBA and the Treasury seems to indicate that the structure and conduct components of the SCP model do not suggest monopolistic behaviour.

Or for that matter oligopolistic behaviour and certainly no super normal profits.

Purists who read Bikker and Bos (2008) might be interested in this exchenge between Jaap Bos and myself.

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37 Responses to Banking competition II

  1. Blogstrop

    As I have mentioned before, the next time I hear any company profit reported by the news media as a percentage of total capital invested, rather than simply as $xxx million, it’ll be the first time. It’s a favourite “progressive” propaganda tactic to make any bank profit sound humungous and evil just because it’s there.

  2. Bruce of Newcastle

    Dr Denniss is a coauthor with Clive Hamilton, a former advisor to Bob Brown, and a favourite of the Australian Fabian Society since a number of his papers are hosted on their website. (I quite like this one where he advocates forced labour). He also got badly pwned by Monckton on global warming during the ABC hosted debate.

    That would place him in the far left end of the political spectrum. Why would anyone listen to a word he said on banks and the banking system?

    Maybe this is why Fairfax is cratering.

  3. Andrew

    I’m applying for a mortgage right now. Not surprisingly, the non-bank rates are well below all but the hapless Ubank (who be loaned themselves so appallingly I would never recommend talking to them).

    If people choose to use banks in contravention of their interests, it IS a free choice.

    The Regressives have to fabricate a problem, because if they allowed a position of “people chose to deal with these guys admidst competition then they would have to accept Murdoch666′s market share.

    Anyhow, stand by for a Henry Tax on banks. The Senior Labor Figure will adopt that platform, announce another redistribution programme (putting back the money Gillard took from wymin who offended her by reproducing) and then slag off A666 for not making banks pay “their fair share”).

  4. Tel

    It is sort of odd that mortgage holders paying a variable rate mortgage in Australia (where the bank faces no risk or rate changes and very little risk of default) have consistently paid higher rates than 30 year fixed interest mortgages in the USA (where the bank is at risk from rate changes and inflation, and arguably it is easier for default, and certainly easier for house prices to fluctuate).

    I thought there was a lot of classical economic theory to say that in a free banking environment such a thing should not happen?

    Even more pronounced if you want to compare mortgage interest rates in Japan, which are less than 1% or something like that.

  5. 2dogs

    The banks are starting t get a huge dose of competition in the form of crypto-currencies, so lets just see that pan out.

    However, the regulatory playing field needs to be levelled for this fight:

    - Issuing a crypto-currency backed by securities would require at least a PDS in Australia, but fiat crypto-currencies are unrestricted. ADIs have a completely different set of obligations.

    - The AUSTRAC regulations hit the banks, but no-one is required to register a crypto-currency address.

    - Cypto-currencies would work better with peer-to-peer banking, but P2P banking is effectively banned by the APRA regulations.

    - While crypto-currency transfers are public information (even though you may not know who has which address), and large bank transfers must be declared under AUSTRAC, only AUSTRAC requires disclosure of the reason for the transaction.

  6. Tel

    - The AUSTRAC regulations hit the banks, but no-one is required to register a crypto-currency address.

    That’s probably going to change, and you just know the data will go straight to the USA.

  7. Tel

    - Cypto-currencies would work better with peer-to-peer banking, but P2P banking is effectively banned by the APRA regulations.

    I heard that “Lending Club” has started operation in Australia, but you need to be able to demonstrate a personal income of at least a million dollars a year in order to be allowed to invest in it. Their primary lending product is offering debt consolidation to those poor sods who are getting smashed with 20% + on credit card debt. Very easy to undercut the banks in that space and still make a profit.

  8. JC

    Very easy to undercut the banks in that space and still make a profit.

    In the high income earner segment perhaps. I think you’ll find that the banks don’t make near the spread people think they do, because its unsecured lending and quite risky. The default rate is quite high.

    There’s a lot of interest to earn to make up for a loss if a bank writes off say a $20,ooo credit card loan. You also need to figure the fraud they get hit with.

  9. rebelwithcause

    It is sort of odd that mortgage holders paying a variable rate mortgage in Australia (where the bank faces no risk or rate changes and very little risk of default) have consistently paid higher rates than 30 year fixed interest mortgages in the USA (where the bank is at risk from rate changes and inflation, and arguably it is easier for default, and certainly easier for house prices to fluctuate).

    I could be wrong here, but I assume Australian interest rates tend to be higher to compensate for currency exchange risk. We rely on overseas lenders for our housing finance, and they expose themselves to considerable risk by taking repayment in Australian dollars (particularly given the volatility of the AUD). Hedging against changes in the exchange rate is expensive and this gets built in to the cost of finance, and it makes fixed Aus rates relatively more expensive (as riskier for o/s lender) than would be the case in markets with strong domestic finance. You don’t need to hedge if you are loaning USD to someone paying you back in USD.

    Happy to hear arguments to the contrary though.

  10. JC

    Rebel

    There’s a very active market in currency swaps out to 3 to 5 years. The banks don’t take risk when issuing commercial paper or any foreign denominated debt overseas. Hedging is the interest differential and the interest rates are basically anchored to the bond rates of the two countries.

  11. Thomas Esmond Knox

    Apparently some of the financial geniuses above want me to accept a lower interest rate on my bank deposits.

    I disagree with them.

    I think interest rates should be higher.

  12. rebelwithcause

    JC – yes, I’ve just taken a quick look and you are correct on this. Don’t come to me for international finance advice!

  13. Sinclair Davidson

    The question is why isn’t there arbitrage across the Australian and US domestic housing markets. I haven’t given this problem too much consideration but my thnking would go along these lines: I would have thought given that the housing stocks in those two economies (indeed across all economies) is non-tradable that some price differential would always persist. Then I’d look to the differing institutional features of the two markets, and then notice that Australians are unlikely to buy a US home and commute to work in Australia. Then I might speculate on the role and structure of government intervention in those markets before thinking about the funding costs and structures of the two banking systems.

    All up, while capital markets are more likely to be highly integrated, housing markets are very likely to be highly segmented. Supply and demand conditions across those markets are unlikely to result in the law of one price holding.

  14. Casey

    Sinclair,
    If you only knew. I expect when you are an older man and have thought this through a little more you will be extremely embarrassed to have posted such an incorrect blog. Oligopolists compete, and in the case of the Aussie banks they compete hard. They just compete on everything except price. The profitability of the major banks is obscene. Prices are too high. Mortgage margins are twice what the need to be. Equity holder risk (and also debt risk) is subsidized by the implicit guarantee of the government/tax payer. And neither political party has the guts to deal with the problem.

  15. JC

    Sinc

    The spread in terms of cost of funds wouldn’t be hugely different from Australia to the US. Banks in both markets are targeting around 15% return on equity which indicates in my mind that the differences aren’t huge.

    The net interest margin for the large US banks is around 2.5%. Is it much different here? I don’t think so.

  16. JC

    So Casey, is 15% return on equity an obscene return? Tell us, you nonce.

  17. Sinclair Davidson

    They just compete on everything except price.

    Strange you should say that – isn’t NAB running adverts about how consistently their mortgage rates have been lower than all the other banks?

    Equity holder risk (and also debt risk) is subsidized by the implicit guarantee of the government/tax payer.

    So I keep hearing.

  18. Sinclair Davidson

    JC – what about the price consumers pay for home loans? Tel suggests they are very different. As per my comment above, if true, it wouldn’t surprise me.

  19. JC

    Sinc

    The US has a 30 mortgage market while we don’t. I think that has a lot to do with the fact that their market breadth and sophistication from a historical context. Until the relaxation of interest rates controls by the Hawke government I believe our banks were only ever able to offer reset mortgages.

    Adjustable mortgage in the US can be had for around 3%

    A one year adjustable rate here is around 4.75%

    I don’t think there’s a huge difference once you adjust for the interest rate differential.

  20. Infidel Tiger

    Here’s a good site for US mortgage rates. Seems to be quite a spread.

    http://www.bankrate.com/funnel/mortgages/

    If anything the margins look much bigger than what Australian banks are making.

  21. JC

    US 2 year note rate is around .35% while Australia’s is around 2.8%.

  22. handjive

    When the NAB came out in it’s advertising that “On Valentine’s Day 2011, we broke up with the other banks“, it was agreed that this was an overt admission that the banks were indeed ‘colluding’.
    And still are.

    As an ‘average-joe’ consumer who has no choice but to use these ‘banks’ (try & get a wage paid cash-in-hand) and, with the knowledge that none of these banks could survive if responsible for failed investment decisions made, I have nothing but disdain for them.

  23. JC

    IT

    You need to be a little careful with comparisons, particularly the US because their interest rates are at zero and the banks there have experienced a great deal of margin compression from that. Banks can’t borrow at less than zero.

  24. JC

    Jive

    Explain to us just how they collude? Do the banks compete on deposited taking which is the cheapest source of funds? Of course they fucking do. It’s the liability side of the balance sheet that dictates how competitive banks can be.

    This factor seems difficult for people to understand.

  25. handjive

    JC, the banks have no need to compete for my ‘custom’.
    I am forced to use these banks, who then can charge me for the privilege.
    With out these regulated charges, these banks would go broke through mismanagement.
    Which brings me to your “explain how they collude?”

    Once upon a time, not so long ago when free markets ruled, when banks could go broke, banks had to ‘fight’ for your custom, usually with greatly varied interest rates. The NAB failed marketing link I provide shows a hark back to the old days. And marketing is all it is. Thimbles & peas.
    They are still going out together.

  26. rebelwithcause

    Jive – Exactly when was this golden age of competitive banking? From the Great Depression up until the 1980s the Australian banking market was essentially closed to foreign competition (and most savings banks were government owned). Not my definition of a free market.

    You’d have to go back to around the late 1800s/early 20th century to find a time when the government allowed banks to go bust. You must have lived a very long life indeed if this seems ‘not so long ago’ to you.

  27. .

    People like Casey ought to learn about the banking industry before pontificating to others.

    You cannot compare the ROE of a bank to a manufacturer. They are completely different. A bank may be levered 20 times in Australia, loan defaults can blow the entire system down. A bank may only earn 1-1.5% ROA but be levered 15 times – hence 15-20% ROE is the norm. They are earning a spread on funding term deposits and MBS which fund superannuation etc. Somehow this is obscene…

    The whole next paragraph ought to be bolded…

    Competition is not decided by the number of market participants. Competition is decided upon by the openness of the market – the barrier to entry to banking is artificial. Australian banks are very efficient and innovative.

    The lack of competition comes from sheer loyalty to banks. This perception arises out of fear if they get a loan elsewhere, the bank won’t treat them as a “prime” customer, even if they are paying 4-5% margin on a high quality loan.

    Customers are treated exactly the way they ask the banks to treat them – like mugs.

    In theory mortgage broking ought to be a river of gold but it’s tough as people refuse to give up their coveted, hated position of an overpaying customer.

    Hopefully firms like Yellow Brick Road can make inroads, and offer far better financial planning than what is on offer.

    Another problem is financial planning itself. Ex bankers who set up mortgage broking often cannot set up financial planning unless in an arcane manner to high net wealth clients. The FPA offers no value to customers, and the idea a former bank mananger can’t offer advice as good as some financial planning firms is a joke.

    If you could offer a full range of services as the bank did, you’d be more attractive to the customer base.

    The contention that prices (mortgage margin) is uncompetitive is untrue. Before the GFC, the margin on residential lending was tending to 1.5%. This is very competitive, we’ve been through a consolidation and seen new entrants emerge as the market settled. Banks don’t require 25% deposits to buy a home anymore, and where I bank (NAB and a Mutual), fees are very low or non existent unless you want FX or a paper trail.

    You can get cash almost anywhere for a small fee, up to lots of 1000-2000 AUD. Less than half a per cent. Instantly.

    Try getting that amount of cash 20, 30, 40 years ago instantaneously. No, and the explicit fee would be huge.

    Customers on one hand are mugs, on the other, whingers.

  28. handjive

    rebelwithcause,
    Not a” long life” like that. As I stated above, just a joe-average getting a weekly wage, but I remember mid-late ’70′s/early eighties, when there was a proliferation of credit unions, (admittedly not ‘banks’), many went broke or were taken over.
    St George was once a credit union that survived those days
    Trying to google to remember some names, I can’t find any.
    I have a friend (rip) who did an advertising campaign for one that went broke not long after back then. Can’t remember the name of the institution.
    Possibly I will wake up in the middle of the night suddenly & remember.
    I think ‘Advance Credit union” was one name that no longer exists in Australia from 70/80.
    Competition for your deposit was fierce in those days, when you pay came in a packet.

  29. .

    I once banked at Advance Bank, as a kid, but didn’t want to go with St George when they consolidated.

    More foreign competition would open up more capital to borrowers and improve competition of deposit and loan margins.

  30. Jim Rose

    sinclair, see http://www.pc.gov.au/office-regulation-review/submission/pricessurveillance for a fine discussion of oligopoly from pages 50 to 59, if I don’t say so myself. the then induistry commission rgued therein that:

    Empirical research suggests that, although the first firm in the market may charge a high price, the entry of one or two other suppliers usually results in effective competition. Once there are three to five suppliers in a market, an additional entrant has little impact on pricing.

  31. Tel

    In the high income earner segment perhaps. I think you’ll find that the banks don’t make near the spread people think they do, because its unsecured lending and quite risky. The default rate is quite high.

    On credit cards the fraud rate is high… perhaps besides the point, but banks just cover that out of their main pool. Anyhow p2p lending takes a more canny approach; allowing individual investors to choose what sort of debt they want to buy into and on what basis. The investor in turn takes personal responsibility for their choices, making the whole thing operate a lot more effectively than the banks… because the people making the key decisions actually care.

  32. Tel

    I could be wrong here, but I assume Australian interest rates tend to be higher to compensate for currency exchange risk.

    In the long run exchange rates can and have gone either way, but overall we can’t say that the AUD has systematically lost ground to the USD… and yet Aus rates have very consistently been higher than US rates. I would accept that there is a risk component, but why do Australians always pay for it?

  33. Tel

    This perception arises out of fear if they get a loan elsewhere, the bank won’t treat them as a “prime” customer, even if they are paying 4-5% margin on a high quality loan.

    Really ?!?

    Who has that perception? I’ve been a St George customer continuously for an embarrassingly large number of years. When I went for a home loan the first bank I asked was St George, and they quoted me a reasonable rate but went to no particular effort on my behalf. I got a very strong sense of “yeah whatever” radiating from them. I ended up with AMP at a slightly better rate and I think they have consistently been just a tiny bit better than the main banks, nothing to do back flips over.

    I kept the account open at St George, but moved all the significant money into AMP and what I found is the St George have treated me with exactly the same indifference they have shown me for as long as I can remember. What in the world are you talking about “prime” customer? Who would believe this? What is a “prime” customer ffs?

  34. Andrew

    Once upon a time, not so long ago when free markets ruled, when banks could go broke

    Check out Basel 3, Hand Jive. The capital structure is certainly intact – starting losses from equity, forced conversion of prefs and sub. It’s only senior debt that has protection. And rightly so, given $25bn of guarantees that will probably never be needed saved us from a GFC in Feb 2008 and $200bn would have done the job in Sept.

    And those “credit union” blow-ups you’re recalling are almost certainly building societies.

  35. Casey

    Some poorly informed commentary above, which in part reflects the excellent jobs the Australian banks have done in capturing the regulators (Treasury and RBA). There is no need to try to defend what is not working just because it is private enterprise. Business is carried on within a legal and regulatory structure and it is important to consider if the regulatory and legal frameworks are serving the best possible purpose. A familiar consequence of oligopoly is a savagely competitive market that competes on all sorts of things EXCEPT price. That is the situation of the Australian banks. They compete their sales service proposition. They no longer close down useless and uneconomic branches. At many branches they now have the ridiculous excess of a concierge at the door to welcome you and point you to the queue. Staff are rewarded for their customer service score. It seems innocuous, even maybe desirable, until you realise that it is an industry strategy build around wasteful ways of avoiding price competition. There have only been two and a half outbreaks of price competition in Australian banking in twenty years. 1 David Murray slashes mortgage rates once and the market follows. CBA was so big in mortgages everyone had to play along, it was the early days of the oligopoly and they hadn’t all thought through the game strategy. 2. The US private placement market 144A allows borrowers to exert pressure on corporate rates during the period 2002 to 2007 – pretty much all gone now. In fact during the GFC there was so little competition that banks refused to take the corporate customers of other banks (easily substantiated by subpoenas) and savagely jacked up lending margins of refinance. 3. The truly pathetic attempt by NAB to start a price war, and no one played along (no more falling into the David Murray trap, lesson already learned, oh yes, that’s what oligopolies do!).

  36. .

    Casey
    #1194990, posted on February 19, 2014 at 10:52 am
    Some poorly informed commentary above

    No. You have quantified nothing and otherwise lied about branch closures.

    Now fuck off.

  37. Casey

    Whatever. But with language like that we can no longer discuss the issue.

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