Medcraft oversteps the mark with his support of tracker mortgages

There is no need for politicians and regulators to dictate the products banks should offer.

ASIC chairman Greg Medcraft.

It is unclear whether Greg Medcraft is advocating that banks should be forced, by regulation or legislation, to introduce tracker mortgages in this market, although that would be the obvious conclusion from his comments at the latest House of Representatives economics meeting hearing today.

What is clear is that any mandating of specific products that banks have to offer would be a significant intervention into their affairs, and potentially a dangerous one. Neither politicians nor a non-prudential regulator should be dictating to banks what particular products they should be offering in a market the Financial System Inquiry determined was competitive.

Medcraft, ASIC’s chairman, went public this week with his support of the introduction of tracker mortgages — mortgages prices at a fixed margin to a benchmark rate, like the Reserve Bank’s cash rate. The committee’s chairman, David Coleman, had revealed a preoccupation with these products in last week’s “grillings” of the major bank chief executives.

Medcraft reiterated his enthusiasm for the products at the hearing today, explaining their absence from this market as a function of the concentration and lack of competition.

ASIC chair Medcraft says Oz banking is oligopoly with "a lack of competition". Calls for tracker mortgages.#banks #ausbiz

— Richard Gluyas (@Gluyasr) 2016年10月13日

Concentration doesn’t automatically, of course, lead to a lack of competition and within the banking system and despite the obsession of politicians and others with mortgages, there is a delicate balance between the intensity of competition and system stability.

There was a lot of competition back in the late 1980s after the entry of foreign banks to the market in the mid-1980s. That saw a slew of smaller banks and non-banks collapse, two of the majors teetered on the brink, more than $30 billion of loan losses and the “recession we had to have’’ in the early 1990s.

More recently, HSBC tried to take the majors head-on in this market, via an aggressive expansion of BankWest. That didn’t end well.

The major banks made it clear last week that they’ve all looked at rate trackers, which are offered in other markets, but (a) don’t believe they would be popular with borrowers and (b) would add a new dimension of risk to their own balance sheets.

The two components are related. Tying a mortgage rate to, say, the RBA’s cash rate in a fixed relationship over the 15 to 30-year life of mortgages when the cash rate doesn’t actually reflect banks’ funding costs creates the potential for a major mismatch if the costs of their other sources of funding don’t move in line with that rate.

Offshore debt markets can be volatile and affected by influences that have nothing to do with the Australian economy or financial system.

While the certainty that a mortgage rate would move directly in line with the cash rate might appear appealing, the product wouldn’t necessarily be popular with customers because the premium over the cash rate required to reflect the risk of the funding mismatch and the shifting costs of the different sources of bank funding would be significant. The tracker mortgages would be priced at a premium to the standard variable rate products the banks offer today.

There is, of course, an alternative product on offer from all the Australian banks today that also offers certainty. Borrowers can fix their home loan rates today, albeit paying a premium to the variable rate products.

A more basic conclusion is that if a bank believed there would be significant and profitable demand for a tracker product today at prices that would reflect the funding risks, they’d be offering it.

The smaller banks and non-banks, which are predominantly funded by domestic retail deposits, would appear to be better positioned than the majors to offer tracker mortgages, but haven’t. That, perhaps, reflects their views of both the likely demand and the degree of risk.

It should also be noted that there is no shortage of mortgage finance, the cost of mortgage finance is at historical lows and, in an indication that the system is competitive, all the banks offer discounts to their published standard rates to attract customers.

There is no need for politicians and regulators to dictate the products banks should offer and their intervention potentially creates risks in what is generally regarded as one of the strongest and best-regulated banking systems in the world. It is also one of the most efficient and more innovative.

Medcraft’s other contribution to the banking debate this week was to suggest the major banks should have higher capital charges imposed on them to level the playing field with smaller banks.

The major banks already have a one percentage point capital surcharge on them, relative to the smaller banks, because of their systemic importance — a tax, if you like, because of their “too big to fail’’ status.

In line with the recommendation of the Financial System Inquiry, the Australian Prudential Regulation Authority has also introduced a 25 per cent risk-weighting floor under their mortgages books, which equates to roughly an additional one percentage point of regulatory capital.

While, at face value, that still appears to leave smaller banks at a disadvantage — their average risk weights for mortgages is about 39 per cent — it isn’t that straightforward.

The comparisons are being made between two quite different sets of calculations.

The majors use an advanced approach that uses sophisticated and quite granular internal modelling and which can only be adopted after meeting quite stringent accreditation standards set by APRA. The smaller banks (some which are working towards accreditation) use a “standardised’’ approach, where there are set risk weights for the broad asset classes.

Apart from the additional capital the majors are required to hold relative to their smaller competitors, and the extra costs of the systems and processes to achieve “advanced’’ status, they have larger and more diversified mortgage portfolios, which inherently reduces risk relative to more regionally concentrated banks.

There are also some differences in what’s included in the calculations — there’s a higher risk-weighting, for instance, for undrawn credit lines and off-balance-sheet exposures under the advanced approach than in the standardised approach.

It should also be noted that the advanced approach isn’t static. At the moment, loan losses within mortgage portfolios are at low levels. As the economic cycle moves over the life of the loan portfolio, the majors’ risk-weights will rise and fall (albeit, now with a floor).

The whole issue of risk-weights is also a continuing discussion — given that the global regulators are still working on their own approach to internal modelling to create their own more standardised approach and allow better comparability and less individual bank or banking system discretions — in the calculations. That’s expected to produce more conservative outcomes and, in some cases, require more capital to be held, which is causing some angst in Europe.

Members of the economics committee and Medcraft appear to see an absolute relationship between industry concentration and competition. Medcraft said today, in answer to a question from the committee, that he would like ASIC to have a role in regulating competition in financial services.

They also appear to see competition as unrelated to systemic stability, despite the lingering (and still substantial and very visible) legacies of the financial crisis and, for those who are old enough, the traumas of the last recession this economy experienced.

APRA’s Wayne Byres told the committee that APRA didn’t see enhanced safety as necessarily requiring a trade-off with competition but as complementary. Only sound institutions would be able to support their customers, both existing and new, through good times and bad.

Australia needed regulated institutions that made an adequate return for the owners to remain attractive to new investment, while providing products and services that offered value for money and performed consistently with expectations.

“Business models and products that only support the community when times are good do not provide the lasting benefits of competition. Put simply, only sound institutions operating with the interests of their full range of stakeholders in mind, and with a long term perspective, are able to provide real and sustainable service to the community,’’ he said.

That’s a more balanced, and sophisticated, view of the system than elevating the absolute intensity of competition over the other elements of a robustly competitive system that remains stable and able to support customers through even the more extreme moments in financial and economic cycles.