Distortions in the Australian mortgage market were debated at length last week by the FSI's David Murray and a number of Australian bank chiefs.
Industry commentator Christopher Joye moderated the panel at the AFR Banking & Wealth Summit, which included Financial System Inquiry chairman David Murray, Westpac deputy CEO Phil Coffey, Suncorp CEO John Nesbitt, ME Bank CEO Jamie McPhee and Deloitte lead partner Kevin Nixon.
Mr Murray opened the discussion by stating that it remains unclear whether there are competitive distortions in the Australian banking system, apart from the risk weighting issues that he raised in the FSI reports.
“Risk weights in mortgage books were important to us, but the focus we put on the mandates of the regulators and the accountability of the regulators to stay on competition was probably more important than any one move that you can make in the system,” he said.
Mr Nesbitt said it is “critical” that Australia has a competitive playing field. Australian lenders currently operate on an “uneven playing field” where there are “different rules for the different players,” he said.
“It should be evened out, particularly around the risk weights, around funding benefits that flow to the majors and also around regulation and transparency around [mortgage] broking.
“Many brokers today are predominantly owned by the majors and there should be transparency there.”
Mr Nesbitt’s comments were echoed by Mr McPhee, who said that levelling the playing field is not “un-Australian”.
Mr McPhee explained that there are two competitive disadvantages that ME Bank currently operates under.
“One is risk weights on mortgages,” he said. “The second is the ‘too big to fail status’, which is clearly a status helped by the taxpayer which enables cheaper funding for the major banks.”
The FSI final report suggested a floor of 25 to 30 per cent be put under the risk weights for mortgages. Mr McPhee noted that the regional banks currently apply “about a 39 per cent risk weight capital, while the major banks apply 18 per cent”.
“We would completely align ourselves with the recommendation of the FSI, which still gives you incentive to further invest in better risk management practices because 25 to 30 per cent is still less than 39 per cent.”
Mr Joye directed the discussion towards APRA’s recent bank stress test, which revealed that in the event of a severe downturn, the capital of the big four banks would be wiped out while smaller lenders would survive.
The 2014 stress test involved 13 large, locally incorporated banks, which together account for around 90 per cent of total industry assets. Participating banks were provided with two stress scenarios, which were developed in collaboration with the Reserve Bank of Australia and the Reserve Bank of New Zealand.
Central to both scenarios was a severe downturn in the housing market.
Scenario A was a housing market double-dip, prompted by a sharp slowdown in China. In this scenario, Australian GDP growth declines to -4 per cent and then struggles to return to positive territory for a couple of years, unemployment increases to over 13 per cent and house prices fall by almost 40 per cent.
Scenario B was a higher interest rate scenario. In the face of strong growth and emerging inflation, the RBA lifts the cash rate significantly. However, global growth subsequently weakens and a sharp drop in commodity prices leads to increased uncertainty and volatility in financial markets. In Australia, higher unemployment and higher borrowing costs drive a significant fall in house prices.
Mr Murray remarked that the scenarios used are not entirely abnormal in Australia.
“They are unusual but not abnormal,” he said. “The aspect about [the APRA stress test] that didn’t surprise me is that largely since the crises the banks have improved their capital ratios but have not significantly changed their leverage ratios.”
The reason for this, Mr Murray explained, is that the growth in bank business has predominantly been in the lowest risk weighted asset - residential property.
“This suggests to me that the return on equity has been kept high and the pay-out ratio has been kept high by driving into this business,” he said.
“From a bank governance point of view, I would ask the question: we’ve driven all of this business, we haven’t changed our leverage ratio, housing prices keep rising in Australia, and the house price to income in Australia is very high by international comparisons; is this something we should discuss more?”
Phil Coffey, deputy chief executive of Westpac Bank, noted that while bank stress tests are valuable, regulators will always be able to design a stress test that banks fail.
“Global regulators actually want to see what will cause you to fall over,” Mr Coffey said.
“I can’t comment on the industry, but I can comment on what Westpac has done in terms of leverage; since 2007, if I look at equity to loans…they have moved from 5.8 to 8.4,” he said.
“There has been a 44 per cent reduction in leverage - or increase in the amount of equity - that we are holding that backstops our loans. I don’t think it is right to say that we do not have greater capital backing our loans today than we did during the GFC.”
Mr Coffey argued that while bank capital is critical, it is not the only measure of strength.
Rating agencies, investors and regulators closely monitor bank liquidity, funding composition, asset quality, and business models, he said, adding that, increasingly, the management strength and culture of the organisation are also called into question.
“We can be the most capitalised bank in the world but if we have very poor liquidity, that’s a very vulnerable positon to be in,” Mr Coffey said.
“We would argue that it is not right to focus solely on one metric of strength and say therefore that’s the panacea,” he said.
“You have to be very careful about only looking at one metric.”