A new report commissioned by the Customer Owned Banking Association (COBA) and compiled by Pegasus Economics – titled Reconciling Prudential Regulation with Competition – has found that changes to the regulatory capital framework have undermined competition in the mortgage market.
According to the report, the Australian Prudential Regulation Authority (APRA) did not give enough credence to competition risks when applying the internal ratings basis (IRB) method for calculating risk weights provided for under Basel II – a banking regulations framework designed to promote financial stability.
The report found that under Basel II, credit and operating risk weights determined under the standard method were “much higher” than those under the IRB method used by the major banks.
Research from the Reserve Bank of Australia (RBA) was cited, in which the central bank found that at the end of June 2015, the average risk weight of residential mortgage exposures using the IRB method was 17 per cent, compared to 40 per cent using the standardised approach used by smaller lenders.
The report noted that as a result of the disparity, higher costs were incurred by lenders using the standard method, which influenced the pricing of lending products and, in turn, reduced competitiveness with major banks.
According to the report, due to the imbalance, the major banks have enjoyed a funding cost advantage in excess of $1,000 annually on a residential mortgage of $400,000.
“APRA downplayed as well as dismissed competition concerns during its implementation of Basel II and did not follow due process by completing the required competition assessment checklist in the Regulation Impact Statement it prepared for Basel II,” the report noted.
“The actions of APRA, in turn, implies the competition-fragility view of banking is endemic to the organisation.
“The outcomes arising from the interaction of the global financial crisis (GFC), coupled with the implementation of Basel II, vindicates the criticisms of Basel II from a competition perspective.”
The report went on to state: “Through its implementation of Basel II, APRA put smaller ADIs at a major competitive disadvantage and undermined competitive neutrality.
“The available evidence suggests the interaction of the GFC combined with the implementation of Basel II provided a major fillip to the major banks to the detriment of other ADIs.”
In addition, the report found that APRA’s decision to increase the average risk weight for IRB banks from an average of 16 per cent to a minimum of 25 per cent has prompted some lenders to engage in “cream skimming” by targeting home loans with the lowest risk profile, which focused competitive pressures on “high-demand” borrowers.
“Cream skimming has adverse consequences as it skews the level of risk in house lending away from the major banks and towards other ADIs who have to deal with an adversely selected and far riskier group of home loan applicants,” the report noted.
With APRA set to release a draft revised capital framework, the COBA-commissioned report called for policy measures that would ensure regulation does not continue to “stifle” competition in the banking sector.
The recommendations include:
- Addressing the lack of coordination between prudential regulation and competition policy and overcoming the “competition-fragility view” of banking, which the report stated would ensure that competition considerations are given due deliberation in prudential regulatory policy decisions through a statutory secondary competition objective for APRA.
- Compelling IRB banks to hold more capital, which the report stated would reduce the fragility of the banking system and ensure benefits achieved from injecting greater competition into the banking system can be realised.
- Increasing granularity for risk weights for banks using the standardised approach, which would “improve competition in home lending”.
Reflecting on the findings of the report, COBA CEO Michael Lawrence said it’s “timely” given the “acute need for a competitive and efficient home lending market”.
“Following the financial services royal commission, there’s a renewed focus on how regulators and government can improve competition in banking and ensure major banks are accountable without reducing financial stability,” Mr Lawrence said.
He added: “The rules on risk weights mean there is too large a gap between the amount of capital that smaller banks must hold compared to the major banks.
“The report says APRA should be looking to close the gap in risk weights and it should ensure that it does so in a way that prevents the major banks cream-skimming the lowest-risk home loans.”
Mr Lawrence recently welcomed the passage of the Treasury Laws Amendment (Mutual Entities) Bill 2019 through both houses of Parliament.
The bill includes a new definition for a mutual entity as a company where each member has no more than one vote, changes to demutualisation rules to ensure that it is only triggered by an intended demutualisation, not by other acts such as capital raising, and the creation of a mutual-specific instrument that can be used to raise capital.
COBA has also published a “Competition Agenda” ahead of the federal election, designed to promote pro-competitive reform in the banking sector.