What is the GFC doing to our banks?

Kevin Rudd declared in the February issue of The Monthly Magazine that "the great neo-liberal experiment of the past 30 years has failed"; that the deregulatory policies of the last three decades (and, of course, the Liberal Party) are to blame for the Global Financial Crisis and this whole sordid mess that we are in.

In his 7,000 word essay, Rudd describes at length the profound effect that the GFC is having and will continue to have on all people, including Australians. Having surveyed the wreckage, he sets out a social democratic manifesto for dealing with the aftermath of the GFC and for rebuilding our shattered economies.

It is difficult to overstate the impact of the GFC on the global financial system and economies generally, but it is important that policymakers in Australia are not overtaken by global events. The Australian financial system is a very different beast compared to its American counterpart, and our banking system faces its own, unique challenges. When examining the Australian banking system in the context of the GFC, it is important that we don't end up treating ourselves for someone else's disease.

It's global, not Australian

While many of America's biggest banks are on life support, our major banks are in good shape. Of the eight AA-rated banks in the world, Australia is home to four of them - CBA, ANZ, NAB and Westpac. There used to be 20 AA-rated banks before the GFC, including the Big Four, who are still there, hanging tough.

Unlike America, where sub-prime lending comprised 15-20 per cent of all loans, sub-prime mortgages in Australia accounted for 2-3 per cent of all mortgages. Australian banks were also far less active in the securitisation and derivative markets than their US counterparts. It is widely regarded that the quality of the loans and liabilities of Australian banks is pretty good, even though Australian households are carrying considerably more debt these days.

In terms of regulation, Australia is operating from a position of strength. The Obama administration has proposed five key objectives to financial sector reform in the United States. A number of those objectives emulate the current Australian regulatory framework.

For example, Obama is proposing a new Financial Services Oversight Council of prudential regulators - a national overarching regulator of prudential risk. This is the American equivalent of the Australian Prudential Regulation Authority, which incidentally the "neo-liberal" Howard government established in 1998.

Obama wants to protect consumers and investors from financial abuse. He proposes a new Consumer Financial Protection Agency to protect consumers across the financial sector from unfair, deceptive and abusive practices. ASIC and the ACCC have been doing this in Australia for years.

Obama wants closer scrutiny of the financial sector, stronger regulation and higher prudential standards. APRA and ASIC, the primary financial regulators in Australia, are well known for their close scrutiny and conservative approach to financial sector regulation.

The Australian position is very different from the America position, which makes Rudd's Australian analysis of the GFC, his attempt to make the world's problems our own, so misleading. Looking at the GFC from Down Under, you can draw a number of conclusions:

1. Australian banking balance sheets are in excellent shape;
2. Australian financial regulation has, on-the-whole and with a few exceptions (e.g. the HIH collapse), been pretty successful and well balanced; and
3. any social democratic program to make sweeping changes to the financial sector would be misconceived.

The Australian financial crisis

Nevertheless, the GFC is having a profound impact on the Australian financial sector. The GFC is reshaping the Australian financial sector and undoing a lot of good developments from the last decade. It has also exposed Australia's vulnerability to international capital flows, as a high debt and low saving nation.

In the last decade, the Australian financial sector has become broader, more dynamic, accessible and competitive.

The deregulation of Australian financial markets, which began in the 1980s, allowed foreign banks to enter the market. Access to wholesale funding and securitisation markets meant new players like Aussie Home Loans and RAMS could undercut established competitors, giving borrowers access to cheaper loans and a broader range of products - like non-conforming and low-doc loans. The growth in online banking and the emergence of brokers that compare rates across institutions has also increased competition.

The benefits have been clear. The spread on business loans has dropped by 2.5 per cent per annum over the last decade. Margins on home loans have dropped by 0.3 per cent - 0.5 per cent p.a. over the same period, and banks offer greater discounts off their headline mortgage rates.

The wider array of products and growth in the size of the financial sector generally has given more people from more diverse backgrounds access to credit.

Now for the bad news.

The GFC has caused a sudden contraction and consolidation in the financial market that threatens to reverse these gains.

Wholesale funding costs have increased significantly thanks to the GFC, leaving small, regional banks and non-deposit taking institutions without access to affordable funding. Without these funds, it is impossible to compete against the larger banks, which can rely on their established deposit bases in order to make loans.

The securitisation markets allowed banks and institutions to free up their capital, so that they could make more loans. The GFC has effectively killed off the Australian securitisation market. Even with the government program to purchase $8 billion of securitised Residential Mortgage Backed Securities (RMBSs), the securitisation market can barely raise $2.5 billion a quarter. It used to raise $18 billion a quarter.

Foreign banks, another source of competition, are withdrawing from the market or have at least put any expansion plans on hold, as they focus inwards and shore up their capital base.

The Rudd Government's three-year guarantee on saving deposits with banks (but not other financial institutions) has unintentionally caused a flight to safety, resulting in a massive exodus of deposits from non-bank institutions, which are not covered by the guarantee, to those that are covered.

The Big Four are uniquely placed to weather the GFC. They have a stranglehold on the domestic banking market, holding about 70 per cent of all deposits and 70 per cent of all loans. Indeed, the Big Four are using their entrenched market position to capitalise on the immense pressures facing their competitors. Since the GFC started, CBA has taken over BankWest, Westpac has bought St George, and Suncorp is desperately seeking a suitor. In the non-banking sector, Westpac has bought RAMS and ANZ bought out Aussie Home Loans. NAB bought Aviva's life insurance arm and is now an industry giant in the life insurance industry.

Normally, the ACCC would never have allowed this sort of consolidation, and would have rejected the mergers on anti-competitive grounds. But in these extraordinary times, with extraordinary pressures on Australia's financial stability, the government has felt compelled to put competition policy on the back burner and focus on immediate threats.

The size and health of the Big Four has no doubt helped the Australian financial sector and the economy escape the worst effects of the GFC, and the government's decision to stand behind them in these circumstances may well have been the right one. However, the government's decisions have unleashed powerful anti-competitive forces that will be difficult to control.

The ACCC is already starting to see evidence of increasing margins on loans.

Since the GFC began, the Big Four have increased their share of the mortgage lending market from 80 per cent to a massive 92 per cent. In the first quarter of 2009, two banks (CBA and Westpac) accounted for a whopping 90 per cent of all new residential home loans.

Total assets of the Australian financial system are valued at 350 per cent of Australian GDP - 3.5 times the size of the Australian economy. The Big Four control a massive majority of those assets.

As the Big Four continue to grow, acquiring insurance and other non-banking businesses, their influence over the market, their competitors and governments will also grow. The Big Four have adopted the multi-business, multi-product banking model that was so popular with America's big banks - Citibank, Bear Sterns, Lehman Brothers - and that brought the American economy to its knees.

The Big Four are becoming Too Big To Fail, creating profound systemic risks and moral hazard in the financial sector. The GFC may well plant the seeds for our own, home-grown financial crisis in the future.

Once the dust settles, if we can't find a way to unwind this, we'll all be paying for it.