Category: Economics and Banking

Having summarised the main observations from the 460 page Financial System Inquiry (FSI) interim report yesterday, today we start to delve more deeply into some of most important issues raised. In a number of areas, we believe the work to date could be sharpened.
Lender’s Mortgage Insurance. The report rightly highlights that for banks with advanced capital models, there is now no benefit to underwriting risks to an LMI entity, as they already receive a 20% weighting, whether or not they are LMI insured. Therefore, LMI may become sidelined, and be used by smaller banks only, reducing volumes and increasing underlying portfolio risks.
However, whilst the report recognises that about 25% of new loans are underwritten by LMI, and the borrower pays, it does not reflect on the fact that the insurance is not portable, so consumers forfeit the premium they pay if they move later; that consumers are confused by the cover provided (protects the banks, not the household) and LMI encourages higher LVR lending. We think the role of LMI should be considered more broadly.
Industry Concentration. The report comments “Some submissions argue that the increasing concentration and integration of the major banks is harming competition. They submit the major banks can cross-subsidise products to drive out competitors in some markets. Submissions also argue that the major banks’ market power has led to oligopolistic competition and higher prices for consumers. The major banks have market power across a range of markets. However, it is not clear they are abusing this power. The ACCC has taken relatively little action against the major banks in recent years. The Inquiry would welcome views on the level and exercise of market power across the various markets in which the major banks operate.”
The major banks have become financial services conglomerates, extending their reach across retail, business and commercial banks, as well as wealth management, wealth management platforms and insurance. In addition, they have become more vertically integrated, with the accumulation of mortgage brokers, financial planners and other advisors businesses, and are extending services into online channels as well as branch networks. There are important implications, first consumers often find the brand they transact with does not clearly indicate its relationship with the parent bank. Second, as players control more of the value chain there is more opportunity for price control and reduced competition. For example, a mortgage broker working for one of the large players may recommend an in-house mortgage, so long as it is not unsuitable.
The report says “Vertical integration of mortgage broking may create conflicts of interest, which could hamper competition. Mortgage brokers can improve competition by enabling smaller players to access a broader range of consumers than their standard distribution networks would allow. However, vertical integration may have the potential to distort the way in which mortgage brokers direct borrowers to lenders. The extent of this issue is not clear. The Inquiry welcomes views on this issue.”
More broadly there is a case for greater transparency in the proportion of industry segments which players occupy. No consolidated data is provided by the regulators, across business streams. In addition, ACCC tends to look at specific transactions, not necessarily setting them in the broader cross segment context. We need an overall industry concentration metric, and regular reporting.
The Implications of Four Pillars. The report noted that “The ‘four pillars’ policy, which prevents mergers between the big four banks, has been in place, with some modifications, since 1990. Allowing a merger between the large banks would likely reduce competition, and this may offset any advantages that flow from larger scale. No submissions supported removing this policy.”
“The Inquiry views this as appropriate and does not plan to recommend changes. The banking sector is already concentrated; further significant concentration has the potential to limit competitive pressure in the market and reduce the choices available to Australian individuals and firms. Although general competition law may prevent a merger between the major banks, the Inquiry sees merit in retaining the four pillars policy.”
Now, I agree that further consolidation in the industry amongst the major banks should be resisted, however, the unintended consequence of this policy is that the banks can complete quite happily on the basis of inefficient processes and systems. This in turn flows on to higher fees and charges. So, with competition dampened by four pillars, what mechanisms should be established to ensure that Australia Inc. does not pay more than it should for banking and financial services products? At very least, we need an objective cost benchmark, against players in analogous markets overseas, to ensure that the four pillars does not artificially support higher margins and fees.
Innovation in Financial Services. The report recognises that innovation, often enabled by new technology is significant and important. “Government and regulators face challenges from the expected pace of change in technological developments. By its nature, regulation lags market developments. Consequently, Government and regulators need effective mechanisms for monitoring emerging trends, a flexible approach, and the ability to adapt and design regulation in a changing environment. Where new, technology-enabled business models, products and delivery mechanisms emerge, regulators need to consider whether and how to regulate such developments. They may also need to be flexible in how they apply existing frameworks.”
The latency between developing new business models, and regulation needs to be reduced. For example, Peer-To-Peer lending, is now on ASIC’s radar, and regulatory mechanisms are being developed.
So the report is considering “Developing a comprehensive Government strategy, in consultation with industry, to ensure the regulatory framework supports technological innovation, while managing risks.” One option mooted is to “Establish a central mechanism or body for monitoring and advising Government on technology and innovation. Consider, for example, a public–private sector collaborative body or changing the mandate of an existing body to include technology and innovation”.
Our recent experience is that the currently constituted bodies are populated predominantly with people who live within the current mode of operation in financial services. There is the need to break the mould, and inject innovation into the heart of the financial services environment. This would indeed require a different model of engagement. In addition, the pace of change, as individuals adopt new devices, and smart mobile becomes the norm, this is important, and urgent.
Next time, we will look at some of the other important area.