My Op Ed piece from today’s AFR is below.When is there too much competition?
In most industries this is just a silly question – at least from the consumers’ perspective. But in banking, intense competition can lead to practices that undermine financial security. That is why we have prudential regulation.
To see how competition can raise risk, think back to HIH. Remember them – Australia’s second largest insurance company that went belly-up in 2001? As then treasurer Peter Costello noted in 2003, when releasing the Royal Commission report into HIH, “the primary reason for the collapse of HIH was the failure to provide properly for future claims”.
It is costly to hold reserves against future claims. An insurance company trades off the price it charges for insurance with the risk of claims and the cost of holding reserves. An insurer never holds enough reserves to pay out all policies at once. That would be foolish. Rather it trades off the risk of a large number of claims with the amount of its reserves. In the case of HIH, prices were set too low to adequately cover actuarial risk and reserves were too small. Competition, at least in part, drove this short-sighted strategy.
Why don’t consumers recognise the risk and refuse to buy? Often consumers do not accept the cheapest quote for a service – whether fixing a car or painting a house. Consumers realise that there is a trade off between price and quality, including the likelihood of a nasty hidden surprise down the track. But it can be difficult for consumers to evaluate these risks. Often consumers rely on a company’s market reputation.
In financial markets, relying on reputation to avoid problems of risk often doesn’t work. Financial products involve significant asymmetric information. For example, a lot of smart people put their money into Bernie Madoff’s Ponzi scheme. They had no way of checking what Madoff was really doing with the funds. The payoffs were high and his reputation appeared impeccable – right up to the time that the scheme collapsed.
In banking two other factors come into play. First, marginal trade offs in risk can make a significant difference to profits. Managers live and die by market share and the current returns to investors. Improving the interest rate paid to depositors while lowering the rates paid by borrowers can raise market share. This can improve short-term profits but, as recent experience in the US and elsewhere shows, banks that play this game have nowhere to hide when something goes wrong. Their prices have been based on hope, not risk.
Second, banks get bailed out. Recent experience shows that governments will step in and rescue bank investors when they get into trouble. Even in Australia, where there was no formal deposit insurance, the federal government’s first reaction to the global financial crisis was to step in and provide that insurance. Our financial system is so interlinked that our government cannot politically or economically allow a major bank – or even a smaller bank – to go bust. This frees the banks from market discipline. They can profit in the good times while the government will step in and protect them when things go wrong.
Competition in banking is intrinsically tied to prudential regulation. The bank managers understand this and it was part of their testimony last week to the Senate inquiry into banking competition. Our major financial regulators understand these issues. The Basel Committee redesigning international financial rules also gets it. Basel III aims to ramp up prudential standards by raising reserve requirements.
Unfortunately, it is not obvious that our politicians get it. The debate on bank competition has focussed on exit fees, creating a ‘fifth pillar’ and general interference in banking markets in a way that ignores issues of risk. It appears that popular vote winning is driving policy on all sides of politics. However, popular measures to benefit particular groups of voters, such as mortgage holders, may alter the competition-risk balance in the banking industry. At best, populist intervention will do no harm. At worst, it will create incentives for banks to compete by mispricing risk and holding inadequate reserves.
What Australia needs is a banking prudential inquiry. Such an inquiry can look back at the global financial crisis and clarify the lessons for Australia’s financial system. Some of those lessons will come from overseas experience. Others will come from our own experience. Government intervention during the GFC has rewritten the rules of Australian banking, but so far the government appears to be ignoring this fact.
A prudential inquiry will necessarily address competition issues. The aim is to set up appropriate prudential standards and allow competition to operate within those standards. It is also necessary to clarify the relationship between the government and the banks. Political reality means that the government effectively insures our banks. The nature of this insurance – what financial products and investors it covers, which institutions it covers, and how much the banks pay for it – need to be determined. In brief, who can compete, how, where and when?
Australia has a once-in-a-generation chance to reset its financial regulation. This regulation will underpin competition for the next 15 to 20 years. But at present the debate is backwards. Competition without prudential standards led to the last financial crisis. Ad hoc competitive ‘reform’ without considering the issue of risk could lead to the next crisis.