Housing Mortgage Contract Design and Banking Sector Competition – The Reform Package

Posted on November 18, 2010
Filed Under Banking, Financial Institutions and Markets, Inquiry Submissions, Media Release, Policy | Leave a Comment

Submission to Senate Economics Committee Inquiry: “Competition within the Australian banking sector”

Professor Kevin Davis, Research Director at the Australian Centre for Financial Studies recommends a 6-point reform plan to improve risk sharing and competition in Australia’s housing mortgage markets.

The Australian Centre for Financial Studies has released a submission to the Senate Economics Committee Inquiry into Competition within the Australian banking sector. The submission focuses upon a subset of the Committee’s terms of reference, and addresses the questions of whether the current structure of housing mortgage contracts involves appropriate risk sharing between banks and customers and implications for competition in banking markets. Analysis of the status quo led to arguments and in turn, recommendations which form the basis of this submission.

The submission reinforces the importance of legislating changes in the Australian mortgage contract design for social and economic benefits. Certainly, the sub-prime crisis in the USA was crystal clear in illustrating the importance of mortgage design for the efficient functioning of financial markets and avoidance of significant social and economic problems.

In summary, the submission elaborates on 6 recommendations:

1. APRA should be required to make publicly available data on mortgage characteristics and terms from data provided by banks and ADIs.
2. Prohibit loan contracts which give lenders absolute discretion to change the interest rate on existing loans.
3. Loan contracts should allow for subsequent variations in the interest rate charged as long as the conditions for such changes are well defined at the initiation of the contract and are verifiable by reference to objective information.
4. Lenders should be precluded from charging exit fees on housing loans if the loan is three years (or more) old and the customer wishes to exit at the end of a period when it is time for a reset (renegotiation) of terms.
5. At a loan reset date, borrowers should be able to transfer a mortgage to another lender upon payment of the outstanding principal, without the mortgage having to be discharged. If the loan is in good standing, the accepting lender should not be required to obtain a new valuation of the property involved – since that would not have been required if the loan were not being transferred.
6. Deferral of loan establishment fees should only be achieved by explicit addition of the amount which would otherwise have been charged into the initial loan principal.

The impact that these recommendations have on risk sharing and bank competition would understandably raise a number of prudential concerns, such as decisions on bank funding and problems of adverse-selection with loan transfers, though the latter is not likely to be a major issue in housing mortgage loans. Removing the variable-at-the-lender’s-discretion characteristic will prevent lenders passing onto borrowers certain interest rate risks which lenders are better suited to manage via their funding choices. It is more reasonable for the consequences to impact upon shareholder profits rather than borrowers.

Kevin remarks,

“Not only are home borrowers unlikely to be able to anticipate the future implications of such market disruptions, it is more appropriate that those risks are borne by bank shareholders, and managed by the bank executives who are paid to do just that.”

The recommendations presented in the submission are one way of achieving improved risk sharing and competition in housing mortgage markets in Australia.

View the full Submission

This Submission was prepared by Kevin Davis, Research Director, Australian Centre for Financial Studies and Professor of Finance, University of Melbourne.

View other ACFS Submissions

Media contact:

Professor Kevin Davis

Research Director, ACFS

info@australiancentre.com.au

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Will the removal of exit fees increase bank competition? Not likely

Posted on November 16, 2010
Filed Under ACFS Commentary, Banking, Financial Institutions and Markets, Policy, Publications | Leave a Comment

Professor Deborah Ralston, Director of the Australian Centre for Financial Studies raises serious questions about how well Australia understands the issue of the lack of competition in its banking sector.

The recent debate over the lack of competition in Australia’s banking sector is nothing new. Indeed, a major objective of the Campbell Inquiry which reported in the early 1980s and led to deregulation of the financial sector was to increase competition in banking through lowering barriers to entry and issuing more banking licences.

The suggestion however that the removal of exit fees could be even a partial solution to this deep-seated and complex problem, raises serious questions about how well the issue is understood.

A recent survey by leading mortgage broker Mortgage Choice of 1,028 Australians who had refinanced their home loan during the previous 12 months, suggests that exit fees had little influence on a borrower’s decision to change financiers. In this survey primary motivations for refinancing were to switch to a cheaper loan, to consolidate debts, fund a renovation, or buy an investment property.

More than four out of every five respondents who switched providers reported that refinancing was either a very easy or relatively easy process, with 46 % paying no exit fees at all and another 21% paying less than $500.  On the down side, almost a quarter of all respondents had delayed refinancing to avoid higher charges, and overall around 16% paid over $1,000 to refinance. Although this is obviously a biased sample in that it does not include those who chose not to refinance, it suggests that the issue of exit fees may not be significant as we are being led to believe.

It is undoubtedly true, however, as reflected in the reduced number of financial service providers and increasing consolidation of market share amongst the major banks that the banking sector has become less competitive over the past decade as a consequence of both market forces and the unintended consequences of government intervention.

In the GFC, possibly for the first time, Australian really learnt the advantages of having a strong and robust banking system. Australia stood out not only as a country with no bank failures or bail outs, but in being able to retain four of the few remaining AA banks globally. Due to the long derided “four pillars policy” and the banks’ focus on raising funds rather than creating complex financial products, Australia had an environment that was protected from the worse excesses of bank competition.  Australian banks were largely immune to the falling credit standards and risky practices that dominated banking in the United States and Europe.

Indeed, the major banks grew from strength to strength through the GFC just as the position of their competitors, the second tier banks, building societies, credit unions and mortgage companies, weakened. As is usually the case in uncertain times, consumers flocked to the perceived strength of the major banks so that their market share in retail deposits and loans grew significantly.  This is most evident in the home loan market where the major banks share of owner-occupied approvals has increased from around 60 % in mid-2007 to around 82 % by the end of 2009.

The unintended consequences of government and regulatory intervention such as the differential pricing in bank guarantees, interventions to support the collapse of the securitisation market and a change to the RBA’s interchange policy for ATMs further disadvantaged smaller institutions.

While the bank guarantee introduced in November 2008 strengthened the position of Australian banks globally, it put the smaller regional banks, building societies and credit unions at a cost disadvantage. On an international basis Australia stood out by way of the significant differential in fees charged on the guarantee. While AA-rated major banks could raise funds at a fee of 70 basis points over the cost of funds, BBB-rated banks such second tier building societies and credit unions paid a fee of 150 basis points. As a consequence few BBB-rated institutions engaged in guaranteed senior debt-raising under the guarantee.

Unfortunately this funding disadvantage hit the smaller institutions just in time to coincide with the collapse of the securitisation market, another critical source of funding. Some smaller institutions had become so reliant on the RMBS market to fund lending that this precipitated consolidation as in the case of St George which merged with Westpac and the demise of some non-bank originators such as RAMS, which had contributed so much to increased competition in the late 1990s.

The Federal government’s intervention to support the securitisation market through the AOFM, unfortunately once again did not work to the advantage of smaller institutions which had difficulties accessing this funding in the right size tranches. While there are some signs that this market is regenerating, its been a long time coming.

In March 2009 the RBA moved to reform the payments system by replacing interchange fees with direct charges to customers on ATM transactions.  By making ATM interchange fees transparent, flexible, and reflective of the true cost of transactions the RBA was seeking to increase competition and profitability in ATM provision, expand the ATM network and make it easier for new players to compete and become part of the system.

While this reform has been largely successful in achieving its objectives it has to some extent further eroded the competitive position of smaller institutions. As the cost of transacting went up substantially for customers using “foreign” ATMs outside their own institution’s network, a clear incentive was provided to move to a larger institution with a more widely dispersed ATM network.

If the government is serious about improving competition it needs to reconsider policies directed at the financial services sector.  Removing exit fees is not the whole answer. The principal of “the level playing field” that underpinned the Campbell recommendations ensures that policies encourage a wider diversity and equivalent treatment of all financial services providers. Over recent times that has not always been the case.

This Commentary is written by Professor Deborah Ralston, Director of the Australian Centre for Financial Studies. Deborah is also a  Professor of Finance at Monash University, and a Director of Mortgage Choice.

deborah.ralston@australiancentre.com.au

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Funding Costs, Fees and Mortgages

Posted on November 15, 2010
Filed Under ACFS Commentary, Banking, Financial Institutions and Markets, Policy, Publications | 1 Comment

Professor Kevin Davis, Research Director of Australian Centre for Financial Studies proposes two reform measures for a fairer and more transparent loan market.

Since the onset of the Global Financial Crisis (GFC) it would have been obvious to Blind Freddie that bank loan interest rates would need to increase more than the cash rate, if bank profitability was to be maintained. And that was probably obvious to bank executives as well.

But whether the many new housing loan customers acquired by the banks under variable rate mortgages over the past two years were informed about that is another matter. Whether they should have been is an important disclosure (if not ethical) issue – although it could qualify as “price signaling” with which the ACCC apparently has some concerns.
The reason that loan rate increases beyond the cash rate could be predicted results from two factors. First, variable rate lending where banks can increase interest rates on existing loans at their discretion, facilitates a form of average historical cost pricing.

An increase in the marginal cost of new or replacement funding (as old borrowings mature) only increases the average cost of funding of a bank’s balance sheet gradually over time. Thus if interest rates on all loans can be increased in line with the average cost of funding, bank profitability will be insulated.

The second relevant factor is that competition encourages such average cost pricing. Rather than increasing the initial cost of new loans to completely reflect their marginal cost of funding, and risk losing market share of new lending, it is much simpler to average the increased cost of funds over the existing loan portfolio. As long as existing borrowers cannot easily exit (and where would they go?) the bank remains more competitive in the new lending market.
But the downside of this approach is, obviously, that if the increased marginal cost of funds is long lasting, new borrowers will find that their loan rate subsequently increases in line with the average cost of bank funding. Unless Australian bankers believed that the GFC was likely to be a very short run disruption to funding markets, this scenario would have been apparent to them.

Not only are home borrowers unlikely to be able to anticipate the future implications of such market disruptions, it is more appropriate that those risks are borne by bank shareholders, and managed by the bank executives who are paid to do just that.

The solution to this undesirable situation where new borrowers face risks of future higher loan rates which are not apparent to them, is to replace variable-at-the-lender’s-discretion loan contracts with adjustable rate mortgage contracts. In these contracts the loan rate is set for a specified period as a fixed margin above some observable market indicator rate, and adjusts automatically at regular intervals as that indicator rate changes.

In such loans, renegotiation of loan terms after the initial specified period may see the borrower wishing to depart from their current lender for greener pastures of better terms on offer elsewhere. This raises the controversial issue of “exit fees”, particularly deferred establishment fees which can make such switching less attractive.

Banning such exit fees, as some suggest, is one option, but at least one bank CEO has indicated that it may lead to re-introduction of up-front establishment fees. So what! If the borrower is cash-constrained, it is a simple matter for the bank to add the establishment fee to the initial loan principal on which subsequent repayments are based.

This is, in effect, what happens implicitly with deferred establishment fees except that: the contract is specified differently (involving a slightly higher interest rate and ex post repayment of the residual fee if the borrower exits); the lender partially “hides” the establishment fees and the borrower is arguably less able to ascertain the likely cost involved. Banks must be able to recoup loan establishment costs specific to a particular loan, but it should be done in a transparent and understandable manner.

Hence, two reform measures are warranted. First abandon variable-at-the-lender’s discretion mortgage loans for adjustable rate mortgages. Second, abolish deferred establishment fees and require any such fees not paid up-front to be added to the initial loan principal. A more transparent and fairer loan market would result.

This Commentary is written by Professor Kevin Davis, Research Director of the Australian Centre for Financial Studies, and Professor of Finance at University of Melbourne.

kevin.davis@australiancentre.com.au

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Mortgages: Time to Re-Design

Posted on November 5, 2010
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Publications | 3 Comments

FRDP – 2010-05
November 4, 2010

Professor Kevin Davis, Research Director at the Australian Centre for Financial Studies proposes that it is time to re-think and re-design the way Australia does mortgages.

Australian housing mortgage contracts have a somewhat unique characteristic. Australian home-buyers sign a mortgage contract with banks which gives banks the right to change the loan interest rate whenever and to whatever they want.

This flexibility given to banks is of considerable value to them, but exposes borrowers to risks to which they arguably should not be exposed. If a bank faces an increase in its funding costs, this can be passed on to existing borrowers. That applies regardless of whether the increase in funding costs is something which affects all banks or only an individual bank – although competition may impose some constraints in that latter case.

At the current time, there is much debate about Australian banks increasing housing loan interest rates by more than Reserve Bank changes in the cash rate.  Figure 1 illustrates how the margin was roughly constant at 180 basis points prior to the onset of the Global Financial Crisis and had increased to 290 basis points in October 2010.

Underpinning this debate is the fact that there have been significant changes in bank funding costs, relative to the cash rate, such that these need to be reflected in loan interest rates if bank profitability is to be maintained. Regardless of whether bank profitability is too high or not, the question of whether both existing and new borrowers should bear the burden of such funding cost changes, or whether this should impinge upon bank profits is an important one.

Changing the form of mortgage contracts would defuse much of that current debate, and would work to allocate interest rate funding risk more appropriately between bank customers and shareholders (and management).

The standard variable rate mortgage loan in Australia has long had the characteristic that borrowers place themselves at the mercy of lenders with regard to future interest rates they will have to pay. Foreigners find this truly amazing, being more used to either fixed rate or adjustable (indicator linked) rate loans. If Australian borrowers are sufficiently naïve to give this power to banks, perhaps they cannot expect to be treated in any other way.

Historically, Australians acceded to such contracts because housing loan interest rates were controlled by governments, and because they had virtually no bargaining power when confronting an oligopoly of large banks. We should not go back to government interest rate controls, but governments could force banks to adopt different loan contracts which would be socially beneficial.

While there has been much innovation in Australian mortgage markets(1), including some use of fixed rate and adjustable rate mortgages, these do not appear to have become predominant. Unfortunately, there are no publicly available official statistics which provide detailed information on the interest rate characteristics of Australian housing loans which would enable an assessment of developments in this regard.

The alternative to a “variable-at-the-bank’s-discretion” floating rate loan would be a loan in which the interest rate is tied at some fixed margin (set at the outset of the loan) over a relevant indicator lending rate. In such a loan, the borrower is still exposed to movements in the general level of market interest rates, but not to other discretionary changes by the bank.

Australian banks have little incentive to introduce such loans. The current mortgage structure makes their risk management job much, easier. As well as movements in general market interest rates being passed onto the home borrower, for them to bear this risk, banks are also able to pass on the consequences and risks of any errors they make in their funding and interest rate risk management choices. A bank which is funding housing loans in a way which subsequently becomes relatively expensive, or bets the wrong way on interest rate movements, can simply increase the rate it charges to existing borrowers.

While such funding (or interest rate risk management) errors will affect the bank’s ability to compete for new borrowers, existing borrowers have limited ability to avoid wearing the resulting costs. Paying out an existing loan to shift to another lender is a costly exercise, and less appealing when all that is on offer is more of the same from a limited number of major players. Also, the banks offer “special rates” to new borrowers involving discounts on the standard variable rate lasting for some number of years, which enables them to compete for new borrowers while not adversely affecting the return on existing loans.

If instead, adjustable rate mortgages (a fixed margin over an indicator rate such as the official cash rate) were adopted, the situation would be markedly different. New borrowers may face a different margin to existing borrowers because the current cost of bank funding relative to the indicator rate has changed. They could make conscious decisions about the merits of taking a loan which locks in that margin (or taking out a fixed rate loan) and banks can (if they wish) structure their funding to avoid taking on interest rate risk.

Existing borrowers would be protected from changes in interest rates other than in the indicator rate which reflects market trends. They would not be exposed to risks arising from poor funding choices or poor interest rate risk management by their bankers.

Of course, there are many details involved in structuring loans this way. It may be too risky for banks to fix the margin for very long periods (because the structure of interest rates may change), suggesting that contracts involving a fixed margin for some period (and ability to exit to another lender at the end of that period) might be appropriate. Whether the cash rate or a wholesale market rate such as the Bank Bill Swap Rate is an appropriate indicator rate is also another design issue.

But regardless of those complexities, it is clear that the current, historically inherited, internationally anomalous, mortgage design we have is creating problems. And while some of those problems affect the banks, they are unlikely to collectively give up arrangements which enable them to pass on risks to customers. Those risks should preferably fall on management and shareholders, and that could be readily achieved by government leadership to bring Australian mortgage loan contracts into line with the reality of twenty-first century financial markets.

(1) See for example Guy Debelle “The State of the Mortgage Market”

This FRDP was prepared by Kevin Davis, Research Director, Australian Centre for Financial Studies and Professor of Finance, University of Melbourne.
kevin.davis@australiancentre.com.au

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The Financial Regulation Discussion Paper Series provides independent analysis and commentary on current issues in Financial Regulation with the objective of promoting constructive dialogue among academics, industry practitioners, policymakers and regulators and contributing to excellence in Australian financial system regulation. More in this series

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Insurance in Super – a partial fix for under-insurance

Posted on November 4, 2010
Filed Under Financial Roundtable Report Series, Funds Management & Superannuation, Insurance, Media Release, Publications | Leave a Comment

ACFS releases roundtable report on “Super: Implications for the Life Insurance Industry”

The growth of superannuation has been significant for the structure of the life insurance industry, with most super funds offering standardized life and TPD insurance as automatic parts of their superannuation plans. For the life industry, it has meant an increase in group policies sold to super funds relative to individual policies, and has had implications for the levels of coverage and distribution mechanisms.

Minimum levels of life insurance must be offered in employer-sponsored superannuation funds under the SIS Act which governs fund trustees. The provision of life, total and permanent disability (TPD), and income protection insurance cover through super funds is now a big business for insurers. With an aging population, and changes to remuneration for financial advisers, it is likely to become a more important business for financial planners within and outside of superannuation.

Australian Centre for Financial Studies (ACFS) Director Prof Deborah Ralston states that “insurance advice is one area where licensing of financial advisers may have had unintended consequences”. For instance, most advisers and accountants who provide advice and administrative services to self-managed super funds are either focused on the investment and tax aspects. or on the insurance product itself. Tailoring for the life stage or risk tolerance of individuals may not be happening. Or if it, it may be that opportunities for tax deductibility (against contributions tax) are going begging.

Ralston noted that “insurance coverage is wider than it would be otherwise without embedding it in super arrangements but there are significant public policy issues involved in the way insurance is offered in Australia. Issues include a significant lack consumer engagement, insufficient focus on insurance in financial advice, and under-insurance among those without superannuation.”

The ACFS discussion paper notes that in employer sponsored funds, trustee determinations about the default level of coverage of their funds are important given the “behavioural biases which tend to lead to individuals not shifting from a default option”. A tripling of the default level by one scheme, while also giving members the right to opt out, was reported to have seen only one per cent opting out.

The ability of super funds to now provide financial advice to members is an opportunity for selling insurance. In so doing it raises questions about incentives and the nature of appropriate fee/commission relationships between the fund, insurance company and member. In not-for-profit funds any commissions will flow to the membership pool at large.

ACFS Research Director Prof Kevin Davis noted that

“With the impending ban on commissions from financial product providers, but an exemption from that ban for life insurance products, there may be enhanced interest shown by advisers in life insurance products.”

Because pricing of individual risk products is critically dependent on the personal characteristics of the individual mechanisms for assisting individuals (or their advisers) in choosing between competing supplier offerings are important. “Whether this will be best served by insurance brokers or though web-based portals enabling individuals to seek bids from participating suppliers is another question” Prof Davis added.

Davis concludes that “income protection and TPD insurance are now sufficiently important to warrant being considered a compulsory element in superannuation alongside life insurance.” He adds that “so too may be trauma insurance”.

The focus of the ACFS Financial Roundtable Report on implications of Superannuation for the Life Insurance Industry is beyond Chapter 5 in Part Two of the Australian Super System (Cooper) Review: Insurance in Superannuation.

It identifies a range of issues worthy of further study:

• Is it significant that major life offices now have a more of their asset holdings in superannuation liabilities (wealth management) rather than in insurance?
• Given the different age composition of super funds, how optimal are current default insurance options?
• Whether the current structure of administrative arrangements and responsibilities between super funds and insurance companies in identifying member deaths and initiating claims payments is optimal.

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The Financial Roundtable Report Series assembles the expertise and thoughts of leading financial services individuals on relevant topics. Through the use of roundtables, ACFS enhances its thought leadership role by facilitating discussion among academics, industry practitioners, policymakers and regulators.  This discussion contributes to the public policy debate and identifies further research areas. More in this series…

Media contact:

Professor Kevin Davis
Research Director, Australian Centre for Financial Studies and
Professor of Finance, University of Melbourne
W: +61 3 9666 1050
Mob: +61 409 970 559
info@australiancentre.com.au

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