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Competition within the Australian banking sector

CHAIR —Welcome. Would you like to make an opening statement?

Prof. Sathye —Yes. Thank you for the opportunity to present before this committee. The main points of my submission are that, firstly, the banking market is highly concentrated, and it is especially so after the global financial crisis. In my opinion, this does not augur well for consumers nor from the perspective of financial stability. Secondly, I have done some calculations of the Herfindahl-Hirschman index, which is typically used for the purpose of assessing competition in the banking sector. I was amazed to find that, especially in the home loan market, the index has risen above 1,800—it could be said to have ‘jumped the red light’—and that really worries me. With this high concentration in the home lending market it is no wonder that the banks are becoming a bit recalcitrant—and that is demonstrated by the banks’ interest rate hikes.

Some measure were suggested recently by the Treasurer, and I have an opinion piece in today’s Melbourne Age which examines those measures. It has been suggested that the scrapping of exit fees could be a way to increase competition in the market. I feel that it may have only a marginal impact rather than any substantial impact. Also, some of the other measures that have been suggested are, as I have written in my opinion piece, more cosmetic than substantial. I feel that the current situation of competition in the banking sector may not be much affected by what has been proposed. I have already addressed some of these measures in my submission.

Another point I have made relates to the view that the banks are ‘too big to fail’. The pre-GFC thinking was that banks should consolidate and become big because there is an advantage in being big. But the GFC very well demonstrated that a larger size is no longer a desirable thing. As a matter of fact, larger sized banks can become a permanent headache for the taxpayer because we do not know when these guys are going to stuff it up and come back to the taxpayer. So I have some concerns about the size of Australian banks. I have said in my submission and through various other outlets that some radical measures are required in order to increase competitiveness in the banking sector.

You will notice from table 4 in my submission that the ratio of the banks’ net interest income to total assets has remained constant through the years from 2004 to 2010. One of arguments the banks have been making is that they need to increase their interest rates because their funding costs have been rising. But the net interest margin has remained the same. Also, their profit margins have gone up significantly. These statistics, which are calculated from APRA’s statistics, show that there is not enough competition in the market. The question that arises is: what is considered to be the right size for a bank and the right level of competition? Unfortunately, there is nothing in that can really tell us the right size for a bank or the right level of competition.

Senator XENOPHON —Is there a right level of profits as well?

Prof. Sathye —You could say that as well.

Senator XENOPHON —A reasonable level of profits?

Prof. Sathye —I would say there is a reasonable level of profits, but how do you find that point? If you look at the profit data of the banks, the average return to shareholders in Australia over the last five years has been something like 9.5 per cent, which is probably the highest in the OECD countries—and Canada is next, with 8.6 per cent. So some questions need to be asked as to whether it is really benefiting the community in the end, or who is it really benefiting? These are questions that need to be asked. I have said in my opinion pieces in various media outlets that the increased profits really benefit only two parties: the shareholders and, more important than them, the managers. We need to address this area in the sense of: what is the right size for banks and what is the right level of competition?

But I can answer that question in a different way. Given the data in table 4 of my submission, one can certainly say that the current state of the banks’ profits has really crossed the level where we have the right level of competition. What that means is that there is a decidedly lower level of competition. If you compare the data of 2004, 2007 and 2010, you will find that in 2007 the ratios, the HIH, was looking much better in the different markets. In 2010 it has again gone haywire; it has gone back to the original levels of 2004 or even become much worse than that.

I have suggested towards the end of my submission what needs to be done to increase competition in the banking sector. I am of the view, as I have said in my opinion piece in the Melbourne Age today, that the measures that have recently been proposed are not really substantial in nature and may not be able to make a significant dent in the competition scenario in Australia. In my opinion, there are two measures that are required if we really want to make the market competitive. One measure—and I do not know how palatable this will be—is to have some kind of provision in our competition policy which allows for a demerger of banks. That will hang as a threat somewhere. At the moment, there is nothing except that you make appeals to them. Moral persuasion is being made to them: ‘If you can bring down your interest rate, it would be great.’ But, at the end of the day, there is nothing in there. It is the community that has given licence to the banks to carry on banking business and, at the end of the day, the businesses—as all business are—are directly responsible to the community as well. I find it a bit disturbing when bank CEOs say in the media, ‘We’re responsible to shareholders only.’ With these initial comments, I leave it to the committee to ask questions.

CHAIR —Thank you very much and thank you for assisting us with the inquiry. You say that you have undertaken an assessment of the industry which suggests that it is not competitive and you used a criterion of some sort—I did not catch the name of it but it is mentioned in your submission. We have had evidence over the last couple of days from a number of witnesses, including regulators—RBA and APRA—that they think the state of the banking industry is competitive. There have been some discussions following whether that is possibly a legacy of a more competitive era prior to the GFC. In terms of ‘competitive’ they are talking about the number of institutions offering lending services, the number of products available and the diversity of the products available. All those indicators of competition in a market are present and so they say that, as you look at it currently, it is competitive. Some of that came about because there was an active competitive force driving competition in the late nineties-early 2000s, particularly from the non-bank sector, which was essentially wiped out during the global financial crisis. Where is the future driver of competition going to come from? Firstly, do you disagree with the conclusions of the regulators—and, from what you say, it appears you do—that the current state of the industry is competitive? Regardless, of that outcome, do you see any potential driver for competition within the industry or that could be formed within the industry?

Prof. Sathye —I am aware of where the regulators are coming from, having been a central banker in my previous incarnation. If you go by the statistics, there are plenty of institutions available. If you ask, ‘What are the various markets in which competition is taking place?’ there are players available in every market, so there are no worries. But, at the end of the day, I feel that, whether or not there is competition in the market, it should be judged on the basis of the outcomes that the players produce. If the outcomes that these players produce have suboptimal outcomes, then I would say that there is no competition in the market.

CHAIR —And that is what you concluded?

Prof. Sathye —That is what I have concluded.

CHAIR —That is not the criteria for assessing the degree of competition in the market that you believe APRA or the Reserve Bank would use?

Prof. Sathye —I would have thought that if they have examined it from the perspective, or from the lens, from which I am examining it then probably they would arrive at the same conclusion, because the conclusions I have arrived at are, again, based on the data published by them.

CHAIR —Okay. You mentioned that you have a piece in the Age today which examines the proposed Swan reforms.

Prof. Sathye —Yes.

CHAIR —I have not had the benefit of seeing that; I was not aware that it was in there. Would you mind outlining your overall view—you mentioned that you do not think it is going to make a substantial difference. In terms of particular reforms, is there anything in there that you think might help? Is there anything in there that you think might be counterproductive?

Prof. Sathye —There are two important things in the Treasurer’s recent announcement which would benefit all the players in the market. One is covered bonds, which is a good move. Of course, there are some issues there with respect to APRA. APRA have been giving their views about covered bonds and are not in favour of covered bonds.

CHAIR —We asked them about that yesterday.

Prof. Sathye —I believe that covered bonds are a good move. That will improve the funding position of all the players. But it is important to note that I am talking about all the players. In that, of course the major banks benefit and the smaller lenders will benefit. The small lenders benefit from the perspective that, during the crisis, the RMBS market completely dried up and they suffered.

CHAIR —Evidence we have had suggests that, for a covered bond issue to proceed, you are talking about a significant scale. I have heard anywhere between $100 and $500 million would be needed as part of the offer, and not all of the smaller players would be able to manage that.

Prof. Sathye —There will be some difficulties for the smaller players in that. When I was going through the reforms I felt that this was okay but that it will again benefit the major banks. The second thing was the listing of government securities in the stock market, which is good.

Barring these two measures, some of the other measures that have been proposed I found to be very futuristic in nature—task forces will be appointed and committees will be appointed and, whenever the task force gives the report, the committee will see what comes out of it.

CHAIR —Lots more consultation and lots more reviews.

Prof. Sathye —We are yet to see what comes out of it. At this stage, if I am asked whether this measure is going to increase competition, I do not have an answer to that because—

CHAIR —Because you do not know how it will turn out.

Prof. Sathye —So there is a question mark there. The only two measures which can help are the covered bonds issue and the government securities on the stock exchange. That will have a liquidity impact and a more funding impact. We hope that with that more funding, the banks will be in a position to pass on the benefit of that impact to the customers. The thing that I have a reservation with today is that there is question mark as to whether the banks would actually pass on the benefit to the customer. The Treasurer said that the cost of funding will be lower, but the question is whether or not it will be passed on to the consumers.

CHAIR —Particularly if the cost of funding is lower to a greater degree for the major banks than it is for the other players.

Prof. Sathye —Very right. Some of the other measures suggested include the exit fee, which I have already commented upon in the submission.

CHAIR —Could you just remind the committee as to your views on the exit fee?

Prof. Sathye —I do not think that the exit fee is going to make any substantial difference. There is only going to be a marginal difference. The switching behaviour of Australian consumers, even without scrapping the exit fee, is in line with international rates of switching. So this is not really going to make much difference. The important thing that happens is that the exit fee only ever addresses the financial cost of switching; it does not address the non-financial costs of switching. One of the big barriers there is the non-financial switching cost. What has been proposed is that there will be some kind of a fact sheet presented to the consumer in the new reforms but, again, that fact sheet is going to add to the cost to the banks. At the end of the fact sheet there will be in small print, ‘Please refer to the detailed product disclosure statement’. So, again, you are back to square one.

CHAIR —When you say ‘the non-financial switching cost’, are you talking about the challenges of actually doing the paperwork and—

Prof. Sathye —The challenge of doing the paperwork, doing the research and finding out which thing is better. At present you will find that there is at least a one per cent difference between the home lending rate of, say, a major bank and one of the credit unions, for example. In that one per cent rate, if that made a significant difference, people would immediately go to the credit union which is offering you a one per cent lower rate of interest. So why are they not going there? Either they are not aware of it or, even if they are aware of it, the hassle that is involved is preventing them. So even with a one per cent drop in the interest rate, it is preventing them from going to the credit unions.

CHAIR —I am aware of the time. We started this session late. So, on the exit fees, I will wrap up. We had high-profile evidence yesterday from John Symond from Aussie, and evidence from other, minor, players, that a lot of the competition that did exist pre the GFC came from non-bank lenders like Aussie, Wizard and RAMS. I would be interested in your view, firstly, as to whether that competition actually had an impact on the banking market during that period. Secondly, exit fees are an important part of their business model because they have upfront costs, which they defer on the basis that they can cover them if the customer stays with them for a while. His view is that the enforced removal of exit fees will impact significantly on the ability of non-bank lenders to regain their position as active competitors to the big banks and that it will therefore have a negative rather than a positive impact on competition. The evidence also suggests that the big banks are not particularly fussed about exit fees being removed.

Prof. Sathye —The big banks are not fussed about it at all. As a matter of fact, even before the announcement two of the major banks had already scrapped it. So it is an indication that it does not matter. From a competitive perspective, the major effect is that it does not matter because they had already scrapped it even before the measures were introduced.

On the second question, of whether the non-bank lenders will be affected by it, I do not think that they will be affected, for the reason that the advantages which non-bank lenders offer, in terms of fees and the services that they provide, may not be comparably offered by the major banks because if an exit fee was the only consideration then the consumer would have already gone, ab initio, with a major bank.

CHAIR —I think they were arguing that, if they cannot have that in there as an incentive for people to stay with them long enough for the costs of new loans being set up to be covered, then they will have to increase their interest rates and will not be able to be as aggressive in their competition with the major banks.

Prof. Sathye —It is true that they will have to cover those costs in some way.

CHAIR —Thank you.

Senator PRATT —Your submission makes some remarks about excessive competition and notes that there are dangers in it. Could I ask what you think the warning signs of excessive competition would be? And do you see any of those characteristics in our banking markets here in Australia?

Prof. Sathye —As I mentioned in my initial presentation, it is hard to determine what the right level of competition is. Hence, it becomes hard to say when the competition is excessive and when it is not. One of the criteria that one can use is the outcome that the present level of competition is producing. If the outcomes for the community that are being produced by the present level of competition are suboptimal, then I would say that the competition is not there—that there is excess concentration and less competition. As the data in table 4 of my submission demonstrates—and I have used those four or five parameters which demonstrate that—there is higher concentration and lower competition in the market because the outcomes that are being produced are suboptimal.

Senator PRATT —Do you have a view about what the impact on competition in this country of tighter lending standards might be?

Prof. Sathye —Tighter lending standards?

Senator PRATT —Yes. As you are aware, we have made some consumer reforms that mean lending standards have been tightened up and you cannot recommend inappropriate products to consumers. Is that going to affect competition in any way in your view?

Prof. Sathye —No, in my view that will not have any impact on competition as such, in the sense that, if we go by the level of borrowers now—the borrowers who satisfy those stricter criteria and the borrowers who do not satisfy those stricter criteria—then, so far as satisfying those stricter criteria is concerned, from the risk management perspective, the credit risk perspective, every institution will certainly desire that they operate within that sort of standard risk rather than in the subprime category, as one could say.

Senator PRATT —Given your remarks about competition, does good regulation and strong regulation by organisations like APRA et cetera mean we can afford more competition and we can encourage that competition?

Prof. Sathye —There is always a trade-off between regulation and competition in making the market competitive. The more you regulate the market, the more you stifle competition. But what I would suggest—and I think I mentioned it in my submission somewhere—is that there is a lot of data that needs to be made available by APRA and the RBA. I had some difficulty when I was trying to examine these issues of competition because the data was not available. When I contacted APRA and the RBA, their statistics departments said, ‘Well, this is what we produce.’ That is an area where probably more work can be done. The more data becomes available, the more transparent the system becomes—and, the more transparent the system, the more it is like a check on the system. So I would suggest going down that track. Otherwise, I think our prudential regulation is doing quite a good job.

I do feel that something needs to be done about our competition laws. When the merger of St George and Westpac took place, I went through the ACCC reasoning behind permitting that merger—and, when these merger decisions are made, they are made at a point in time. And that point in time was in 2007, pre the financial crisis—

Senator PRATT —Yes, pre crisis.

Prof. Sathye —so the ACCC felt, ‘Oh, well, everything is okay.’ But suddenly things changed, and we do not have any measure there, in case things change, as to whether or not a decision that we made at a certain point in time is now reversible. It is not reversible at the moment. There needs to be some provision in there, and the lawyers can apply their minds to how that can be done. But there has to be something in there, and that is what I feel.

Senator PRATT —Thank you.

CHAIR —Senator Xenophon.

Senator XENOPHON —Professor, because of time constraints—and my colleagues no doubt have questions for you too—I will try to roll three questions into one. In your submission, you talk about the concentration of the banks and you say:

… in the … home loan market and investment home loan market it has crossed the safety HHI threshold of 1800. It implies severe concentration which can be detrimental to stability of the financial system—

if you could talk about that more. Also, there are two competing concepts in the evidence that has been given. The Australia Institute said that the banks are making ‘superprofits’ but, yesterday in Sydney, Jonathan Mott from UBS said that unless the banks earn healthy profits, good profits, they will not be able to maintain their credit ratings; if they do not maintain their credit ratings, it will cost them more to borrow; therefore, interest rates will go up. Where do you stand on those two competing concepts? Also, can you elaborate on your concern about the concentration in the market, and the threshold you refer to, being detrimental to stability.

Prof. Sathye —I will answer the last question first. I do not agree with that analysis that more profits mean a better rating or that the credit rating of the banks will be affected if their profits are lower. As a matter of fact, the Canadian banks have lower profits than the Australian banks, but their rating is not affected; their rating is similar to that of Australian banks.

Senator XENOPHON —How much lower? What return?

Prof. Sathye —It is a bit hard to say to what extent we can bring it down without affecting the credit rating, but the thing is that a credit rating does not depend exclusively on the profits that the banks make. A credit rating takes into account a number of factors, and those factors are basically the prudential standards in Australia and the asset qualities of banks. Those are some of the issues that are considered by the credit rating agencies, and on those counts Australian banks are in quite a good position. Profit is not the only indicator for determining the rating of the banks, so I do not agree with that proposition. Coming to the second question—

Senator XENOPHON —About concentration?

Prof. Sathye —Sorry?

Senator XENOPHON —The HHI index of concentration.

Prof. Sathye —Yes. I feel that too much concentration among the banks in the mortgage loan sector can be detrimental from a financial stability perspective in the sense that it has come out of several studies that Australian housing prices are already inflated. There was a study by the London based Economist which said that Australia ranks top so far as the housing prices are concerned. Housing prices are something like 63 per cent higher than what would reasonably be required.

Senator XENOPHON —Does that mean that the bubble could burst—

Prof. Sathye —That is my worry. There is a bubble there and if that bubble bursts then that is going to affect Australia because of the concentration with the major banks. That is going to affect the major banks.

Senator XENOPHON —What do you forecast as a time frame? If the bubble is going to burst, are you talking in the imminent future, next year, in 10 years?

Prof. Sathye —It is difficult for me to say. I would probably put two years on that. You will see a significant correction in the market in two years time. That is my feeling. We hope that we have a softer landing rather than a crash. That is my worry because there is a lot of concentration there.

Senator XENOPHON —Thank you.

Senator WILLIAMS —Just one thing of interest I noted in your submission it says:

Second, scrap the deposit guarantee for major banks but continue it for the mutuals along with a wholesale funding guarantee.

This wholesale funding guarantee seems very important to me because that allows those smaller financial institutions to actually borrow their money at a competitive rate. The government has removed the wholesale guarantee. Surely that is bad for those smaller competitors in the industry.

Prof. Sathye —Yes, that is correct. I agree with that. As a matter of fact the government needs to take actions that are decidedly in the favour of smaller financial institutions. The smaller financial institutions, the cooperatives, the mutuals, need to be given some kind of favourable financial institution status. If the deposit guarantee is restricted to the smaller players then that will create competition for the majors. What is proposed in the recent reforms is that the guarantee is going to be there for everyone. Again, you are back to—

Senator WILLIAMS —That is the retail investment guarantee is going to be there for everyone. The wholesale guarantee—

Prof. Sathye —The retail deposit guarantee.

Senator WILLIAMS —For all ADIs.

Prof. Sathye —Yes, it is for the ADIs, so it is planned for everyone. If it is planned for everyone then it is not giving any favourable treatment to the smaller lenders, so how can they compete with the majors? That is a worry. The second thing is the wholesale funding guarantee. That was scrapped on 31 March this year. I would suggest that that wholesale funding guarantee should be reinstated for the smaller financial institutions.

Senator WILLIAMS —So they can source their funds, especially overseas funds, at a competitive rate.

Prof. Sathye —So they have a good funding source available and with that funding source they are in a position to compete in the market.

Senator WILLIAMS —What about those non-ADIs that are secured investment companies? They do not get any guarantee. In fact, under the regulations, when they advertise they must state at the end of the advertisement that the investor may lose some or all of their money. That is surely making it difficult for those secured investment companies. I emphasise secured.

Prof. Sathye —I would probably restrict myself to the deposit taking institutions only.

Senator WILLIAMS —Yes. You talked about the break up of banks if they get too big and too powerful. Do you disagree with the amalgamation of Westpac and St George? Do you think the ACCC had it wrong in allowing that merger to go ahead?

Prof. Sathye —At the time when that merger was allowed with the criteria that was used for allowing that merger—and this is precrisis years—everything looked okay because things were moving in a different direction, but suddenly we had the crisis and it is a big revelation to us now that what we were doing there was really not okay. In the post-crisis scenario that is presented I personally would not have said yes for that kind of merger. That is why I am proposing there be some provision there which allows for the demerger of banks.

Senator WILLIAMS —My final question is on that point. Europe, the UK, the USA and even New Zealand have divestment powers but Australia does not have divestment legislation. Should that same power be given to the ACCC?

Prof. Sathye —I believe that should be given to the ACCC, yes.

Senator WILLIAMS —It would be a pretty radical move though if the ACCC split a bank up, wouldn’t it?

Prof. Sathye —It would be a radical move, but there is nothing in place at the moment which really can work as a sort of deterrent to the major banks acting against the interests of the community and producing suboptimal outcomes.

CHAIR —Thank you, Professor.

Proceedings suspended from 10.16 am to 10.30 am