Australian Banks: Back To The Future

Feature Stories | Sep 30 2020

The Treasurer has re-eased bank lending restrictions recently tightened as a result of the Royal Commission, in order to stimulate the economy. Will it work?

-Royal Commission reversed
-Borrowers still telling fibs
-Will the plan work?
-Negative rates, perhaps

By Greg Peel

It is a truth universally acknowledged that banks lend money too freely at the top of an economic cycle and not freely enough at the bottom. When things look good, they’ll hand it out to anyone. When things look bad, they keep it for themselves.

It’s counter-cycle impact that’s been going on for years, decades, centuries…probably back to the benches (bancs) set up in Italian piazzas in the fourteenth century, and it only exacerbates economic boom and bust. As each decade brings a new generation of CEOs, history repeats.

It repeated most recently in Australia as the result of the housing bubble, which was aided by profligate bank lending, and led the RBA to encourage APRA to tighten lending restrictions to ward off an inevitable bust. When APRA first tightened the screws on risky mortgage and investor loans, nothing happened. So APRA tightened them again.

It worked. By the second half of last year the RBA was back in rate-cutting mode, looking to ward off a housing crisis-led recession.

In between was the Banking Royal Commission, initially established to investigate issues regarding exorbitant fees, redundant insurance policies and other tricks of the trade aimed at customers alive or dead. But when the rock was lifted, the country was shocked by what else was found.

One element the Commissioner recommended should be swiftly resolved was a very lax approach by the lenders to assessing the servicing capacity of the borrowers. For the most part this involved no fact checking at all with regard a prospective borrower’s other financial commitments. Too much time, too much effort, too costly.

The result was a “lender beware” approach applied in the National Consumer Credit Protection Act, placing the responsibility on the banks to confirm a borrower’s servicing capacity rather than taking a borrower on their word.

Then along came covid. No longer need we worry that the housing crisis might lead to a recession. Having already become “aware”, now the banks became “wary” about whom they might lend money to. Here we were, back at the bottom of the economic cycle, and once again banks were clamming up.

Which was making things difficult for a Treasurer who was having nightmares about ranks of militant “Back in Black” coffee cups invading his bedroom. While not even Labor was prepared to blame the government for the virus, and did not stand in the way of swift and substantial fiscal stimulus that killed off any idea of a surplus (this is not America), clearly Josh did not want his name forever associated with the biggest budget deficit in Australian history at a stage when more stimulus is still undeniably needed.

It was not helping that while the government had to date done the right thing, and the RBA had done its best up to the point of pleading for the government to do more, shell-shocked consumers and businesses simply were not coming to the party on everything from credit cards to business loans. The Australian savings rate has soared, and corporate capex plans have been shelved as fast as dividends have been suspended.

Even if consumers and businesses were prepared to take the risk and borrow at this uncertain time, the banks were not about to lend any money without the closest of scrutiny.

And even before the banks were forced to put away significant provisions for anticipated virus-related loan losses, they had to put aside significant provisions for anticipated RC-related remediation and fines. Moreover, they had to spend a lot more in terms of “cost of doing business” in complying to the “lender beware” requirement. And now the cash rate is as good as zero, so earnings capacity is all but zero too.

Fearing the government would be stuck topping up fiscal stimulus into the distant future, the Treasurer saw an opportunity – let the banks provide the stimulus. But to do this, the banks had to be encouraged to lend. How?

Throw out the RC recommendations.

Okay, the RC has not now been rendered a complete waste of time, and the banks know they will still be under close regulatory scrutiny (APRA regulations still stand), but under Josh’s new rules the responsibility of determining a borrower’s loan servicing capacity is now back in the hands of the borrower and not the bank.

It will be the “borrower’s responsibility” to, in a nutshell, tell the truth.

This will reduce banks costs, and open the door for growth in lending, and thus earnings. The question now is: will it work?

Pros & Cons

The market thought so, at least on Monday in response to the Treasurer’s announcement. The financial sector rose 3.7%. It’s been giving that back ever since, but this does not necessarily imply a change of heart, rather other macro issues.

Morgan Stanley has weighed up the new order, and sees both pros and cons in terms of bank earnings.

Firstly, the loan approval process will be sped up. The onus is now back on the borrower to provide requisite information which the bank can take as gospel, unless there is good reason to be suspicious. The bank does not itself have to undertake extensive verification. Faster loan process times will be a positive for both borrowers and mortgage brokers, notes Morgan Stanley, and some of the cost of mortgage origination will be removed, which is incrementally positive for the banks.

Secondly, harping back to the Royal Commission, the risk of litigation against the banks for lax loan scrutiny will be reduced. However, this was only one aspect of the RC findings, with resultant remediation and fines relating more to poor financial advice, financial crime and the over-charging of fees, Morgan Stanley points out, and those aspects are still being watched.

On the other hand, the Treasurer highlighted in his announcement that the new rules will “reduce barriers to switching between credit providers, encouraging consumers to seek out a better deal”. This is not good for banks.

Australian bank customers are notoriously “sticky”, preferring to stay with the bank they’ve been with for some time rather than go shopping for a better deal. This could be put down to “too much effort”, “couldn’t be bothered”, “don’t have the time”, “don’t like to make a fuss” or “don’t understand it all anyway”. But now the Treasurer is giving consumers a nudge.

If consumers respond, the banks are at risk of net interest margin erosion (the spread between deposit rate and lending rate) as they lose their “front-book/back-book” advantage.

The “front book” consists of new loans, the “back book” refers to existing loans. Competition demands the banks must offer an attractive deal to potential new borrowers, but unless they kick up a fuss, existing borrowers do not enjoy the same offer. New mortgages are set at lower rates to old mortgages. This spread is even more important today than when it was when bank analysts first started highlighting the risk that banks would not be able to hang on to what was increasingly a yawning gap of a front/back spread.

For today, the cash rate is 0.25% (and tipped to go to 0.1%) but the banks cannot drop their deposit rates to zero or lower, lest they lose all their deposits. Competition forces banks to offer lower mortgage rates, which reduces the net interest margin from which bank earnings are mostly derived.

Margin pressure is already bad enough, Morgan Stanley notes, without everyone shopping around for a better deal.

Finally, and most importantly, will the banks now rush out in the Days of Covid with bags of cash, throwing it around with gay abandon, just because the Treasurer says they can? We don’t need Morgan Stanley to suggest this is unlikely, as high debt-to-income ratios for borrowers and high loan-to-value ratios on mortgages are more of a risk now than arguably any recession in memory.

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