Avoiding an unnecessary funding fix

Conventionally, one identifies and defines a major problem before devising a radical solution. Apparently that's not how it works in discussions about the availability and cost of home loans.

In recent weeks, Yellow Brick Road's Mark Bouris and economist and YBR Funds Management director Christopher Joye (who also writes regularly for Business Spectator) have been popping up in major newspapers and on the ABC's website advocating their preferred measure for increasing competition within the banking system.

While his approach differs, my own colleague Robert Gottliebsen has been mounting a similar campaign over the past several weeks to increase the supply and reduce the cost of credit. As his argument has developed, it has elements that over-lap with those of Bouris and Joye.

The Bouris/Joye position starts by arguing that, post-crisis, the four majors are too dominant and too big to fail. Without the benefit of their higher credit ratings, which now include an assumption by Standard & Poors that the Australian government wouldn't allow the majors to fail, smaller banks and non-banks find it almost impossible to compete effectively. Recent issues of covered bonds by the majors have exacerbated that position by making all other bond issues more expensive.

Their solution? They suggest either a progressive financial tax regime that would penalise the majors for their size or, in a reprise of a proposal that Joye and another economist, Joshua Gans, mounted in 2008, that the federal government guarantee assets rather than institutions by insuring/guaranteeing highly-rated issues of asset-backed securities. That would enable a regional bank – or YBR – to raise funds at the same price as the majors.

Gottliebsen has a more straightforward proposal and one more focused on the cost of funding than on competition. He has advocated that the federal government should use its sovereign rating to raise funds cheaply and then on-lend those funds to the banks, charging them less than the rate at which they are currently borrowing in wholesale markets. The quid pro quo would be that they would on-lend those funds at rates lower than would otherwise have been the case. Alternatively the government could charge market rates and pocket the margin, but the ambition of his proposal is to lower borrowing costs. More recently he has picked up on the Bouris/Joye/Gans notion of wrapping the government's credit rating around securitised mortgages.

Both proposals are not only doable, but in fact have been and are still being implemented elsewhere.

The Europeans are imposing financial transaction taxes on their big banks, as well as capital surcharges on banks deemed too big to fail that will handicap them relative to smaller competitors.

The US has, unhappily for the US taxpayer, Freddie Mac and Fannie Mae to provide funding and insurance to its mortgage markets and Canada has its own Canada Mortgage and Housing Corporation which is often cited by advocates of government intervention here as a model (because it hasn't experienced the near-death experiences of Fannie and Freddie).

In Europe, the European Central Bank is lending banks hundreds of billions of euros at one per cent to help them refinance their maturing borrowings and encouraging them to invest in sovereign debt with yields of five or six per cent to both bolster their profitability but, as importantly, to lower what had been soaring borrowing costs for European governments. The ECB intervention, which has stabilised the market in European sovereign bonds, has been unkindly referred to as a giant Ponzi scheme.

The critical question is whether current circumstances actually require any government intervention.

Yes, bank funding costs have risen relative to the cash rate, but the cash rate has fallen and lending rates, as the Reserve Bank has said, are at roughly average levels – and certainly well below historical peaks.

The banks, big and small, have been able to access the funding they need, helped by the rising tide of deposits.

Yes, there are fewer competitors, but margins are similar to where they were pre-crisis – when the system was probably as competitive as it has ever been.

Demand for credit is very subdued, with households and businesses risk-averse and deleveraging.

The risk in taking unconventional steps to address a problem whose existence has yet to be established is one of unintended consequences.

Whether or not the Australian housing market was in bubble territory, there is now a quite gentle deflation of prices occurring and a more conservative profile of household balance sheets emerging. That is, after a decade and a half of households borrowing against rising house prices in order to increase their ability to consume, a good thing.

Increasing the supply and reducing the cost of mortgage finance by exploiting the Commonwealth's credit rating – either by borrowing directly or by wrapping a sovereign rating around securitised debt issues – would inevitably, given the physical constraints on increasing the supply of new housing stock, drive prices back up.

Either taxpayers would stock on more government debt in order to provide gains to home owners and subsidised entry to the market for first home buyers (again) or taxpayers would have a mounting contingent liability within the government's accounts.

While Joye has always argued that the credit enhancement of mortgages should only be applied to vanilla and high-quality mortgages, quality evolves with conditions — apparently conservative loan-to-valuation or debt-servicing ratios at the peak of a housing cycle might look quite different at its nadir.

In any event, deploying the sovereign rating transfers risk from banks to taxpayers generally benefits a particular and relatively small group at potential cost to the rest of the community.

There are some circumstances where government intervention is inevitable.

The government guarantee of bank debt issues during the worst of the initial financial crisis was unavoidable once Ireland guaranteed its banks and triggered a rush of copy-cats that, because the sovereign guarantees conferred AAA status on their banks, immediately rendered irrelevant the fact that the four Australian majors were among the top eight-rated banks on the globe. (Although, with hindsight, the majors were still a far better credit risk than most of those European governments).

Federal Treasury, of course, collected billions of dollars and will ultimately receive more than $5 billion for renting the government's rating to the majors.

Gottliebsen did raise an interesting issue in his most recent column on the subject (Gillard's secret weapon, 22 Feb).

There is a prospect that, eventually, the tide of deposits that has helped materially reduce the majors' exposure to offshore wholesale funding markets might ebb as households and business regain confidence and a willingness to accept some risk for higher returns.

That would force the banks back into wholesale markets to fund any asset growth and, as Gottliebsen said, could create a questionmark over the majors' AA ratings.

One assumes a reversal of the flow of deposits could only happen if depositors were convinced that markets had normalised and economic conditions were unthreatening, in which case access to funding probably wouldn't be an issue and, if the ratings agencies maintain their view that the majors would never be allowed to fail, the threat of a downgrading would be relatively minor.

In any event, a higher cost of funds for the banks flowing from a downgrading, assuming it were passed onto borrowers, could be leant against by the Reserve Bank. The RBA may not be able to dictate bank spreads, but it can push the yield curve around to influence absolute lending and borrowing costs in this market.

For the moment there is no problem with the way the banking sector is operating of sufficient scale and urgency to contemplate radical measures that introduce new and different risks and potentially add to the existing moral hazard within a system that has banks deemed too big to fail, therefore there is no need to contemplate implementing any of the various solutions.