Banking's new, imperfect order

Reserve Bank deputy governor Philip Lowe today described the post-financial crisis banking system. It looks quite different to the one we've become accustomed to.

In some senses much of what he said to the Australian Conference of Economists isn't news.

The pre-crisis environment of abundant cheap credit, lots of leverage and extremely profitable banks disappeared some time ago, albeit the changes haven't been as dramatic or painful in this market as elsewhere. It's also not news that the response to the crisis entails more and higher quality capital and liquidity and a reduction in the proportion of short term funding – the maturity mismatch – used to fund banks' balance sheets.

It is the implications of those changes, however, that are of interest and Lowe's description of them is useful.

As he says, the end-result of the various changes that have occurred and are occurring in the system is that the cost of financial intermediation has increased and less intermediation is occurring. The perceived benefit is a safer and more stable system.

The obvious flow-on effect of higher costs of intermediation is that borrowers pay more, relative to short term money market rates, than they did pre-crisis. If banks are safer, Lowe says, some of the higher costs will also be shared by shareholders, through lower returns on equity.

Perversely, there is also the possibility that now that investors, and perhaps depositors, understand that credit and other risks are higher than they previously thought, they might want to be paid more for exposing themselves to those risks despite the efforts to make the system safer.

To the extent that shareholders experience lower returns from the out-workings of the various strands of the post-crisis environment, there is an incentive for banks to pursue higher risks to improve those returns (and maintain or increase their performance-related remuneration) and to pursue extra cost-cutting.

In this system we haven't yet seen banks become less risk-averse but most of the majors have embarked on new and substantial cost-reduction programs. Lowe worries that overzealous cost-cutting could introduce new risks, particularly if related to risk-management functions.

The higher cost of intermediation is evident in the relationship between mortgage rates and the RBA's cash rate. In the decade leading up to the crisis mortgage rates averaged 150 basis points over the cash rate. Today the spread is about 270 basis points.

That swelling of spreads flows from the higher costs banks have to pay for their wholesale funds sourced from capital markets but also because the banks are competing aggressively for deposits to reduce their reliance on short term wholesale funding.

Depositors are the winners from the systemic shocks generated by the crisis. As Lowe said, it wasn't that long ago when depositors were being paid something close to the cash rate on at-call deposits and only a few years earlier they were being paid significantly less than the cash rate. Today there are deposits returning 200 basis points over the cash rate.

Lowe, as other senior RBA staff members have done, made a point of saying the RBA had taken the higher costs of intermediation into account in setting monetary policy in recent years and had offset the increase in borrowing rates relative to the cash rate by lowering the cash rate by more than it would otherwise have done. The cash rate today, he said, was roughly 150 basis points lower than it would otherwise have been.

The higher cost of intermediation has resulted in less intermediation. The banks are lending less and demand from borrowers is lower than it was previously.

The banks aren't aggressively pursuing balance sheet growth because of the higher funding costs, the demonstrated risk of relying on wholesale funding to grow their loan portfolios and the progressive introduction of the new capital and liquidity regimes. At the moment the modest credit growth that is occurring is in line with their ability to grow their deposit bases.

Bank customers – households and businesses large and small – aren't borrowing because they are deleveraging because of their own anxieties about the environment post-crisis.

As Lowe says, the "brand" damage suffered by banks generally during the crisis has created a novel situation, unlikely to be reversed any time soon, under which many large businesses can borrow directly from capital markets more cheaply than the banks. We've seen that several times, now, most notably in BHP Billiton's ability to raise long-term funding at rates that in real terms are probably close to zero.

If the change in sources of big business funding is structural and permanent, the banks will have to focus even more heavily on lending to households and small and medium-sized enterprises. That could generate its own risks.

Lowe said the intrinsic flexibility of finance was causing the international regulatory community to spend a lot of time thinking about "shadow banking" because of concerns that tighter regulation of banks would push activities off bank balance sheets and create new risks for the global system.

He is an advocate for "whole-of-system" supervision, where regulators consider the implications of institutions pursuing similar strategies, examine the inter-connectedness of institutions, including those outside the regulated sectors, monitor aggregate credit growth and assets prices and understand the competitive dynamics of the system. He gave the Australian Prudential regulation Authority credit for its approach to supervision.

The essential point he was making is that while Australia didn't have a financial crisis, events elsewhere are having a significant impact on our system, much of which is positive and should lead to a safer and more stable system but which also has the potential to have unforseen and not necessarily positive consequences for banks, borrowers, shareholders and the system-at-large.