The final report of the Murray inquiry has made a number of recommendations that address the very heart of the debate concerning the conduct of our banks: how to build a resilient and stable banking sector, but at the same time ensure that is efficient and that competition and innovation can thrive.
As the interim report noted, we have a highly concentrated banking sector. Our major banks have served us well, but with about 85 per cent of on-balance sheet housing loans, around 90 per cent of SME lending, and ownership or affiliation with about 85 per cent of the financial advice industry, this is a very concentrated sector. Our banking sector is also one of the most profitable in the developed world. There is obviously room for greater competition.
Although international approaches to “too big to fail” such as “ring fencing” and “bail in” have not featured, Murray’s recommendations emphasise the important role of bank capital with respect to building the resilience of the banking system. There are three major recommendations in this respect.
First, increases in capital ratios, second, a narrowing of the gap in different levels of capital required for lending under both IRB and standardised risk weights, and third and possibly most importantly, the introduction of a leverage ratio.
The complexity of existing capital standards is well demonstrated by the difficulties facing the inquiry in establishing the relative strength of Australian bank capital levels with respect to their international peers. Recommendation 1 to increase bank capital will put Australian banks into the top quartile of internationally active banks. Although an increase in capital will, to some extent, impact on the banks’ return on equity, dividend imputation should ensure a cushioning with respect to return to shareholders. An important point given that most of us hold bank shares, either directly or through our super funds.
Throughout the course of the Inquiry, much has been made of the differing capital assigned to loans for the five banks, the majors and Macquarie that use the Internal Risk-Based Model approach, and other ADI credit providers that use standardized risk weights. While IRB banks have an average of 18 per cent capital behind their mortgage lending, regional banks, mutual banks and credit unions have to allow for an average of 39 per cent. Not only can the use of IRBs lead to excessive leverage but international studies have shown some extreme variation in resulting risk weights depending on the assumptions underlying the models.
Consequently the use of IRB models is under review. Murray’s recommendation 2, to narrow the differential between risk weights accorded to mortgage lending by IRB and standardised models will not only lead to a lower overall leverage ratio in home lending, but will also introduce a more level playing field between different groups of credit providers.
Recommendation 7 in the final report, to introduce a minimum leverage ratio of 3-5 per cent, would bring Australia into line with countries such as the US, the UK and Canada, which have introduced such leverage ratios over recent years. Such a ratio puts a floor under risk-weighted capital requirements. The need for such a ratio once again highlights concerns about the resultant level of total capital held by banks when risk-based models are used.
Somewhat surprisingly, however, the inquiry has made no recommendations with respect to the financial claims scheme, although it notes that the existing cap of $250,000 per account holder per institution “is relatively high compared to other countries”. Given that the vast majority of deposit holders have balances well below this level, it is somewhat puzzling to see no amendment to the FCS. This is good news for banks that benefit directly from the FCS, relative to other financial institutions seeking retail funds.
At the same time as the Murray inquiry seeks to build resilience in the banking sector through increases in capital levels and a leverage ratio, it is also recommending a number of measures that will enhance competition across the sector. Whether or not these recommendations concerning increased capital result in a higher cost for borrowers will depend to some extent on the success of competition measures. International experience suggests that higher capital ratio will only lead to higher lending costs, in the absence of competition.
Of course it remains to be seen whether these recommendations will be adopted, but government needs to be fully aware that a piecemeal adoption of the agenda may well lead to unexpected outcomes. Balancing competition and stability remains the central issue.
Professor Deborah Ralston is executive director of the Australian Centre for Financial Studies