Murray must address the moral hazard in housing

The Financial System Inquiry interim report rightly identifies the risk in Australian banks’ fixation with high-leverage mortgages, but it must go further and address the source of the problem.

The interim report from the Abbott government’s Financial System Inquiry dropped yesterday and appears to have been fairly well received. It went some way to acknowledging our banking system’s obsession with mortgages but remained fairly tight-lipped on the taxpayer guarantee that distorts asset allocation and allows banks to avoid the full risk of their behaviour.

A full inquiry into our financial system was well overdue. Our four major banks are huge by international standards; three of the four are currently among the biggest 20 banks in the world for market capitalisation. All four sit among the world’s top 50 banks for total assets.

This is a remarkable achievement for four banks that are mostly irrelevant outside of Australia. But not an achievement that we should necessarily be proud of.

The sheer size of Australia’s financial system, and the high level of system leverage, has been driven by two factors: an obsession with mortgages and a government guarantee that puts taxpayers on the hook if the banking sector stuffs up.

In May 2014, lending to owner-occupiers and housing investors increased to around 60 per cent of total credit outstanding, compared with just 24 per cent at the end of 1990. Since the onset of the global financial crisis, growth in credit has almost been entirely driven by mortgage lending.

Graph for Murray must address the moral hazard in housing

Our tax arrangements and financial system regulations are designed -- intentionally or not -- to promote mortgage lending. An implication of this, recognised by the Murray inquiry, is that elevated household lending may crowd out and raise the cost of finance for other, more productive, activities (How the housing obsession is short-changing business, June 2).

Banks favour mortgage lending simply because it carries a lower risk weight. Risk weights affect the extent to which a financial institution must fund its assets using regulatory capital, such as equity, rather than deposits and wholesale debt.

The greater an asset’s perceived risk, the more capital they need to hold to fund it. By comparison, a lower risk weight -- such as that applied to mortgage lending -- means that an asset can be more highly leveraged, raising the risk to the bank but also increasing their short-term profits.

Requiring banks to hold more capital to fund riskier assets is a good idea but it has also distorted funding allocation. A housing loan is less risky than a business loan but it doesn’t necessarily hold that a system which disproportionately favours mortgages is less risky than a financial system with a more diverse allocation of debt -- particularly if those mortgages are undermining the very business sector that ultimately pays the bills.

The Murray inquiry noted that “housing is also a potential source of systemic risk for the financial system and the economy … A large enough disruption to the housing market could have significant implications for household balance sheets, financial stability, economic growth, and the speed of recovery in housing spending and broader economic activity following a shock”.

None of this would be as big a problem if the taxpayer wasn’t on the hook when the banks stuff things up. Moral hazard remains a genuine problem for our financial sector, encouraging the pursuit of short-term profits at the expense of sound lending.

Following the global financial crisis, the federal government intervened in the form of wholesale and deposit guarantees. In doing so it announced that our banks were ‘too big to fail’ and limited their potential losses.

This guarantee -- which has effectively lowered the cost of bank funding -- has come with no strings attached. It didn’t come with a government equity position, nor was it received with an expectation that banks would reduce their risk exposure.

Unfortunately, while the Murray inquiry was happy to address our obsession with mortgages and the systemic risks that this creates, it remained tight-lipped on the implicit government guarantee that encourages risky behaviour and distorts incentives.

Which brings us back to my initial point: our banking system is huge, and our major banks are among the biggest in the world. They are also highly connected -- to the extent that if one stumbles the other three will stumble; if one collapses, the other three will follow suit.

The Murray inquiry has correctly recognised the systemic risks created by high levels of mortgage risk -- this is long overdue. But it will all be for nought if they don’t follow through on solid recommendations and adequately address the implicit government guarantee that ensures that our banks don’t bear the full risk of their decision making.

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