Too-big-to-fail banks warp the playing field
Our regulatory arrangements pathologically favour the large over the small and legacy business models over newer ones. This weakens competition, fattens margins and salaries, and paves the way for future crises.
Where banks attract deposits to fund loans, a more recent business model involves "securitisation": pooling loans into securities and selling them to wholesale investors. Securitisation enabled non-banks, such as Aussie Home Loans, to break into the banks' market and force a near halving of margins.
Competing on a level playing field, securitisation might well dominate home lending. It avoids the banks' extreme asset-liability mismatches - with banks' short-term borrowing supporting long-term lending. Because they've been crafted for the external scrutiny of investors, mortgage-backed bonds (MBS) are more comprehensible to outsiders, whereas complex banking institutions with revolving managers getting bonuses for short-term performance are difficult - arguably impossible - to regulate effectively.
But it's not a fair fight. When banking markets get skittish they can seize up without a risk taker of last resort. Three centuries of banking evolution, three centuries of crises have given us central banks that go lender of last resort, delivering liquidity to distressed banks' balance sheets when others are heading for the exits.
As we've seen, securitisation markets seize up too and making them liquid would require similar action, though in this case the risk taker of last resort would be buying MBS.
Large banks also enjoy an implicit guarantee of their solvency because, being too big to fail, they'll be bailed out in a crisis. Because smaller banks and non-banks aren't too big to fail, they pay wholesale funders much more.
Our two banking regulators, the Australian Prudential Regulation Authority and the Reserve Bank of Australia, focus on "financial system stability" within the "official family" of banks. Competitive neutrality with "shadow banking" from securitisation gets short shrift.
As Professor John Kay puts it: "The principal objective of regulation appears to be to stabilise the existing structure of financial institutions, this goal is in fact a guarantee of further, and potentially more damaging, crises."
Sure enough, when the crisis came, the big banks got huge public support.
Taxpayers guaranteed their retail deposits for free and guaranteed their wholesale loans at fees reflective of credit ratings, which incorporated the too-big-to-fail distortion, further disadvantaging the small fry.
While no investor in AAA-rated Australian MBS ever lost principal during or after the crisis, liquidity in this market nevertheless collapsed. Securitisers needed a buyer of last resort. The Australian Office of Financial Management gingerly provided life-support, but still allowed the securitisers' market share of home lending to fall by around three quarters while the major banks snapped up RAMS, Aussie, Wizard and Challenger's lending arm.
The Bank of England calculates the annual too-big-to-fail taxpayer subsidy for the world's 29 biggest banks at $70 billion before the crisis. Today it's around a third to half a trillion (yes, trillion) - coincidentally around the same amount as our four monster banks' collective market cap.
Are we fixing this by busting them up (scale economies are exhausted well before you get to the majors' size) or reducing their complexity? No.
In trying to minimise the chances of future crises the global regulator of banking regulators, the Basel Committee, recommends banks hold buffers of "level one" liquid assets (mainly government bonds) and riskier "level two" assets on which they'll be expected to draw before turning to their lenders of last resort - you and me.
But not here. Australia's government debt is too low to provide our banks with enough level one assets and our regulators are concerned that they face similarly slim pickings of level two liquid assets - which include MBS. So the RBA will give them a loan - via its new "Committed Liquidity Facility".
Why are there so few MBS in our market? Because enjoying such exorbitant privileges, mortgages that might otherwise be securitised repose blissfully - implicitly guaranteed - on bank balance sheets. What collateral will banks pledge to the RBA to draw on its CLF? Why the same mortgages that could be securing MBS.
So as the RBA ramps up its support for banks with policies that increase moral hazard as they depress demand for MBS, the AOFM's last annual report announced its "increasing focus on the need to encourage a transition towards a . . . securitisation market that is not reliant on government financial support".
So much for a level playing field.
Frequently Asked Questions about this Article…
Too big to fail refers to large banks that are implicitly expected to be bailed out in a crisis. The article explains that this implicit guarantee gives big banks a funding advantage, distorts competition, and creates a taxpayer-backed subsidy that can fatten bank margins — outcomes that matter to investors because they influence the risk, pricing and competitive landscape of financial services.
Securitisation pools loans (like mortgages) into mortgage-backed securities (MBS) and sells them to wholesale investors, rather than funding loans from deposit-taking. The article notes securitisation helped non-bank lenders such as Aussie Home Loans compete with banks and cut mortgage margins, making it an important structural alternative to traditional banking that investors should watch for competition and liquidity risks.
Although AAA-rated Australian MBS did not lose principal during the crisis, liquidity in the market collapsed. The Australian Office of Financial Management provided limited support, but securitisers still lost about three quarters of their market share in home lending while major banks bought up lenders such as RAMS, Aussie, Wizard and Challenger's lending arm.
Under Basel guidance, level one assets are highly liquid holdings (mainly government bonds) and level two are less liquid but still usable buffers (including MBS). The article points out Australia has relatively low government debt and limited level one assets, making level two assets important — and influencing regulator decisions about backstops and bank resilience.
The CLF is a facility where the Reserve Bank of Australia will provide loans to banks that lack enough high-quality liquid assets. The article explains that banks can pledge the same mortgages that might otherwise be securitised as collateral for CLF loans, which risks depressing demand for MBS and increasing moral hazard.
The article says APRA and the RBA focus on financial system stability within the official family of banks, and give less attention to competitive neutrality with shadow banking. That regulatory focus can leave securitisation at a disadvantage compared with deposit-taking banks.
The article notes that during the crisis no investor in AAA-rated Australian MBS lost principal, but liquidity evaporated. So while principal was preserved historically for top-rated MBS, liquidity risk and the potential need for a buyer of last resort remain important considerations for investors.
Everyday investors should recognize that regulatory preferences for large, legacy banks can weaken competition, concentrate risk, and create implicit taxpayer subsidies. The article argues this incentive structure can fatten margins, reduce choice, and increase the chance of future crises — all factors that can shape investment outcomes in financial stocks and fixed-income markets.
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