The Interim report of the Murray Inquiry has found that on balance the banking system is competitive. Interest margins of the major banks are at historic lows, and return on equity is comparable to other large Australian businesses. However, the level of competition varies cross the banking sector.
As a potential means of addressing this issue, the Inquiry is seeking further input into the policy option of providing direct Government support to the RMBS market, or allowing RMBS to be treated as a high-quality liquid assets for the purpose of the liquidity coverage ratio.
Both of these options would seem to be a very direct and appropriate means of encouraging stronger competition across the total banking system, especially for smaller institutions.
The benefits of securitization as a stimulant to competition were well demonstrated in Australia in the late 1990s. The introduction of Residential Mortgage Backed Securities (RMBS) had a major impact on competition in the mortgage market, with the emergence of non-traditional players, funded through this market rather than through deposit funding. Although non-traditional mortgage providers were only a very small part of the market, the margins on home loans fell from 4 to 1.5 percent over the period 1996 to 2000.
For the new entrants and for capital constrained institutions, such as smaller banks and mutual building societies and credit unions, the mechanism of securitization allowed such institutions to extend credit on low-risk housing loans and then to on sell to investors. Selling loans off balance sheet allows institutions that are capital constrained, due to higher capital adequacy requirements or a mutual structure, to extend credit and more readily compete with larger organisations.
The appetite of international and domestic investors for these high-quality fixed interest securities played a key role in supporting the domestic securitization industry. In the decade prior to the beginning of Global Financial Crisis in 2007, issuance of Australian RMBS increased from around $5 billion dollars to almost $50 billion dollars. More than half of these RMBS were issued in foreign currencies and purchased by international investors, primarily American and European.
The events that occurred post-GFC, however, also show the fickle nature of international capital and the potential impact reliance on international capital flows can have on the functioning of real economies and real industries. In 2008, Australian RMBS issuance decreased to around $8 billion dollars, none of which was purchased by international investors.
This sharp reduction in the purchase of RMBS had the potential to wipeout the securitization industry in Australia, and had a clear impact on the interest rate spreads on mortgage finance which remain around twice their pre-GFC levels.
Consequently the suggestion that the government should intervene to support securitization has considerable merit, as a means of further encouraging competition in the banking market. While both direct Government support to the RMBS market or including RMBS as a high-quality liquid assets within the liquidity coverage ratio have merit, the former has been done before with great success.
In late 2008, following the withdrawal of international capital inflows, the Australian Office of Financial Management (AOFM) began purchasing RMBS to provide support to the industry and thereby increase the flow of funding to lenders. AOFM intervention into the RMBS kept the securitization market alive at a critical time, and provided a great demonstration of timely and appropriate regulatory intervention. In 2009, domestic investors again increased their investment in Australian RMBS and by 2011 domestic investment had returned almost to pre-GFC levels.
With the passing of time, international investors have still not yet returned to the Australian market, possibly as a result of the reputational damage that poor quality RMBS generated in the US market at the time of the financial crisis. As the Murray Inquiry has suggested, there would appear to be some form of market failure in place in this regard. The opportunity therefore exists to further support this market in the domestic economy.
Not only does such intervention in the market encourage competition, but such investments by the OAFM actually generate returns on the taxpayers investment. Hard to see why such a measure should not be encouraged.