Banks' 'low-risk model' high risk for Australian economy

Extract from ABC News

Analysis

By business reporter Michael Janda

Posted 13 Jul 2016, 4:50pm

Photo: The Reserve Bank has been more sanguine about Australian home prices than many economists. (Torsten Blackwood: AFP)

You have to listen to a lot of talk from central bankers to glean the odd tidbit of enlightenment, but it's worth it when you get an insight.

Yesterday provided a particularly worrying insight into the Reserve Bank's attitude towards home lending, and perhaps one reason why it's generally stood idly by while Australian banks have inflated what is on most measures one of the world's biggest ever housing bubbles.
The insight came at a banking conference from the Reserve Bank's head of financial stability Dr Luci Ellis, and one can only hope the sentiment stems from her relatively narrow role and doesn't reflect a broader view at the RBA.

The banks in Australia have coordinated on a low-risk business model, everything else they could be doing other than lending on mortgages is higher risk overall.

Her comment was in answer to a question about whether the 60-plus per cent concentration of big four bank loans in the housing sector was a concern to the RBA.
In the second part of her answer, Dr Ellis effectively said a severe housing crash in Australia would kill the major banks through bad business loans first.
"All of the stress tests that our colleagues at APRA have done have generally shown that, by the time you've got to a position where the mortgage book is sending you out of business, you've already gone out of business because of the other bits of business that you have," she added.

Lax home loan rules boosted housing addiction

Certainly, the bank regulator APRA has historically considered housing loans safer, allowing the major banks and Macquarie to use their own internal risk weightings to assess how much capital they needed to hold to cover potential losses.
That saw risk weights for housing bottom out below 15 per cent for some banks, meaning they potentially only needed to hold $1.50 in capital for every $100 in mortgages they lent out.
However, on the recommendation of former CBA boss David Murray's financial system inquiry, APRA has now imposed a 25 per cent floor on housing risk weights.
In large part, it has been these lower risk weights, relative to the 100 per cent risk weighting on most other loans, that have encouraged Australia's banks to overinvest in housing.
The less capital they have to hold, the better the banks' return on equity, which means higher dividends for shareholders and fatter bonuses for bankers.
However, what this home loan addiction has also done is create a housing market that most respected financial authorities - from the OECD and IMF to The Economist magazine - think is dangerously overvalued.
Combined with a pro-housing tax and transfer system, these rules have also resulted in Australians and their banks directing far too much "investment" towards real estate, and far too little towards expanding local industries.

Real estate overinvestment hollows out economy

While, from a microeconomic point of view, home lending may appear a whole lot safer than business lending, from a macroeconomic point of view it simply results in a hollow economy.
The home lending fetish results in underinvestment in new businesses, research and expansion, and an over-reliance on foreign capital which can easily evaporate in a crisis.
It also creates a higher cost of doing business because of inflated land prices, and because workers' wages need to be high enough for them to also afford inflated housing costs, making Australian firms globally uncompetitive.
If (or, perhaps more accurately, when) this results in an Australian recession the banks will have to be bailed out through central bank loans.
The further disappointing news from Dr Ellis is that this Reserve Bank largesse is likely to be granted based on bubble home prices, rather than bust ones.
"People sometimes forget that this means lending against collateral valued at pre-panic prices," she said in her prepared remarks.

Some people will always regard whatever happened before the panic as inflated and somehow illegitimate.

"While some asset prices can reach over-exuberant levels in the lead-up to a panic, fire-sale prices in a panic are no more based on fundamentals than mania-phase prices are."
So savers who have elected not to over-leverage themselves to speculate on the housing boom are not only losing out through low interest rates designed to prop up the bubble, but are also likely to have to wear some of these costs of bailing out those who did jump in.