Submission to the Inquiry into Competition within the Australian Banking Sector 2. Trends in Lending

Australian borrowers have enjoyed ready access to credit, with credit growing at about three times the pace of nominal GDP over the past 25 years. As a proportion of GDP, credit increased from around 50 per cent in the mid 1980s to over 150 per cent by the late 2000s (Graph 1). A significant increase in demand, mainly from households, was accommodated by an increase in supply through new participants, more diverse products and some easing in lending standards.

2.1. Housing

There has been a transformation of household balance sheets in response to the effects of financial deregulation and the lower interest rates as a result of the low inflation environment. Housing credit grew at an average annual rate of 15 per cent in the two decades to 2007, before slowing in the past three years to a pace of around 8 per cent per year, roughly in line with nominal income growth ( Graph 2).

The increase in the demand for housing credit was facilitated by the expansion in the activities of non-bank lenders, particularly mortgage originators.^[1] These non-bank lenders were reliant on the securitisation market for their funding. They did not have either a balance sheet or a capital base from which to fund their lending. Mortgage originators took advantage of developments in the packaging and pricing of risk to package mortgages into a product that was attractive to investors. The banks also began to use securitisation as a source of funding given its relative cost and the potential for a broader investor base. As a result, by mid 2007, securitisation accounted for over 20 per cent of new housing loans (Graph 3).

Furthermore, lenders that had only a small presence in the Australian market – including some large foreign banks – were able to overcome their lack of branch networks through the use of the internet and brokers. In addition, the reduction in inflation and nominal interest rates eroded the banks' relative funding advantage from low-cost deposits. Together these factors saw the larger banks' share of housing credit fall from over three-quarters to around two-thirds (Graph 4).

The growth of housing credit was also supported by the expansion in the range of mortgage products, including:

• Home equity loans began to be offered in the mid 1990s and provide a line of credit against residential property. Home equity loans currently account for about 7 per cent of owner-occupied housing loan approvals.
• Low-doc loans are targeted at self-employed borrowers, or those with irregular incomes, who lack the documentation required for a standard loan. Low-doc loans are estimated to currently account for about 7 per cent of owner-occupied housing loans approvals.^[2]
• High loan-to-valuation ratio (LVR) loans were marketed by an increasing number of lenders, allowing borrowers to access the property market with either a small or no deposit.
• Interest-only loans, especially among investors, for whom the reduced payments and potential for increased tax benefits are important.
• Non-conforming, shared appreciation and reverse mortgages, although each remains a niche product.

There were very few mortgages offered that were similar to the US sub-prime mortgages. In 2007, less than 2 per cent of mortgages were of such a type (and almost none of these mortgages was issued by a bank).^[3] Since then, most of the companies that offered such products have ceased writing new business. As a result, sub-prime equivalent mortgages now account for less than 1 per cent of the stock of housing loans outstanding.

Beyond the expanded product range, competition also contributed to a gradual easing in credit standards over the past couple of decades. There was a relaxation of permissible debt-servicing caps and genuine savings requirements, an increase in maximum loan-to-valuation ratios and the introduction of less onerous property valuation techniques. Recently there has been some tightening in standards, but this has only partially retraced the easing in standards that occurred over the past couple of decades.

While the easing in standards was nowhere near the scale that occurred in other countries, most notably the United States, there was some evidence that the lowering of credit standards did contribute to subsequent increases in housing stress in some parts of the country. Parts of south-west Sydney were particularly affected earlier in the decade.^[4]

The securitisation market was particularly adversely affected by the financial crisis. The contraction in securitisation markets was not unique to Australia, but was a world-wide trend driven by changes in global markets. The business models of some of the Australian lenders reliant on it were no longer viable and they either ceased lending or were bought by a larger institution.^[5] This has seen the major banks' share of housing lending rise to a little above 75 per cent. However, the fact that the major banks were able to fill the gap created by the withdrawal of the non-banks allowed the supply of credit to the household sector to be maintained at a satisfactory level.

In recent months, there are signs that the market share of the larger banks has started to decline again, with loan approvals data indicating the major banks' share of new lending has fallen from a peak of 84 per cent to around 78 per cent. At the same time, the share of smaller Australian banks has increased from a trough of just under 5 per cent to around 9 per cent, and credit unions and building societies have also seen their share increase to around 6 per cent (Graph 5).

Such large movements in the competitive position of lenders have occurred in the past. Banks had steadily lost ground to non-banks for many years prior to deregulation in the early 1980s, before recovering much of the fall over the following decade (Graph 6).

To support competition in residential mortgage lending, in September 2008, the AOFM was mandated to purchase up to $8 billion in residential mortgage-backed securities (RMBS), of which $4 billion was to be made available to non-ADI mortgage originators. In October 2009, the Treasurer announced that the program would be extended by a further $8 billion, with an additional objective of providing support for lending to small business. In all, the AOFM has invested just over $12 billion in Australian RMBS which has supported total issuance of $26 billion from 17 lenders.

The purchases by the AOFM as a ‘cornerstone’ investor have been at below-market yields to make securitisation more economic for the lenders. While this has supported activity in the market, securitisation has been slow to recover from the fallout of the financial crisis for a number of reasons including the ‘brand damage’ suffered by RMBS because of the US experience and a number of entities that had previously purchased RMBS have exited the market. Offshore structured investment vehicles (SIVs) were significant purchasers of Australian RMBS and were forced to liquidate their portfolios during the crisis as they were wound up. As a result, there was an overhang of supply of RMBS in the secondary market which has only now been run off, and importantly, there is less demand for RMBS given the SIVs are no longer around.

In terms of providing support to the market, the AOFM program has a number of advantages relative to alternative means of support: it can be directly tailored to help specific types of institutions; the support can be phased out easily; the likelihood that the Government loses money on its investment is very small; and there is no ongoing contingent liability to the Government from the support. If instead a government guarantee of RMBS were provided, it would be difficult to phase out, creating a commitment that could ultimately generate a large contingent liability for the Government.

Securitisation is again becoming a more viable funding option for lenders. While the volume of securitisation currently is considerably smaller than in the pre-crisis period, relative to the flow of new housing lending, the decline is not nearly as dramatic, given the slower growth in housing credit. A rough calculation would indicate that for securitisation to maintain its current share of housing credit, annual issuance would need to be around $25 to $30 billion, compared with the current pace of $18 billion.

2.2. Business

Business credit grew particularly rapidly in the second half of the 1980s following financial deregulation and the entry of a number of foreign banks into the domestic market. It declined sharply in the early 1990s recession before returning to average growth of around 10 per cent per year. Prior to the onset of the financial crisis, business credit expanded at an average rate of around 15 per cent over the year to June 2007.

The onset of the financial crisis saw a temporary increase in business credit growth as some businesses that had difficulty accessing non-intermediated debt markets turned to the domestic banks for their financing needs. Since then, the growth of business credit has fallen reflecting both supply and demand factors. There was a general tightening in supply, particularly in the commercial property sector. But a number of businesses have chosen to rely more upon internal funding and equity raisings to fund their investment and working capital plans.

On the supply side, there has been some exit of foreign banks that had a small presence in the market, but at the same time, a number of other foreign banks have looked to expand their presence in the local market. Nevertheless, the largest decline in business lending was from foreign banks, many of which had expanded credit rapidly in the years prior to 2007, particularly to the commercial property sector (Table 1).

As noted above, there has been a tightening in lending conditions for business borrowers, both large and small. Liaison suggests that small business borrowers have faced lower maximum loan-to-valuation ratios, stricter collateral requirements and higher minimum interest coverage ratios. Nevertheless, developments in business credit indicate that lending to small businesses has risen over the past year (Graph 7).

The decline in credit outstanding to large businesses reflects a number of factors, including the record level of equity raisings by these businesses in 2009, which enabled them to repay debt. This decision was often taken by management as a precautionary action given the uncertain financial environment, as well as reflecting the increased cost of intermediated credit. The decline in lending to large businesses also reflects the fact that some businesses have found it more cost effective to access credit directly from the market rather than through the banking system. Finally, a number of large businesses, particularly in the mining sector, have been able to fund their activities and repay debt from their retained earnings resulting from their strong cash flow.

A sector where there has been a significant tightening in credit conditions is the commercial property sector. This tightening has been driven by banks reassessing the risks of, and reducing their desired exposures to, this sector. The reduction in credit has been particularly marked in light of the very strong growth in lending to this sector in the years immediately prior to the crisis, particularly from foreign-owned and the smaller Australian-owned banks (Graph 8). Those banks which expanded their lending the fastest through the boom have experienced the sharpest increases in impaired loans. As a consequence, a number of banks are concerned that their exposure to the sector remains too large and are reluctant to extend new lending.

Of late, there have been some indications that conditions are improving in the provision of credit to business. There has been renewed foreign bank activity. The improvement in capital market conditions, which has enabled some companies to tap markets directly at competitive rates, has seen the banking sector compete more aggressively to attract some of that business. These factors, along with increased risk appetite among banks, have seen risk margins begin to decline from their peaks (see below) and some banks have announced plans to increase their focus on business lending by, for example, increasing their business-banking staff.

Footnotes

See, for example, and Gizycki, M, and P Lowe, (2000), ‘The Australian Financial System in the 1990s’, in Gruen, D and S Shrestha (eds), The Australian Economy in the 1990s, RBA Conference, July and Ryan, C and C Thompson, (2007), ‘Risk and the Transformation of the Australian Financial System’, in Kent, C and J Lawson (eds), The Structure and Resilience of the Financial System, RBA Conference, August. [1]

See Reserve Bank of Australia, (2005), ‘Box B: Developments in the Low-doc Loan Market’, Financial Stability Review, September. [2]

See Debelle G (2008), ‘A Comparison of the US and Australian Housing Markets’, RBA Bulletin, June. [3]

See Australian Prudential Regulation Authority and Reserve Bank of Australia, (2007), Inquiry Into Home Lending Practices and Processes, Submission, August. [4]

For a detailed discussion on developments in the Australian securitisation market, see Debelle G (2009), ‘Whither Securitisation’, RBA Bulletin, December. [5]