Saturday, April 11, 2009

Credit Rationing by Australia's Big Four(?)

The week following the announced mortgage freeze for “victims” of the Global Financial Crisis, the "four pillars" of Australian banking said they would not be passing on in full the reduction of 25 basis points made by the Reserve Bank to the cash rate. They were of course villfied for the latter, while hardly any praise was given for the former. Some would say that in both cases, the banks were simply looking out for their own interests. Could these two decisions be interrelated? Are these banks undermining monetary policy?

A freeze on payments for the unemployed is of course welcome news to those who are at risk of being laid off. It is a voluntary rewriting of contracts to prevent the swelling of non-performing assets in the books of these banks. Missed payments will be capitalised and recovered down the track. Meanwhile, delinquent borrowers will remain in their homes. Of course implementing such an arrangement does not come without costs. How will the banks recover them?

Unfortunately, the only way to pay for the sour loans would be by keeping rates steady on the remaining ones. It would not surprise me if this were the case. As Stiglitz noted in his pathbreaking article, the pricing of loans is not based purely on the law of supply and demand as one might expect. This is because of imperfect information and risk. Setting loan rates is a way to screen out certain types of borrowers and signals to them the type of projects to seek financing for.

An equilibrium rate is one that maximises returns for the banks. This implies that if rates are set too high, loans would suffer an adverse selection problem where borrowers would veer more towards high risk, high return projects in order to make a decent return. Setting them too low would sacrifice profits unnecessarily. Competition amongst the banks would essentially discipline those that did not adhere to this optimal rate.

So even if the rate consistent with supply and demand were lower than the optimal rate, credit rationing would ensue where the banks would require greater collateral or create quotas for certain types of loans, which would in turn bid the rates up to the optimal level.

It is not hard to see how this could be taking place in the banking sector now. Given the cocktail of 50 year historically low rates courtesy of the RBA, generous home owner grants courtesy of the government and the impending growth in unemployment over the horizon courtesy of the global financial crisis, would it be inconceivable for the banks to start rationing credit to slow the inflation of yet another unsustainable asset bubble?

Information Costs and Bank Deposit Guarantees

Another plausible explanation for the big-four's imperviousness to public backlash is the fact that they have had easy access to credit courtesy of the government's AAA-rated bank deposit guarantee, and as a result can park their funds elsewhere at higher yields and contract their lending activities during this economic downturn.

The bank deposit guarantee was enacted at the height of the financial meltdown in 2008. It was a case of policy plagiarism of action taken by the Republic of Ireland, a country that has suffered heavily from the piercing of their local asset bubble. The question is, given the disparate situations faced by Ireland and Australia, was it appropriate to transfer the policy from one to the other?

Perhaps, yes, no and maybe would be the best answer. Yes - it might have been necessary to raise the deposit guarantee simply to promote confidence amongst the depositing community to prevent capital flight. No - it was not necessary to raise the guarantee to a million dollars, as the type of depositor who would have such large cash holdings also has access to informal social networks that have information about the relative quality of certain deposit taking institutions. Maybe - given that a majority of analysts see economic growth returning by the latter part of this year, the three year guarantee period was a case of overkill.

As for the question posed at the beginning of this discussion, whether the banks are distorting the market for capital, it should be noted that the deposit bank guarantee will have by far a greater distortionary effect in the medium term.