Tuesday, May 16, 2017

The bank competition myth

Australian banks are upset. Their $30 billion per year gravy train of profits from the Australian people is finally being slowed down.

A levy on bank liabilities of 0.06% annually was announced as part of the 2017 Federal government budget, and is expected to raise about $1.5 billion per year, or 5% of bank profits.

To be clear, the banking system is a regulated cartel. Its primary function is to provide a public good in the form of the money supply of the country. As such, we would expect it to be uncompetitive, and use tight regulatory controls to ensure that the privileged position of private banks is not being abused.

In my book, Game of Mates, I explain that the result of this uncompetitiveness and lack of adequate regulation in Australia is that over half of the banks' profits can be considered economic rents, which could be taken back with better regulation and shared with the public at large.

I want to use this blog post to explain in detail the underlying administrative mechanics of why any modern banking system is necessarily uncompetitive.

The first thing to know is that banks do two things. They make money by extending loans, which expands the money supply; a function that is an essential public service in a growing economy. Second, they settle obligations between parties both within their own bank, and between banks, which is another essential public service.

But letting private entities simply make money is risky. So our central banking system constrains the private banking system by making the banks settle payments between each other with a different currency held in accounts at the central bank. In Australia these are called Exchange Settlement Accounts. Every private bank in the system must have an account at the central bank so that they can perform this second function of settling payments.

By controlling the second function of banks by making them use a currency controlled by the central bank, it indirectly controls the former function of money creation. No one bank can rapidly create new money by writing loans faster than the rest of the banks. If they do, when the borrower deposits the money created into an account at a different bank, like when they use the loan to buy a house from someone who banks with another bank, it will require the originating bank to settle this payment flowing from their bank to a different bank with their central bank money.

This process reduces their net asset position and increases their costs. They can’t continue to do this. What limits their rate of money creation through new loans is how fast other banks are creating money and transferring central bank money to them. Each individual bank is constrained in their money creation function by their settlement function.

Keynes wrote as such in his 1930 Treatise on Money:
…it is evident that there is no limit to the amount of bank money which the banks can safely create provided they move forward in step.
The words italicised are the clue to the behaviour of the system. Every movement forward by an individual bank weakens it, but every such movement by one of its neighbour banks strengthens it; so that if all move forward together, no one is weakened on balance.
The Australian bank data shows this process in action. Below are two graphs. On the left is the size of the loan book of Australian banks. There is a clear concentration here and a surprising regularity to the trends at all banks. To show these trends more clearly, on the right is the monthly growth of the loans made by the four major Australian banks. As you can see, there is no sustained deviation by any banks from the core growth trend. All banks are moving lock step, as they should.

The whole point of a central banking system is that the growth rate of loans for all banks in the system will quickly equalise. If you are a small bank, this means you can never grow abnormally fast in order to gain market share by competing for loans with the larger banks.

Any central banking system is therefore, by definition, unable to be competitive.

In Game of Mates, the solution proposed to stop the economic losses from the abnormal profits of the protected private banking cartel is to let the central bank itself offer basic low-risk lending and deposit functions directly to the public. Because it has the ability to create for itself its own central bank money, it is the only entity that can grow faster than the existing banks in the system.

Of course, the reality is that the solution would be a far greater hit to bank profits than the small levy proposed. In fact it would likely take back over $20 billion per year in profits from the private banks, which would be shared with the government through its profits on banking operations, and with its bank customers through lower costs. If the banks are upset about a levy of just $1.5 billion a year, they are going to really crack it when they hear this proposal!

*This proposal is actually widely called for by economists, and the idea can be mostly attributed to Nicholas Gruen. See here for example. 

Wednesday, May 3, 2017

The impossible home deposit

After reading today about how home buyers need to save over $500 per month for 10 years for a deposit in NSW and Victoria, I thought I would republish the below post of mine from January 2010 about the impossibility of saving a deposit in a market with rising prices. 

Baby boomers and older generations often cite high expectations, and the inability to save, as the main hindrance to the younger generations’ ability to buy their own home. They go into great detail about how much it has always been a struggle to buy a home, and that if young people decreased their expectations and bought something small they could work their way up the property ladder.

I am one of those generation Ys looking to buy my own home, and from this perspective, it is not quite that simple.

The mythical property ladder
The argument that if younger generations decreased their expectations, and maybe bought a small apartment now, so that they could somehow work their way up the ‘property ladder’, is entirely misleading.

For example, a young couple buys an apartment for $200,000 in lieu of a $400,000 house they really want based on the contemptuous advice of older generations. They imagine that in 10 years they might be able to sell for $350,000, netting a profit of around $100,000 to spend on a larger home (after transfer costs). The problem is that larger homes have also increased in price by 75% so that the $400,000 house is now $700,000. Buying that dream home has gone from a $400,000 prospect to a $600,000 prospect even with the apparent advantage of being on the property ladder.

The way to benefit from increasing property prices is to buy multiple investment properties so that you leverage the benefits beyond your single dwelling needs.

No more avocados
Next, we can look into the arguments about spending a little less on luxuries to get a person into a home-buying financial position. Dining out, gadgets, and holidays all seem to get mentioned. But if we look into it, these relatively small expenses are not the main factor – the main factor is income.

A hypothetical future home buyer might spend $200 per week on dining out, ‘gadgets’ (mobile phones etc), and travel. That’s $10,400 per year – maybe $3,000 on a trip to SE Asia, $2,000 on gadgets, $2,000 on dining out, and the balance for other luxury items. Let’s see what that money could have done if it were funnelled into a property-buying strategy.

Assuming a starting point with no savings, this hypothetical person (or couple, or family) can save about $58,000 in 5 years assuming they receive 6% on their savings. If they thought they might one day want to live in a home that currently costs $300,000, by the time they save their $58,000 the home is worth $400,000 (at a 6% price growth rate). They now need $80,000 for their deposit. They continue saving instead of splurging and in another 5 years they have $137,000 saved. The home is now worth $535,000. They have enough for a deposit, but the repayments on their home and associated ownership costs are now around $900/week.

So after ten years of saving, living life without those luxuries that make it so much more enjoyable, they are in no better a position than before.

I’ll leave you with a question. If you bought a home for $100,000 in 1990, and the market his risen so that it is now worth $600,000, how much better off are you?

Tuesday, May 2, 2017

Would a loan-to-rent limit for home investment work?

What if the rules about lending for housing investment limited the size of a loan to an amount based on the rental income of the property rather than its market value? Could such rules constrain wasteful lending growth that simply fuels speculation, and instead encourage lending that fosters long run investment in housing?

Let me take you through one possible version of such rule that I think could ensure that the enormous economic power of new money creation that lies at the heart of our banking system is used for productive purposes.

My proposed loan-to-rent-ratio (LRR) rule is this:
Loans can be made at 80% of the amount where the gross rent of a property covers the interest repayments at an interest rate 2% points above the offered rate.
How would this work?
Imagine a home that rents for $400 per week, or, say $20,000 per year. Mortgage interest rates are 4.5%.

The loan limit calculation starts by asking what size loan can be serviced with $20,000 a year at a 6.5% interest rate (4.5% plus the 2% buffer). This is $308,000. Using this as a benchmark value, 80% of this value can be created as a new loan, which is $246,000.

It is possible to beef up this rule further with a requirement that any remaining payment for the home must come from savings accrued from incomes, not from home equity lending secured against another property asset.

With this rule in mind, we can look at its effect through the property market cycle compared to a rule that restricts lending to a proportion of home values, say 80%, rather than tying it to rental income.

For simplicity, let us start at a point where the market value of our example home is $308,000. Here, an 80% loan-to-value-ratio (LVR) limit would allow lending of $246,000 against this property, which is the same as my proposed LRR rule.

But then the market begins to rise in the property up-cycle.

A year later
Now, the property's market value has increased 15% to $354,000, but the rent is unchanged. Under an LVR limit, a new buyer could now borrow $283,000 (or 15% more). But since the rent has not grown, under the LRR rule, a new buyer could still only borrow the same $246,000. The LRR rule would thus reduce the amount of new funding available during a speculative upswing, where the rise in market value is not matched by a rise in rental income, and therefore dampen the price swing by not increased borrowing and new demand.

During a downturn
The reverse effect happens during a property market downturn. If the 15% price gains reverse, the LVR rule effectively restricts new lending by the same 15% during this market downturn. The LRR rule does not. Again, a dampening effect.

Any downsides to this plan?
The main one is that benefit of lower demand for housing mainly comes in the form of lower prices, which most current homeowners won’t be especially happy about. Banks won’t be happy that their cash cow of new lending is brought under control. Nor will the vested interests of the land-banking property development lobby be happy that their massive stocks of empty land will become worth far less than they thought.

But these are the downsides of any reforms that make housing more affordable. That’s why no effective reforms have been enacted in the past 20 years.