## 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.

1. "it will require the originating bank to settle this payment flowing from their bank to a different bank with their central bank money."

That's not really how it works.

The intraday is essentially an infinite overdraft at the central bank, which is then cleared at the end of the day.

So the process can best be expressed without a central bank.

For a bank to transfer to another bank, the destination bank *takes the place* of the original depositor at the source bank. That is what the overnight banking market consists of.

The central bank is then just a clearing house that allows banks to shuffle the overnights around between themselves until they are happy with the risk burden. Like all clearing houses it reduces collateral requirements.

Without any government spending muddying the waters the net position in all accounts at the central bank every evening would be zero.

Reserves are largely irrelevant for bank clearing - as long as the banks trust each other.

1. I think we mostly are on the same page here.

In addition to clearing with ESA balances, banks can instead borrow/lend overnight between each other using the interest rate set by the RBA as a benchmark for negotiating the rate on these arrangement (since the RBA creates the outside option for clearing).

The same problem arises about the risk/trust that other banks will place with a single small bank running up new loans at an astonishing rate. If they try to "out-lend" the other banks, their costs will rise, reducing their competitive position - whether they settle with ESA balances or loans from other banks.

I'm trying to communicate a simple story that banks must buy into a clearing system with each other that constrains the rate at which they can grow by issuing new loans. That's all. The day to day operations can get quite complicated to explain

2. Nice post thanks for sharing this post.