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Hmm, I had written a short post yesterday laughing at Joe Hockey, and in particular, Don Randall (faceless Liberal backbencher) mistaking Hockey’s policy for that of the Greens (or, as he calls them, the ‘lunatic fringe’) but it seems to have disappeared.

I think banking reform is quite interesting, but I’m dubious as to how effective the heavy-handed approach suggested by Joe Hockey would be. Any direct attempts to control interest rate rises would be complicated by the fact that the RBA influences the overnight cash rate (ie the interest rate for one day loans) whereas most residential mortgages will be over 5 or 10 or 30 years and the interest rates will be higher. If you tried to constrain increases in residential mortgage interest rates to the increases suggested by the RBA, you would in effect lock in one yield curve. And yield curves are important – they are the reflection of the market’s belief as to future economic conditions and they are the market mechanism for distribution of risk, given those beliefs. If we were to ignore that problem, mandating the residential interest rates (which is what he’s essentially talking about) would mean that the banks would have to recoup their increased costs from either business loans or from their profits. Whilst its always tempting to take away bank profits, you have to remember that this will disproportionately hurt the small banks the most so the big banks will gain an even stronger oligopoly than they already have.

So we are left with the status quo – where banks are allowed to set their interest rates as they please, subject to the rates their competitors set. That, of course, is a major constraint on bank behaviour – competition is what stops the price of anything skyrocketing too high. The other major constraint is that if the ACCC can provably demonstrate that increased funding costs are not forcing up residential interest rates, then the banks could face legal action on that front.

But aside from that, what can we do to stop the banks? The first thing I would do is increase competition in the banking sector. That means increasing the number of smaller banks. Unfortunately, funding costs are greatly increased for smaller banks for various reasons. The major problem is that if I were to open a smaller bank in a country town, I would have a completely undiversified customer base which exposes me to major risks. That’s in addition to the normal problem with starting any new business, which is attracting market share away from existing businesses.

One solution is to effectuate a securitisation mechanism in Australia. We had a small securitisation market in Australia prior to the GFC, with some specialist high yield growth funds purchasing securitised loans on a ad hoc OTC basis. Many of those funds collapsed, as did many mortgage providers based on that model (such as RAMS). The securitisation market has recovered, but not to any great extent.

I think, if Australia is to have effective competition from the smaller banks, they must be armed with an effective mechanism to securise loans internationally. I mean, it would be an excellent way for overseas investment funds to buy into Australia’s booming residential property market. It’s a novel financial instrument which isn’t readily available.

Perhaps the Australian government could set up a government run securitiser (let’s call them Fannie Mae and Freddie Mac) which would centralise the securitisation risk. It could allow a constant flow of purchasers and sellers, to avoid temporary liquidity risks that brought down RAMS. (RAMS had to refinance its debt; and that refinancing period happened to be during the worst of the GFC).

There are, of course problems with this model. I think it may have caused some kind of Great Recession in the US. The key to resolving that problem is ensuring proper information flow – which means very strong disclosure requirements for any loan securitised through this measure.

The only question I have in my mind is whether we have a large enough population to sustain this business model. With only 20m people in Australia and 90% of the mortgage market held by the Big 4 banks, it would be hard to start up an effective securitisation market, which is why the government must be the one to do it.

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