The ACCC’s Final Report on its “Residential Mortgage Price Inquiry” (Section 4.3) listed four challenges faced by the smaller banks in making decisions about their residential mortgage product offering; specifically 1) APRA’s prudential benchmarks, 2) APRA’s regulatory capital requirements, 3) service levels to brokers and aggregators, and 4) customer loyalty to the big four banks and customer inertia.
The smaller banks undoubtedly face a number of challenges in competing with the bigger banks but I have argued previously that the difference in regulatory capital requirements is overstated.
The ACCC describe the challenge with APRA’s regulatory capital requirements as follows:
For otherwise identical ADIs, the advantage of a 25% average risk weight (APRA’s minimum for IRB banks) compared to the 39% average risk weight of standardised ADIs is a reduction of approximately 0.14 percentage points in the cost of funding the loan portfolio. This difference translates into an annual funding cost advantage of almost $750 on a residential mortgage of $500 000, or about $15 000 over the 30 year life of a residential mortgage (assuming an average interest rate of 7% over that period).
The report does offer some caveats on the size of the difference in risk weights …
This estimate is indicative only. No allowance has been made for the cost to IRB-accredited ADIs of achieving or maintaining their IRB accreditation, or for other differences between IRB and standardised ADIs in funding their residential mortgage portfolios, such as differences in wholesale funding costs and other aspects of APRA’s capital adequacy regime which impose additional capital costs on IRB-accredited banks.
But the commentary I read in the financial press just focussed on the nominal difference in the risk weights (i.e. 25% versus 39%) without any of the qualifications. My early post on this question identified 5 problems with the simplistic comparison cited by the ACCC:
- Problem 1 – Capital adequacy ratios differ
- Problem 2 – You have to include capital deductions
- Problem 3 – The standardised risk weights for residential mortgages seems set to change
- Problem 4 – The risk of a mortgage depends on the portfolio not the individual loan
- Problem 5 – You have to include the capital required for Interest Rate Risk in the Banking Book?
My aim in this and the original post was not to defend the big banks but rather to try to contribute some of the knowledge I have acquired working in this area to what I think is an important but misunderstood question. In the interests of full disclosure, I have worked for one of the large Australian banks and may continue to do work for them in the future.
On a pure risk basis, it seems to me that the loan portfolio of a large bank will tend to be more diversified, and hence lower risk, than that of a smaller bank. It is not a “gift” for risk weights to reflect this.
There is a legitimate debate to be had regarding whether small banks should be given (gifted?) an advantage that helps them compete against the big banks. That debate however should start with a proper understanding of the facts about how much advantage the large banks really have and the extent to which their lower risk weights reflect lower risk.
If you disagree tell me what I am missing …