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Mark Bouris: Big or small lender?

When taking out a mortgage, is big always better?

PT1M39S http://www.canberratimes.com.au/action/externalEmbeddedPlayer?id=d-217bw 620 349

AUSTRALIANS look at the Reserve Bank's cash-rate announcement on the first Tuesday of each month and make decisions based on it.

They make decisions about their vehicle purchases, their hiring, their expansion plans and their need for renovations based on the direction of the price of debt.

The RBA bases its decision on many indicators about the health of the economy. But mainly it has been charged with keeping inflation in the target range of 2 per cent to 3 per cent: the sweet spot for an advanced economy.

The big four banks of a pedestal cartel unstable downgrade room at the top jostling cartoon illustration generic.

Photo: Karl Hilzinger

When inflation is trending on or above 3 per cent, the Reserve can raise the cash rate to curtail borrowing and reduce consumption. When inflation is low, it can reduce the cash rate to stimulate spending and consumption.

However, key parts of this structure have been breaking down into a new order that hasn't settled yet.

Part of this breakdown is the extent to which inflation and growth affect the general economy. That is, if there's wage inflation in West Australian mining is there also wage inflation in Victorian manufacturing? Or, if the economy is growing at 3.5 per cent, does that mean all Australians in all industries?

In its published decisions on the cash rate on April 3, the RBA board described it as "the sharp differences in performance between sectors and regions of the economy, and the considerable structural change that was occurring."

For instance, investment in mining rose by 60 per cent during the year while investment in the non-mining sectors was flat.

And while the unemployment rate has remained at about 5.25 per cent for more than six months, in the March quarter there were employment increases in mining, health and public administration while there were declines in manufacturing, retail and accommodation/food.

The upshot is that many householders feel that official interest rates have been raised to head off inflation from which they have not benefited.

The Reserve is also trying to balance our cash rate with global factors: Chinese growth has been slowing (off a high base); Europe is still shaky; and the US may be showing signs of a recovery but its housing market is still weak.

Perhaps the clearest sign of a structural change lies in how the major banks now react to the Reserve Bank. For 20 years the major banks set their variable-rate loans according to where the RBA set the cash rate. But, lately, variable-rate loans have been moving independently of the Reserve Bank.

The current average margin on variable-rate loans in this country is 2.4 percentage points, whereas 10 years ago it was about 1.4 percentage points.

The reason given for this is a blowout in "funding costs"; however, it is more likely that with four banks having 95 per cent of the mortgage market, they must maximise their profitability to keep their shareholders happy.

This creates a liquidity problem.

Because the residential mortgage market is so profitable for the banks, they are now concentrating their lending in that market, to the detriment of business lending, which is less secure and more costly to distribute and manage.

This is creating a bulge in our economy: banks are pumping funds into home loans while many business owners can't get finance.

I don't advocate regulating the markets because regulators typically distort before they remedy. But in our current situation there's a case for using incentives to alter the structural problems.

A first step could be to foster competition by ensuring there are more lenders from which to choose. This means encouraging our regional banks, plus foreign banks, to compete in mortgage lending.

There are tax incentives that can be used, plus government-guaranteed wholesale funds could be made available to complying non-bank lenders.The government could even guarantee the small and non-banks, but not the big banks.

It doesn't matter how we get there. What does matter is we see more competition in lending. Competition will bring down the margins on variable-rate mortgages and lure the big banks towards business lending again.

So the market is actually poised to correct itself, but there has to be an incentive.

And what about the broader structural problems in the economy? Don't blame the Reserve Bank: they only have interest rates to use against a dynamic set of forces that haven't yet settled into their new shape.