This is an edited version of the NZ Council Of Trade Unions’ Submission to the Parliamentary Banking Inquiry, held in August 2009. It was orally presented by Bill Rosenberg, the CTU’s Policy Director and Economist. The title and subtitle of this article are ours, not the CTU’s. This Inquiry was conducted by the Opposition parties (Labour, Greens, and Progressives) but boycotted by the Government parties and the Australian-owned banks. To quote from its terms of reference: ” The primary focus of the Banking Inquiry will be on the pass-through of recent cuts to the Reserve Bank’s Official Cash Rate (OCR) to short term variable interest rates. This is the most pressing issue identified by the Reserve Bank in its commentary to date. Banks and other interested groups have also argued that the pass-through issue must be seen in context. Accordingly the following contextual issues have been deemed relevant and within the scope of the Inquiry:

• lending margins, including the cost of wholesale funding from various sources
• banking profitability and how that has changed over time
• bad debt and risk provisioning by banks
• lending terms and practices
• other matters considered relevant by submitters”.

The Inquiry reported in November 2009 that banks have pocketed as much as $2 billion in interest rate cuts they have failed to pass on to lenders (a charge denied by the Government and the banks). Three of the four Australian-owned banks (ANZ, BNZ and Westpac) are finalists in the 2009 Roger Award for the Worst Transnational Corporation Operating In Aotearoa/New Zealand. Ed.

In welcoming the Parliamentary Inquiry the Council of Trade Unions (CTU) noted the value that could have been achieved had a multi-party understanding, if not agreement, of the underlying structural issues in the banking sector, been possible. In light of the international financial crisis the non-participation of parties from the Government was to be regretted. The banking system not only has direct effects on the cost of housing through mortgages, on the cost of credit to union members, and the cost and availability of business finance enabling investment and continuity of business, but also has a critical effect on macro economic variables including the exchange rate, inflation and growth in the economy. In addition the banking sector is a large employer and as a business its profits are significant to both the New Zealand tax system and to our international current account balance.

Lending Margins, Including The Cost Of Wholesale Funding From Various Sources

The submission addressed two ongoing factors affecting domestic interest rates set by the banks. One, the margin between the interest rates they pay to fund lending and the interest rates they charge for lending. The second, the reliance of New Zealand’s banking system on foreign sources of funding.

Lending Margins

With regard to lending margins themselves, the data presented by the Reserve Bank in its paper “New Zealand Bank Funding Costs And Margins” (6/7/09) is persuasive with regard to floating rates. The difference between short term market rates (exemplified by the 90 day bill rates) and floating mortgage rates has increased faster than changes in borrowing costs, implying profit taking by banks. Similarly, credit card interest rates, which would also be expected to track short term interest rates, have not fallen nearly as much as the Official Cash Rate (OCR) or 90 day bill rates. The Reserve Bank paper showed that while the OCR had fallen 575 basis points (i.e. 5.75 percentage points) between its peak at 8.25% and its recent low of 2.5%, average credit card rates had fallen only 190 basis points, from 20.3% to 18.4%: easily the smallest reduction in rates listed in the paper.

These concerns have not diminished since then. The average credit card rate in July was a further ten basis points higher at 18.5% (1), reducing the fall from its peak to 180 basis points. At July 2009, average floating rates were unchanged compared to the Reserve Bank paper, though they have fallen a little since July. Another useful comparison is with Australian interest rates. The banks dominating the two systems are the same yet have higher rates in New Zealand. According to the Reserve Bank of Australia (RBA) (2), banks’ standard variable rate mortgages there averaged 5.80%, and discount variable rates averaged 5.15% in July 2009. The Reserve Bank of New Zealand (RBNZ) (3) gives the average floating first mortgage new customer rate as 6.44% for July. So New Zealand floating rates were significantly higher, despite the OCR in New Zealand at 2.5% being lower than that in Australia (3%).

It would be difficult to argue that this difference is due to higher risks of default by customers in New Zealand. At March 2009, the average ratio of impaired assets to total assets among New Zealand banks was 0.6% according to the RBNZ (4). The corresponding impairment ratio for Australian banks according to the RBA (5) was 0.95%. In March, floating interest rates were still at 6.44% in New Zealand (though the OCR was at 3%) and at 5.85% (standard variable rate), and 5.20% (discount) in Australia with an Official Cash Rate of 3.25%.

Increased Profit Taking By Banks

In summary, as the table shows, New Zealand rates have been higher than Australia despite lower official cash rates and lower risks of default. Further supporting evidence comes from Statistics New Zealand in its 2009 Producers Price Index for the period ended March 2009. It reported that for that quarter: “The margins that financial intermediaries [mainly banks] make on their borrowing and lending operations… increased due to the rates for borrowing falling more than the rates for lending”. This followed increases in the previous six months, and both the quarterly and annual increase were the largest since records began in 1994. It reported:

“In the March 2009 quarter, the major offsetting effect on the output prices came from the finance index (up 14.6%). This index is dominated by 'financial intermediation services indirectly measured' (FISIM), which is a notional measure of the margins that financial intermediaries make on their borrowing and lending operations. In the latest quarter, this margin increased due to the rates for borrowing falling more than the rates for lending. The increase in the finance index followed rises of 10% in the December 2008 quarter and 6.1% in the September 2008 quarter. On an annual basis, the finance index rose 32.1% in the year to the March 2009 quarter compared with falls of 2% and 4.9% in the years to the March 2008 and March 2007 quarters, respectively. Both the quarterly and annual rises in the finance index in the March 2009 quarter were the largest recorded since the series began in the June 1994 quarter”.

The rise continued in Statistics New Zealand’s most recent release (that for the period ended June 2009). It again reported: “The major offsetting effect on output prices in the latest quarter came from the finance index (up 13.2%), following rises of 14.6% and 10% in the March 2009 and the December 2008 quarters, respectively. The latest quarterly increase was mainly driven by an increase in the financial intermediation charges index”. In the year to June the finance index rose an astonishing 51.6%.

It is, on the evidence, reasonable to conclude that there has been increased profit taking by banks, at least through their floating rates and credit card services. It is worthwhile noting that with that release, Statistics New Zealand warns that their measurement of the bank margins currently excludes foreign currency funding, a matter which its source of information, the Reserve Bank, is currently working on to remedy. Statistics New Zealand does give reassurance that the exclusion would affect the accuracy of the index only “if the relative movements of the foreign currency funding rates were significantly different from the relative movements of the New Zealand dollar funding rates”. It is looking for alternative sources of information on the rates. The dependence on foreign sources of funding is the next matter we address.

Reliance On Foreign Sources Of Funding

While there is a strong case that the banks have been increasing their lending margins, this cannot be the full story. The small New Zealand banks, notably Kiwibank and TSB, have increased interest rates almost as fast. Given their competitor status, they would be more likely to have taken greater advantage of the increasing margins to undercut the Big Four (ANZ, ASB/CBA, BNZ/National Australia Bank and Westpac) by reducing their own margins had that been possible. There are other factors affecting the unresponsiveness of interest rates to changes in the OCR. A second explanation for the apparently excessive difference between longer term rates and the OCR is our virtually unregulated movement of funds between New Zealand and the rest of the world: open international capital markets. As a result, to a large degree we import the monetary conditions of the rest of the world (interest rates and availability of finance) and have much reduced ability to control those conditions to suit the country’s needs.

To simplify, if interest rates offered to savers here are lower than the rest of the world, fund managers can take their money to where interest rates are higher, forcing banks here to raise the rates they offer. If our domestic rates go higher than international rates, the banks can (and will) borrow more cheaply overseas in order to lend for mortgages and business loans. There are complicating factors such as margins for risks in our economy and changes in the exchange rate, but it means that the Reserve Bank has much weakened ability to influence monetary conditions within New Zealand. It has some influence on short term interest rates, because the OCR is for short term lending. But longer term rates are much more connected to international conditions because they can be funded profitably from overseas.

We saw an opposite symptom of the same cause when the property bubble was at its height. The Reserve Bank had to set the OCR punitively high to have any effect. The high interest rates pushed up the exchange rate, hurting exporters, worsening our balance of trade, and discouraging productive (as opposed to speculative) investment. Now, no matter how low the Reserve Bank cuts the OCR, it seems that longer term rates won’t respond sufficiently. This undermines the needed stimulus to a depressed economy. We have a persistently overvalued exchange rate, penalising exporters and threatening the security of jobs in the export sector.

The dominant Australian owned banks have led the increasing dependence on overseas financial markets. At June 2009, 37% of M3 (6) institutions’ funding was from overseas residents. This proportion rose strongly through the second half of the 1990s and reached this level in 2001. As at March 2009, 71.7% of the net international liabilities owed by New Zealand resident institutions and individuals was the net debt owed by banks overseas (7). Economist Geoff Bertram concluded that at June 2008: “The banks, in summary, account for nearly 70% of investment income debits on the balance of payments, and for 74% of the economy’s net overseas indebtedness” (8).

In 2004, David Tripe of the Centre for Banking Studies at Massey University estimated that “for the June quarter 2003, the net exposure of the banking system can be said to account for 62.28% of the net deficit in the balance-of-payments income account” and that bank indebtedness appeared to be increasing. Noting that “what is unusual about the New Zealand situation is that the high level of indebtedness is associated with such an overwhelmingly foreign-owned banking system”, he concluded that “ New Zealand thus appears to be at risk of a balance of payments or currency crisis. The banks are significantly dependent on non-residents for their funding, while banks’ relatively high ratios of loans to assets by international standards mean that banks are particularly exposed to major withdrawals of funding.” (9)

Kiwibank has not until now participated in this use of overseas funding, but has announced it is intending to do so, presumably in order to compete with the Big Four, which together at December 2008 had 90% of the assets of registered banks (10). The situation is consistent with the so-called “open-economy trilemma”. Proposed by supply side economist Robert Mundell, it has been advocated and investigated by prominent international finance economist Maurice Obstfeld. It can be stated as follows:

A country cannot simultaneously pursue a monetary policy oriented toward domestic goals and maintain stability in the exchange rate while allowing the free movement of capital. Governments may choose only two of these.

International Capital Movement Needs To Be Regulated

In other words, complete capital openness results in high social costs. Our volatile exchange rate is a further result of unregulated international capital movements. As Obstfeld has put it, commenting on the open financial markets of the 19 th Century and their dire social consequences:

“Compared to the world of the late 19 th Century gold standard, however, we increasingly reside in broadly democratic societies in which voters hold their governments accountable for providing economic stability and social safety nets. These imperatives sometimes seem to clash with the reality of openness”. (11)

New Zealand should therefore consider ways of regulating international movement of capital, and in the current context, regulating the ability of financial institutions to borrow abroad to finance lending in New Zealand. This could have benefits with regard to exchange rate stability, the effectiveness of monetary policy, and the persistent current account deficit. One avenue could be through prudential regulations, but this may not be sufficient. The Reserve Bank’s June 2009 Liquidity Policy for registered banks tries to wean the major banks off their risky habit of borrowing at short terms (like 90 days, often overseas) and lending for mortgages longer term, and in general to lengthen the terms of their borrowing. The policy was expected to lead to banks increasing the proportion of their funding which is obtained domestically. One of the Reserve Bank’s concerns was that another freeze in world financial markets would force it to again arrange overseas funding lines to be used to prevent New Zealand’s financial system from also freezing up, as it was forced to do in 2008. Management of international capital movements might include provisions to regulate

• Volumes of overseas borrowing;
• Capital movements out of the country, with emergency provision for times of crisis;
• End use of overseas borrowing such as to give preference to trade and foreign currency earning investment;
• Minimum maturities (terms) of overseas borrowing, and matching of maturities between borrowing and lending.

A small financial transactions tax (“Tobin tax”) should also be considered to discourage speculative financial market transactions which can cause volatility in the exchange rate and create instability in the financial system. More broadly, within a system of capital and currency management, options could then be considered for stabilising the exchange rate.

Bank Charges

In addition to concern over lending margins, there has been well publicised concern over the level of bank charges such as break fees. We see merit in legislation to increase the transparency and accountability of the banking sector and other deposit takers and lenders. This could include provisions like those in Australia which require charges to be related to real costs, and for stronger consumer protection such as through a Financial Consumer Agency as proposed by Finsec (the bank worker’s union. Ed.). (12)

Competition

One remedy frequently raised for the high interest rates experienced in New Zealand is greater competition. Disgruntled customers are advised to shop around. Smaller banks, particularly Kiwibank and TSB are certainly having a positive effect on interest rates, but remain very small compared to the Big Four. Competition could be increased in a number of ways, including providing more capital to Kiwibank, and buying back one of the large banks. The community-owned trustee savings banks and the BNZ when it was State-owned frequently led in keeping down costs. The trustee savings banks were also leaders in services to retail customers and in local provision of finance, investing back into their own communities. However there should be caution in advocating greatly increased competition. Firstly, it is likely to have limited affect on interest rates for the reasons outlined above.

Secondly, we need to reflect on the reasons why the Australian and New Zealand banking systems survived the financial crisis relatively unscathed. It is not clear that it is due to the quality of supervision and regulation. For example, the ANZ was in fact involved in similar practices to the US banks through its half-owned associate, ING (NZ) Ltd. Two of ING’s managed funds have led to large losses for 13,000 investors, 2,800 of whom invested in the funds as customers of ANZ. It is also known that the banks use off balance sheet entities (13). Their use can undermine the validity of public disclosure and prudential requirements. So it was not that high risk practices were prevented in the two countries’ systems, but that there appears not to have been the incentives for the behaviour that led to them becoming widespread.

A former Governor of the Reserve Bank of Australia, Ian Macfarlane, has suggested the main reasons may be firstly the lack of competition between the Big Four. This is enforced in Australia by the “four pillars” policy which makes it unlikely they will be taken over. Secondly, he suggests that it may paradoxically be the lack of savings in Australia to invest in the high risk US markets. He thought “they would have if they could have” and described the result as “dumb luck”. (14) Other observers have made similar observations (for example, “Easy money saved the day”, by Ian Verrender, Dominion Post, 25 June 2009, pC4, reprinted from the Sydney Morning Herald).

This does also underline the high degree of dependence New Zealand has on the Australian banking system and its regulatory settings. It may be simply “dumb luck” this time that having all our eggs in that basket was favourable to us. There are therefore a number of reasons to consider whether ownership of our major banks needs regulation. In addition, when considering the soundness of our financial system we should not forget the collapse of the finance company sector which has lost investors hundreds of millions of dollars. Further consideration of suitable supervision and regulation of New Zealand’s financial system is therefore merited in the light of the international and domestic financial and economic crisis. Aspects could include:

• Legislation to ensure the separation of traditional commercial banking (deposit taking and lending) and investment banking;
• Requirement for regulatory approval for financial services which are of high risk (whether sourced from New Zealand or abroad);
• Reducing the overseas ownership of the New Zealand financial sector and diversifying the home countries of overseas ownership;
• Addressing the reality that each of the Big Four banks is “too big to fail” and is capable of significantly impacting economic (including monetary) policies.

Responsible Behaviour

In addition to the above important matters surrounding the stability of the financial system, there are concerns that have been raised by the recent behaviour of the Big Four banks which demands attention. One is of course the question as to whether they have been taking advantage of their dominant position and the financial crisis to extract additional profits. There are also longstanding concerns at the difficulty in obtaining funds for investment in business expansion and developing new enterprises in New Zealand. Some of this activity can be relatively high risk and therefore (as the international financial crisis has amply demonstrated) not a safe role for the banks to take on directly. However some is legitimate bank lending, and given the banks’ dominant role in the financial system they also bear some responsibility for the scarcity of sources of finance for the higher risk but necessary ventures.

The Big Four banks also either have recently been convicted of, or are defending charges in court of tax avoidance on a massive scale. Taxes lost to New Zealand legally or illegally, which have had to be made up by taxes on working New Zealanders, total well over $2 billion. Evidence presented to the courts shows that the banks had designed complex financial structures which allowed them to in essence choose their tax rate. Bank staff have also demonstrated mounting concern at both the pressures put on them to sell bank products which are not necessarily in the interests of their clients, and the increasing use of outsourcing overseas, losing and deskilling jobs and increasing customer dissatisfaction.

On the other hand, the crisis has shown that any one of these banks is “too big to fail”. The financial system would be at high risk if failure of any of the large banks was allowed to occur. This has required the risking of tens or hundreds of billions of public funds to guarantee their continued viability. Even if the current crisis is over (which is not yet assured) banks cannot ever say again that they are not dependent on Government support. Given the implicit and explicit support afforded them banks should be subject to monitoring, supervision and governance structures that ensure their good behaviour as corporate citizens and optimise their value to the economy rather than leaving them to their individual profit maximising self-interest.

Conclusion

In conclusion the CTU reiterated that there is a need for a wider inquiry to learn from the financial crisis, and other recent behaviour of the banks. Equally, given the evidence of excessive lending margins on floating mortgages and credit cards, compounded by the unregulated nature of international capital movements to and from New Zealand, consideration of ways regulating international movement of capital is needed. This would have benefits with regard to exchange rate stability, the effectiveness of monetary policy, and the current account deficit.

In light of the international and domestic financial and economic crisis - compounded by the evidence on bank charges, competition in the sector and the behaviour of banks - further consideration of suitable supervision and regulation of New Zealand’s financial system is merited. Particular note should also be afforded the expert view that excessive competition will encourage the high risk behaviour that led to the financial crash in the USA. In light of the “too big to fail” status of the Big Four banks, the consequent extraordinary level of State support given to them, and their recent behaviour, the banks should be subject to requirements accompanied by monitoring, supervision and governance structures that ensure their good behaviour as corporate citizens and optimise their value to the economy rather than leaving them to their individual profit maximising self-interest.

Endnotes

1 Reserve Bank of New Zealand, “C12 Credit card statistics: balances outstanding, limits and interest rates”.

2 Reserve Bank of Australia, “F05, Indicator Lending Rates”.

3 Reserve Bank of New Zealand, “B3, Interest rates on lending and deposits”.

4 Reserve Bank of New Zealand data series G1 and G2.

5 Reserve Bank of Australia, “B05, Banks - Consolidated Group Impaired Assets”.

6 ANZ, ASB, BNZ, Citibank, Deutsche Bank, GE Finance and Insurance, Rabobank, Southland Building Society, The Hong Kong and Shanghai Banking Corporation Limited, TSB, and Westpac.

7 Statistics New Zealand, “International Investment Position at March 2009”.

8 “The Banks, the Current Account, the Financial Crisis and the Outlook”, by Geoff Bertram, Policy Quarterly Vol.5 No 1 (February 2009) pp9-16.

9 “The New Zealand Banking System and The Balance of Payments”, by David Tripe, Paper for 8th New Zealand Finance Colloquium, Hamilton, January 2004.

10 Reserve Bank of New Zealand, “Financial Stability Report”, May 2009.

11 “The Global Capital Market: Benefactor or Menace?”, by Maurice Obstfeld, Journal of Economic Perspectives, Vol. 12, 4, p28.

12 “Fairness in lending”, Finsec, August 2008.

13 See for example http://www.converge.org.nz/watchdog/15/06.htm.

14 “Saved by dumb luck”, by Alan Kohler, Business Spectator, 2/3/09, http://www.businessspectator.com.au/bs.nsf/Article/Foundational-fluke-$pd20090302-PR559, accessed 6/3/09.