Introduction: Following a career of more than 40 years in domestic and international financial markets, Michael Witts retired as the Treasurer of ING Bank Australia (IBAL), a position he held for more than 12 years. IBAL is a significant participant in the Australian mortgage market. This article reflects upon his observations over the years especially in the mortgage market, regulations and the dynamics of funding opportunities.
Mortgage market
Over the past 20 years, innovation in the mortgage market has continued at a rapid pace. Competition in the sector remains intense, with the increasing role of brokers meaning that a mortgage is seen as a commodity, which can be readily substituted from one provider to a second or subsequent provider.
From a consumer viewpoint, this has been a positive development, with sharper pricing becoming more widespread. From a mortgage provider viewpoint, previous generous margins have been partially eroded, with a value exchange in favour of the consumer. Despite this erosion, the return on equity on Australian mortgage books remains attractive on a global basis.
The distribution of mortgages via brokers has enabled participants to broaden their geographic footprint beyond their traditional market. The enhanced geographic spread has reduced location related concentration risk. In addition, the broker channel supports new entrants to get their products into the market in a more efficient and cost-effective manner. This contributes to increased competition.
The recent introduction of 10-minute mortgage approval process is to be applauded, however, as with most things the devil is in the detail. In a drive to improve mortgage approval turnaround times, credit decision engines are used to automate the process to the maximum extent possible. The quality of the decisions that result is a function of the design of the rules. While these will work well for loans that are clearly strong (approved) or weak (declined), there is the potential for the population in the middle to generate several exemption escalations and/or adverse customer outcomes. This should be a watch point as these programmes gain momentum.
Fintechs and new banking participants
The doors are open for new banking participants to enter the market. Generally, they benefit from having no legacy systems and their technology is cutting edge, however, they lack customer numbers to achieve economies of scale. As a result, they need to closely manage their cash burn rate during the early years. Improvements in the technology employed by incumbents, together with Covid, has seen many of the newer participants exit the market.
The alternative outcome has seen new participants being taken over by more established financial institutions. This effectively results in a dual banking technology stack being used within institutions, where the 'old' and the 'new' bank run side by side, with the end game that existing customers are transitioned to the new technology. This approach is likely to be repeated in the future. Also, it further underlines the power of incumbency and an existing customer base.
Impact of regulation
A key outcome of the GFC was a series of regulatory changes designed to improve the liquidity self-sufficiency of banks. The driver of this was that public funds would not be required to bail out the banking sector in the future.
While these measures have achieved the objectives of strengthening bank liquidity and funding models, they have also made explicit the cost of providing market liquidity. In many cases, banks have opted to decrease or cease their market making activities.
Consequently, volatility in financial markets has increased significantly, especially at times of unclear or turning market direction. The first half of 2022 has been characterised by extreme volatility across equity and financial markets. Market observers agree this year has been potentially the most volatile in recent memory due to a turning monetary policy cycle. This reflects the sharp jump in inflation and inflationary expectations, surging commodity prices, especially energy, stemming from the war in Ukraine and Covid-related supply chain issues across the globe especially in China. Mixed messaging from central banks has compounded a volatile and fragile environment as Covid was being unwound.
Funding options for non-major mortgage lenders
Retail deposit funding has been a key source for major banks to fund their asset portfolios, especially their mortgage books. The major banks continue to tap into retail funding options, in addition to longer term wholesale funding alternative (both domestic and offshore), including medium term notes, residential mortgage-backed securities (RMBS) and covered bonds.
In contrast, mortgage lenders without access to significant retail funding alternatives rely on warehouse funding facilities pending the issuance of RMBS bonds to generate term funding. Prior to the winding down of the Committed Liquidity Facility (CLF), the major bank balance sheets were strong supporters of the RMBS market, as assets that could be pledged as collateral for the CLF were available at attractive spreads relative to alternative assets with similar collateral features.
In September 2021, APRA advised CLF banks that the CLF would be reduced to zero effective end December 2022, reflecting the growth in government and semi-government bonds on issue arising from the fiscal impact of Covid. Hence, the rationale for the CLF, the previous shortage of government and semi-government securities, (High Quality Liquid Assets, (HQLA)) was no longer applicable. This resulted in a transitioning of demand from RBMS towards HQLA.
The decrease in demand for RMBS became quickly apparent in late 2021 and continued into 2022. In practical terms, this translated into smaller individual deals and wider spreads. The continuation of this trend appears likely and means that competitive sources of volume term funding for non-major lenders in the mortgage market is reduced, increasing the risk that price competition in this sector could lessen.
Conclusion
The Australian mortgage market and associated funding markets have successfully responded to changing customer expectations and the dynamics of funding markets over many years. While at times these elements may get out of line, through the combined efforts of market participants and regulators working with a positive co-operative approach, issues have been resolved. Innovation, with a focus on customer outcomes, will continue to drive the market in future years.
Michael Witts has worked in domestic and international financial markets more than 40 years and is the former Treasurer of ING Bank Australia (IBAL), a position he held for more than 12 years. These comments represent the author’s observations only and should not be considered to be the views of IBAL or ING.