Sunday, April 22, 2012

Are Australian banks and supermarkets killing the goose that laid the golden egg?

The phrase Killing The Goose That Laid the Golden Egg comes from Aesop's. Interestingly, and this bears upon the discussion on the nature of civilisation, there is debate as to whether Aesop drew from India or India from Aesop.  However, that's a discussion for another day.

The point of the story and saying is that greed can lead to its own destruction. Two stories in the Sydney Morning Herald bear directly on this question.

Ian Verrender's Banks playing risky game with rates looks at the approach adopted by Australia's big banks to the setting of interest rates.

For the benefit of readers who don't know the Australian scene, four big banks dominate. There are smaller local banks and other financial institutions, but they play a subsidiary role. Overseas banks are present, but their role is even more limited and has become more so since the global financial crisis. This is a matter of economics, not legislation. Even in the days of the internet, It is very difficult to access the domestic savings base without an extensive network of branches, ATMs (Automatic Teller Machines) and EFTPOS facilities,

The smaller local banks, the regionals, and other institutions do provide a measure of competition at the margin.

Over the last thirty years, there has been a pattern in which the big banks effectively vacate certain niches because they can't make enough money out of them. Sometimes those decisions make sense, at other times not. The closure of bank branches in the name of efficiency is an example of the second. In recent years, all the majors have had to spend quite heavily rebuilding branch networks in order to maintain access to their customer base.

The niches neglected by the big banks create opportunities for other players. They move in and grow. That's competition. Government policy prevents the big banks buying each other, That's competition policy. Instead, the big banks buy the more successfully minnows, thus regaining the markets they abandoned, Again, that's competition.

In market terms, the Australian banking scene is best described as an oligopoly, a market in which a small number of players have the ability to be price setters rather than price takers. They watch each other and respond to each other, but try to do so in ways that will not damage their profits.

This is where Ian Verrender's article comes in. He argues that the approach adopted by the big banks to the setting of interest rates actually threatens the Australian economy. Instead of trying to sell money, that's what banks normally do, they are focused instead on increasing the margin between their costs of borrowing and the return obtained on loans. Watching each other carefully as they do, they wait for one bank to move and then the others follow. It's a ratchet effect.

To Mr Verrender's mind, this approach has two adverse results. It limits the availability of credit to new borrowers, while increasing costs for new borrowers. Profits rise as margins rise, However, if all the banks follow this approach, total lending will be adversely affected. Economic activity will decline, and so will bank profits. The goose will have been killed.

If the Australian banking sector displays oligopalistic tendencies, the Australian retail sector is a very clear oligopoly with two huge chains dominating most market sectors. To their many competing suppliers, those chains are an effective oligopsony, a few buyers and many sellers. The buyers control the market.

In competition terms, oligopoly is inherently unstable. Profit maximisation effectively depends on firms not competing on price, for if one firm shifts on price, the others must follow. Subject to price elasticities, the extent to which lower prices increase demand, profits fall for all.

The equation changes if the oligopolists are also oligopsonists. Their market power allows them to pass the costs of price competition on by squeezing their suppliers. Now the costs of competition are carried in whole or part by the supply chain.

This is just what is happening in Australia at the moment.

The two retail giants are in a price war centered on essential groceries. From an overall consumer perspective, the immediate gains are not as clear cut as might appear, for the chains have been increasing prices on other items. Still, products like bread and milk are at prices not seen for decades. This affects the consumer price index, for we actually have deflation in some areas. In turn, this makes it easier for the Reserve Bank to lower interest rates.      

So far so good. The problem lies in the squeeze placed on suppliers. This is explored in another Sydney Morning Herald article, Suppliers count the cost as Woolies and Coles shoot it out over prices.

As a consumer, I have noticed the progressive withdrawal of products I like from supermarket shelves. I do buy store brands, often I have no choice, but I don't have to like it. Beyond my personal response, the supermarkets are now effectively forcing industry restructuring in those sectors most dependent upon them as they seek to cut costs and build their own brands. They are holding their profits despite the competition, but the costs of that competition are being forced on suppliers.

In the longer term, that's not sustainable. Again, it seems another case of the golden egg.  


Anonymous said...

Hi Jim

I actually thought (and still do think) that the ANZ move to de-link its rate setting from the Reserve Bank was a good thing. While I take Verrender's point (and yours?) that this might come back to bite them at some stage, this presumes they, along with the other banks, will not then react to potentially adverse outcomes.

I thought the particularly good thing about the ANZ's move was one of perception: it quite rapidly showed just how little 'real control' the Reserve Bank has in the marketplace; and it raised the base question: is the centralised decision on rate setting by a non-responsible quasi-government instrumentality a good thing in any event?

At least if the big four get it wrong they lose profit, and will therefore react; what does the Reserve lose, apart from street cred?

One thing most assuredly in the Reserve's favour is the (I hope!) ability to maintain a longer strategic timeframe for it's prognostications; that is a good balance imo for the sometimes remarkably short termism of the banks - and I'd include your example of branch closures in this category.

In any event (and I accept that I'm wandering) the government has only itself to blame, having so recently demonstrated that they consider our Big 4 too important to be anything but cosseted.

BTW I bank with ANZ, and at $600k this 'delinkage' has cost me significantly, so I am not writing from some sort of unaffected Eiffel tower.

ps forgot to say, thanks for a very interesting post!

Jim Belshaw said...

Good morning, kvd. As a general statement, I am inclined to agree that the ANZ's move to delink was a good thing, although it does make the RBA's task a little more difficult.

On the RBA, the evidence suggests that Australia has been well served by the Bank, although that's a matter for another post.

It's not the fact that the banks might be bitten that's the problem, but the way their herd behavior might bite the rest of us. Here I tried to put this in the context of market economics, the way certain market structures can lead to perverse outcomes.

Evan said...

Hi Jim, the oligopoly seems quite stable - and governments are willing to bail out banks at the expense of the rest of us (politics is not separate in my view). So I'm not sure the idea that oligopolies are unstable makes sense (except in economics textbooks).

I do think that economics works with fictional entities - 'consumers'. Those consumers are actually people - some of whose livelihoods are being destroyed by the supermarkets exploitation of their market power.

Jim Belshaw said...

The economic theory of oligopolies works pretty well Evan. In setting price, they watch one another. If one moves dramatically in price terms, the others are forced to follow no matter the cost.They can actually bleed each other out; consumers benefit in the short term, but in the end either you end up with a monopoly or one raises price and the other gratefully follows! In the supermarket case, they can pass the costs onto suppliers, thus putting off the evil day. Eventually, though, they will kill the goose.

The banks are a little different. There are more of them. Notice how carefully they watch each other. NAB is competing on price, but its tightly controlled. Because the big banks between them dominate their market, they can squeeze customers. The problem is that what is okay for one becomes a zero sum game if their combined actions end up contracting credit in such a way that their total profits suffer.

That's the supermarket case.

Anonymous said...


I can see where you're going on bank margins, but would suggest the implacable march to oblivion coming from your comments is tempered in my mind by having lived through far higher, and far longer extended high interest rate conditions.

If you talk in round %s then our current 8% is only around what was the prevailing regime up to about 1974. From 75 to 96 (20 years) the variable rate was 10% or above (two small blips below 10, but not below 8)- this including 83-92 (9 years) where rates were above 12%, peaking around 16-17% for a year in 90-91.

I'm talking your basic standard home loan variable interest rate here.

I realise there were, and are, a multiplicity of other factors throughout the past 30+ years, but to the 'man in the street' working to a weekly budget, the present fixation on the Reserve's monthly deliberations is possibly overblown given we are presently experiencing a fairly benign rate compared to the past 40 years.

The thing is, people can adjust a lot of their spending, up to and including food and clothing; but the mortgage payments march on regardless. Not saying we never had it so good; just saying things aren't so bad.


Jim Belshaw said...

I had to think about this a little, kvd.

To begin with, you have to look at real interest rates. I had investment properties during the very high interest rate rate period and did rather well. Inflation reduced the real value of my loans, my rents kept increasing, and the value of the properties in nominal value terms grew.

Now we live in a different world. Real interest rates are quite high, increases in capital values low. Even though nominal interest rates are low, Australia is a highly indebted society. Fewer people want to borrow whether for consumption or investment. The banks are squeezing their existing locked in borrower base to increase margins, but in so doing they are reducing new business.

Horses for courses, I guess.

Anonymous said...

Somebody else who thinks our memories are far too short.


Jim Belshaw said...

That's an interesting piece, kvd. I think that Michael Pascoe is right. It's nothing like Mr Keating's recession!

Anonymous said...

More grist for your mill:

- sourced from SMH article

It seems perception is quite a deal more important than reality...


Jim Belshaw said...

Perception can indeed be more important than reality, kvd. But the report raises another issue. Assume that people are, in fact, rational. Then why do perceptions vary so much from apparent reality? Is there in fact a rational reason?

Evan said...

Perception being viewed in terms of past experience (we NEED approximation, but it does have problems);
blanking our particular areas of perception,
refusing to believe particular perceptions.

One way of saying this is that 'everybody is sane' ie. our behaviour makes sense when the way we construe reality is included. This includes construals like, "I got this message from the TV talking to me" - which is a way of understanding experience (one at some variance with reality I think).

There is lots of understanding about how our perceptions of what is 'out there' varies from what is 'out there'.

Jim Belshaw said...

That's interesting, Evan. Some years ago I browsed a history paper back that argued that the concept of mental illness, of insanity, was a cultural construct. There is some truth in that idea, illustrated by current medical discussion on the definitions of various mental illnesses.

Evan said...

It gets even more complicated because the same complex phonemenon can be truly described in different ways (the blind persons and the elephant parable). So the different descriptions of say schizophrenia in different books and countries may still lead to the same diagnosis of a particular individual.

Mental illness is inevitably cultural - people aren't separable from culture in their lives (though it may be possible to do this for the purposes of focusing on some aspects of persons - say the structure of mitochondria).

And behaviour is influenced by environment. Observe the same person in a hostile office, loving family and concert they enjoy.

Jim Belshaw said...

The elephant parable would, I think, suggest that you get very varying results. The only way you could get to a common answer - the elephant - would be if you had some way of breaking through the the varying partial perceptions. I broadly agree on the cultural point, although I also think that its a question of boundaries as well as interactions.

Evan said...

Yes, we desperately need processes for collaboration that can lead to innovation.