Showing posts with label Australia. Show all posts
Showing posts with label Australia. Show all posts

Tuesday, September 2, 2014

The Global Water Shortage: A Transparent Issue

“When the well is dry, we know the worth of water,” wrote Benjamin Franklin in 1746.[i] Over 250 years later, it seems we are only beginning to know the true worth of water. More than one expert has said that water will be the oil of the 21st century[ii], but that is to understate its value.

Water is so essential that its shortage will impact the world in ways we cannot yet accurately predict. It will affect countries differently, depending on context (geography, demography, etc.) and the actions they take. For politicians, the peak oil crisis will seem quaint in comparison.

This paper will seek to address the economic consequences of the global water shortage. These are already being witnessed and have led to financial innovation in the area of efficient water consumption, some of which is analysed here. The hope is that these innovations are a trickle, which turns into a stream that becomes a mighty river.

Go long on water
The Dow Jones Index (DJIA) reached a new all-time high at the end of August 2014.[iii] However, its impressive growth is put in context by that of the Dow Jones Water Index, which contains water-related stocks only. In chart 1 below, the DJIA is in red and the Dow Jones Water Index is in blue.


If we agree that stock market performance is based on the accurate expectations of future earnings, chart 1 tells us that we can reasonably expect water prices to rise dramatically in the near future. This prediction even allows for a significant margin of error in the stock price.

In fact, according to data provided by the Bureau of Labour Statistics[iv], water prices have been outpacing the general basket of consumer goods – the consumer price index (CPI) - in the United States for at least 30 years. Figure 1 below shows cumulative inflation of water against the CPI from 1984 to late 2013.


The graphs above probably only indicate that water has been extremely under-valued until now. However, the justifiable argument that water needs to be priced better needs to be balanced with the equally justifiable “water is a human right” argument: A change of thinking is called for.

An extremely liquid asset
The return on US Treasury bonds has traditionally been used as a measure of the risk free interest rate. “Risk free” is not to be taken too literally here. The American government has defaulted on its debts at least twice[v] but the idea serves to promote confidence in the financial system. Besides, the risk associated with these bonds is generally negligible.

In the highly unlikely event that the US Treasury disappears along with the risk free rate tomorrow, we can be certain of one thing: everyone will still require water. That is literally a “risk free” assumption. Taking this into account, might risk free water bonds offer a solution?

On August 26th of this year, the city of Detroit sold slightly under $2 billion in bonds tied to their water and sewer system[vi]. A city whose debt is classified as junk[vii], has now issued water bonds which currently allow the city to refinance at a 10-year rate of 3.24%[viii] - less than 1% above the yield for so-called risk free government bonds for the same period.[ix]

This is a more sensible solution from a societal standpoint than the profiteering from water that seems inevitable on the stock market. In theory, the demand for a true risk free return could push the yield on these bonds to below that of a treasury bond with the same time to maturity (although given how bad we have been at valuing water until now, it may take a while).

Detroit aims to save $11.4 million a year from the initiative as well as raise $150 million to update the city’s sewerage system.[x] It is hardly going to provide a panacea for Detroit or the water crisis, but the adoption of a new mindset is encouraging.

A new mindset
It is reasonable to suggest that businesses should pay more for water than consumers. One company in Canada was able to bottle 265 million litres of fresh water and pay nothing.[xi].It’s easy in cases like this to point a finger at corporations but an antiquated way of thinking about the value of water effectively gave the company a green light to do it.

Encouragingly, the same Canadian state where this occurred will put into force a Water Sustainability Act in 2015 to ensure it doesn’t happen again.[xii] No doubt other jurisdictions will follow suit: a growing consensus is emerging which recognizes that, where water is concerned, people and companies have different consumer surpluses.

Consumer surplus is the amount a buyer is willing to pay for something less the amount the buyer ends up paying for it. For companies, given their incomes next to the typical individual’s income, this surplus has to be much more. On that basis alone, they should be charged more.

Hopefully, the introduction of taxes like these would provide an incentive to big business to innovate new, more efficient ways of consuming water. The precedent of Australia’s water market might provide a blueprint for how water is allocated to corporations.

This system operates much like the carbon trading scheme, where companies trade carbon emissions permits; Australia’s water market provides businesses with water entitlements beyond which, if they wish to consume more water, they need to trade entitlements with other businesses.

The Water Commission of Australia estimated at the end of 2011 that turnover of entitlements amounted to AU$ 2.7 billion annually.[xiii] The system means that the government can limit the quantity of water consumed on the macro level, while a fair price is being paid on a micro level.

Conclusion
The economics surrounding water currently make grim reading (unless you happen to own shares in the Dow Jones Water Index). Economics teaches us that a shortage of anything with a demand causes its price to rise. Clearly, this is the case for water in the midst a global shortage.

Recognizing a problem is the first step to finding a solution, however. The example set by both Detroit and Australia, who are using financial tools to address their individual issues is encouraging and offers a template for others to follow. Hopefully, these represent just the start of the financial innovation that will emerge: water futures markets are an undeveloped area, for example.

Water is above all a human issue rather than a financial or economic one. Unfortunately, as with many global issues, decision makers often only begin to really take notice of the human perspective when they are confronted with the gravity of the economic perspective. For all of our sakes, let’s trust that time is now.


[ix] http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

[x] http://www.bloomberg.com/news/2014-08-26/detroit-1-8-billion-water-bond-sale-said-to-set-initial-prices.html


[xii] http://engage.gov.bc.ca/watersustainabilityact/

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Sunday, June 1, 2014

Australia's Banking Oligopoly


Markets which are categorized as oligopolies are distinguished by few sellers offering near identical products. Typically, these markets have high barriers to entry and exit, while the behaviour of each firm depends on the predicted behaviour of the other firms in the market. Taking these criteria into consideration, it is fundamentally clear that the Australian banking system is an oligopoly. The “big four” in Australia (being National Australia Bank, Commonwealth Bank, Westpac and the Australia and New Zealand Banking Group) dominate the domestic banking industry.

It is not unusual for a nation’s banking system to be an oligopoly. Given the characteristics of banking and how it lends itself to better-known names, economies of scale and small margins at the retail level, it is somewhat inevitable. Australia is not alone in having a “big 4” banking oligopoly. Similar oligopolies exist in countries ranging from Ireland to Sweden to China.  Even a study by Beck and co. in 2003[i] cited the examples of Norway and Finland – considered in anecdotal terms to be equitable societies with well-functioning economies – whose largest 3 banks had industry concentrations of 84% and 85% respectively.

In the same study, the authors note that high concentration in itself is not necessarily a bad characteristic for a banking industry to possess. They note that high concentration leads to high stability in the banking industry. In particular, they noted that a concentration level of 72% or above could be directly correlated with fewer occurrences of banking failures within the particular country. They argue that large banks are easily diversified, which allows them to spread risk (and therefore, attain lower overall risk) across several sectors of the banking industry. Also, the authors state that a concentrated group of bigger banks should be easier to monitor than a fragmented group of smaller banks.

In addition, a report in Australian Banking and Finance from late 2013[ii] notes that the big 4 banks in Australia, have “scale advantages, cost advantages, efficiency advantages, investment advantages, capital advantages – flowing from their ability to use internal ratings based capital allocation against assets, funding advantages, competitive advantages and so on.” The report also states that they dominate in an oligopoly that gives them “a durable structural competitive advantage.”

That is not to suggest, however, that the oligopoly was a planned measure by bureaucrats with a long-term vision for the Australian banking system. Like most other countries experiencing similar levels of concentration in the banking industry, Australia’s oligopoly came about through a long process – central to which was deregulation.

Giving Historical Context to the Australian Banking Oligopoly
The Australia Institute Paper of 2012, “The Rise and Rise of the Big Banks,” examines deregulation of the Australian financial system in some detail. This process began in the early1970s and continued right until the early 2000s, by which time the industry had undergone extensive change. Predictably, the major outcome of this change was huge consolidation in the banking industry in particular. The paper notes that in the 1980s, banks controlled around 50% of the financial industry but currently, that figure stands at around 90%.

Banks, which were previously rather one-dimensional entities, through a long process of deregulation started by the Hawke government at the beginning of the 1980s, have swallowed up other niches in the financial system, which catered for different niches, such as credit unions, building societies and financial co-operatives. The government and the central bank decided to move away from the old system in the 1970s for a few reasons[iii]:

i)              To allow banks to better respond to consumer needs. At the time, banks were losing market share in the financial system, falling to as low as 40% from a previous high of 70% in the 1950s.
ii)             To make the financial system (slightly?) more centralized and thus, easier to regulate.
iii)            To allow banking authorities to engage in large foreign exchange transactions and better manage domestic liquidity by stabilizing the foreign exchange rate.
iv)           To bring greater efficiency to the financial system in terms of better interest spreads, innovation and access to credit lines.

All of the aims were achieved with varying degrees of success. Point (ii) does raise the question about where regulation should have stepped in once more to stop the oligopoly of banks arising. Whereas the debate in other countries has centred round how to diminish the influence of banking institutions (and therefore, their size) in Australia, 24 years of solid growth has led many people in places of political power to believe that the oligopoly that exists may be more of a strength than a weakness.

Political Support for Oligopoly in Australia
Whereas the political class might be expected to oppose oligopolies (and probably do when the moment suits), the success of the Australian banks seems only to have made them national champions in the eyes of the country’s politicians. In August 2013, opposition finance spokesman Andrew Robb courted controversy when he claimed to support oligopoly in the financial industry. He told one delegation, “we are an oligopoly community. We shouldn’t fight it. We should make the most of it. It does provide us with the critical mass and the size and innovation and for that ability to compete with overseas countries.”[iv]

There might be something to Andre Robb’s comments, rather than just point-scoring with the powerful financial industry (which is three times the size of Australia’s GDP). Australia has given rise to oligopolies in a number of industries. Could it be that its size (and lack of any natural competitors from outside, being an island) is a factor in determining oligopolies in each industry? The media, grocery and telecoms industries are also characterized by oligopolies (although a system fault in any of the others would not be as catastrophic as one would be for the banking industry).

Nevertheless, the political support extends from politicians themselves to the central bank, the Royal Bank of Australia. This semi-political institution, has – in the words on one Australian commentator – “bent over backwards during the last 24 months to defend the concentration of Australia’s banking market.”[v] It seems a consensus has been reached between government and the Royal Bank of Australia that because Australia avoided the brunt of the global financial crisis and its banks in particular remained unscathed, that the banking system is fine in its current oligopoly form. They seem to be saying that if it’s not broken, don’t fix it.

While Australia’s banking system as at 2014 is lightly regulated, policymakers could well benefit from looking at financial crises in various countries in the past five years and learn from them. In this case, the adage “prevention is better than cure” may be more appropriate than “if it’s not broken, don’t fix it.” For example, the report into the Australian banking system conducted by the Australia Institute in 2012[vi], begins, “the Australian banking industry is the most concentrated in the world and also the most profitable. In fact, the ‘big four’ Australian banks make up four of the eight most profitable banks in the world.”

It’s not difficult to see why there are such large profits at the “Big 4” Australian banks, when one considers how they have shared up the market between them (see Table 1 below).



The same paper mentions that, “examinations of the top 20 shareholders of the banks’ annual reports shows that, on average, over 53% of each big bank is owned by shareholders that are among the top 20 shareholders in all of the big banks.” Further evidence in the report shows that the next biggest banks exhibit similar shareholder stakes. It could be suggested that this points to more of a monopoly than an oligopoly. In addition, all their business models are nearly identical (relying on wholesale loans for most of their business), giving further weight to the existence of an effective oligopoly.

Consequences of Australia’s Banking Industry Oligopoly
As with any industry, high industry concentration in banking leads to low levels of competition and higher prices (i.e., the consumer stands to lose out). In addition, higher interest rates are often the by-product of high levels of bank concentration. The 2009 best-seller, Too Big to Fail by Andre Ross Sorkin chartered the catastrophe occurred when a highly deregulated banking system becomes too centralized within a small numbers of banks. Australia escaped the brunt of the global financial crisis not because of financial prescience, but rather because it was (and still is to a lesser extent) undergoing a mineral extraction boom. It is important not to forget this in the context of the banking system in particular.

A 2012 IMF report which examined Australia’s financial industry[vii] noted: “a higher capital threshold for the systemically important institutions may be desirable to further bolster financial system stability. The four major banks are systemically important, which imposes a negative externality on the domestic financial system. Significant and protracted difficulties in any one of them would have sever repercussions for the entire financial system and in turn, the real economy.”

The report goes on to state, “the Basel Committee considers it appropriate for supervisory authorities to conduct more intensive supervision and require additional capital of systemically important institutions.” Elsewhere in its recommendations, the IMF Report that there is a moral hazard inherent in having such a highly concentrated banking sector. This mirrors the concerns it laid out about the American banking sector before the financial crash in August 2008. It suggests some ex-ante funded deposit insurance, which the banks should put up themselves.

The issue here is that what the IMF is suggesting goes against the grain of what Australian banks and the financial regulator are doing. The oligopoly in the Australian banking system will likely cause some problems for the economy further down the line. As we have seen, there exists a clear oligopoly, which has been under-regulated and may begin to over-compete with itself in order to gain market share in a market which will stop growing sooner or later.

As for breaking up the banking oligopoly? It would seem that Australia has learned little from the experience of America. In November 2013, the government launched a “root and branch” review of the Australian financial system[viii] (i.e. its banking system). The aim of this review is to “make recommendations to foster an efficient, competitive and flexible financial system, consistent with financial stability, prudence, integrity and fairness.” Notably, these are not typically traits associated with an oligopoly. The review will be headed by none other than David Murray, the former chief of the Commonwealth Bank of Australia, one of the Big 4. This is analogous to Goldman Sachs officials running the Federal Reserve at the time of the US financial crash. Plus ça change.












[i] Bank Concentration and Crises, NBER Working Paper 9921, Beck, Kunt and Devine (2003).
[ii] http://www.australianbankingfinance.com/banking/major-banks-enjoy-structural-advantage/
[iii] http://www.rba.gov.au/speeches/2007/sp-dg-160707.html
[iv] http://www.theaustralian.com.au/business/companies/we-are-an-oligopoly-economy-robb/story-fn91v9q3-1226699531519#
[v] http://www.businessspectator.com.au/article/2010/5/21/interest-rates/time-blast-banking-oligopoly
[vi] The Rise and Rise of the Big Banks, Technical Brief No. 15, The Australia Institute, December 2012.
[vii] Australia: Financial system stability report. IMF Country Report No. 12/308, November 2012.
[viii] http://www.smh.com.au/business/the-economy/former-cba-chief-david-murray-to-head-review-20131121-2xwdp.html
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The Australian Banking System is an Oligopoly



Oligopoly is a well-defined theory of economics that needs little introduction. All economists from Keynesians to Classicists agree on its parameters. Put simply, it is “a situation in which a particular market is controlled by a small number of firms. An oligopoly is much like a monopoly, in which one company exerts control over most of a market. In an oligopoly, there are at least 2 firms controlling the market.”[1] Even to an outsider of economics, this appears to describe well what has happened inside the Australian banking system with the “four pillars.”
The Four Pillars

The “four pillars” is a name given to the four banks that dominate the Australian Banking sector. These are, in descending order of size, the Commonwealth Bank, Westpac Banking Corporation, the Australia and New Zealand Banking Group and the National Australia Bank. The “four pillars” name conveys importance – and indeed, the banks are of significant importance to the stability of the Australian economy at large – but given their similarity to each other, the banks might well be known as the “four sisters.”

By any stretch of the term, the “four pillars” operate in a virtually unchallenged oligopoly, controlling between them around 80% of the Australian banking sector at any one time. The issue is a constant topic of discussion (and grievance) in the Australian media (one article referred to them as the “four pillows”), who note that the banks have become omnipotent since deregulation of the finance industry occurred at the beginning of the 1980s, after the by-now infamous Campbell Report (1981).

How the Oligopoly was Created

Deregulation of the Australian financial system began in the early 1980s. Its primary goal was to stabilize the Australian economy (which was doing badly at the time) and put Australian banks on a more even footing with their international peers. The steps taken to achieve this in the initial phase of deregulation were the free-float of the Australian dollar and the abolition of direct interest rates and portfolio controls for banks and other financial institutions at the end of 1983, issuing new foreign exchange licenses in 1984 and granting foreign bank licenses in 1985.

Assessing these reforms is difficult. Likewise, try to establish if deregulation was in fact responsible for the breakaway group of four large banks in Australia is almost impossible to tell. Giving banks the ability to compete on a level playing field with international competitors is no bad thing in itself, of course. And allowing the Australian dollar to free-float is in line with most economies around the world. That is not to say that the process happened without anyone observing.

A series of mergers (mergers are almost always acquisitions) occurred in the 1980s and 1990s, which, at least in part led to the oligopoly that the Australian banking system now plays host to.  National and regional governments allowed their own savings banks (such as the NSW bank or the State Bank of South Australia, for example) to be purchased by larger commercial banks, in a series of bolt-on acquisitions. I believe now – although it is easy to be wise after the fact – that these acquisitions should not have been given the go-ahead by the competition authority, as they were sowing the seeds for the oligopoly now evident in the sector.

Assessing Oligopolies
That banking in Australia is an oligopoly is hardly surprising. In his book, Principles of Economics (2008), Gregory Mankiw gives examples of oligopolies that exist in various industries in the United States based on figures provided by the U.S. Census Bureau and the Federal Trade Commission. The list is extensive. It includes breakfast cereal with a concentration of 92%[2], soft drinks with a concentration of 93%, and beer, with a concentration of 85%. These figures at least show that banking is not alone as an oligopoly.

Given that so many industries take the structure of oligopolies, why is there such an issue when banking takes a similar market structure? In short, the answer is that banks most likely play the role of scapegoats. They become an easy target for everything that is ill with the economy. 

The Herald Sun neatly captures this in one of its opinion pieces from August 2008:[3]
“Kevin Rudd[4]  goes for a crowd favourite – greedy bankers:
Kevin Rudd stands accused of bank-bashing after vowing to penalise financial institutions that lavish executives with multi-million-dollar pay packages without requiring them to follow responsible investment practises.
Mr. Rudd has asked the Australian Prudential Regulation Authority to prepare rules penalising banks that reward risky behaviour by requiring them to have greater capital reserves than those with more responsible investment practises.
…How the crowd hoots!”

The reality is that oligopolies – in the banking industry or otherwise - aren’t as bad as the media and others would like to portray. A cursory glance at interest rates offered by the “four pillars” shows that they offer consumers a reasonably good spread of interest rates on loans over the same period[5]. By the principles of an oligopoly, all would be striving to offer as small a spread as possible. I still contend that the Australian banking system is an oligopoly but that it is in fact quickly heading towards a monopoly.

In 2012, the range between the market capitalizations of each of the four pillars varied between $30bn and $35bn. As of May 2014, the range is over $51bn, with the Commonweath Bank opening up a considerable distance between its valuation and that of the National Australia Bank (see chart on next page) Likewise, in 2012, the range between the leading two banks, Commonwealth Bank and Westpac Banking Corporation was approximately $20bn. It is now $25bn.

Bank
Market Cap (May 2014)
Commonwealth Bank
$130bn
Westpac Banking Corporation
$105bn
Australia and New Zealand Banking Group
$91bn
National Australia Bank
$79bn
Source: Bloomberg
An Increasing Need for Regulation
The “four pillars” which began as “the six pillars” (when it included Australia’s two large insurance firms), seem sacred to successive governments in Australia. Various excuses are given for the sanctity of the four. The latest on record was given by the head of the current government’s financial system inquiry, David Murray, whose reasoning goes: “if you relax the four pillars policy and went to three, inevitably in some unforeseen circumstance you would finish up having to go to two. And at two, there is definitely a too big to fail question.” So much for sound economic analysis.

What Murray and others in government consistently fail to recognize is that countries which suffered massive banking crises in the not-too-distant past all had banking oligopolies which, in fact, were less concentrated than Australia’s (Australia’s being the most concentrated banking sector in the world)[6]. Given this is the case, it would seem like negligence to ignore the fact that Australia’s banking industry is need of a regulatory shake-up. However, despite the glaring need, there is still opposition from the big four and even the financial regulator in Australia.

When the IMF provided an assessment of Australia’s big 4 in November 2012, the response from those in Australia was predictably hostile. After suggesting in the report that the big 4 should possibly hold more capital to further bolster financial system stability, “Australian Prudential Regulation Authority chairman John Laker and ANZ’s John Morschel rejected the finding, and Westpac’s Lindsay Maxsted warned the banking industry risked becoming globally uncompetitive if there was a further increase in capital requirements.”[7] Anyone who has taken a look at the Australian banking sector would know that these individuals aren’t overly concerned with competition. Capital requirements often have leaders of the banking industry come over in a fit of competitive spirit, however. The IMF’s report was also met with the common lambast that Australian banks are “amongst the most highly capitalized in the world.”

Further Down the Road
As I have pointed out elsewhere in this paper, Australia’s banking industry is not only an oligopoly but it appears to be heading towards a monopoly (or at least a duopoly). The financial industry, which is now a few times the size of Australian GDP (admittedly not unusual for most countries´ financial sector) is in desperate need of regulation. There exists a good chance that the gulf between the largest bank in the “four pillars” will open up a bigger and bigger gap between itself and the fourth biggest of the group.

The popular media in Australia often mentions politicians and financial leaders talking about the need to be competitive internationally (as Australia’s banks seek to tie up business abroad), but this ignores the fact that Australia avoids many banking crises by the very fact that it hasn’t been closely linked to the global financial system until now. By becoming more intertwined with outside banking systems, its risks become more systemic.

Australia’s authorities have failed to see that these banks are already “too big to fail.” By allowing them to grow in the same manner in which they have been until now is negligent on their part. The fifth biggest bank by assets is only around a quarter of the size of the fourth[8], meaning the hegemony is unlikely to be broken anytime soon. The Australian government needs to take action in one of any number of ways. Among potential measures which they could take are:

i)             Higher capital controls for the four pillars than other banks. In this manner, at least other banks are given an incentive to play “catch up.”
ii)            Higher capital controls for all banks, thereby making the system safer, although possibly doing little to break up the existing oligopoly.
iii)           Allow a foreign bank to take over one of the four pillars. This is probably too politically unpopular to ever happen now.
iv)           Nationalize and merge some smaller banks to create a fifth pillar.
v)            Re-regulate some sections of the financial system, such as funds, to encourage new business startup and banks to break off sections of their businesses.

Conclusion
I believe that the seeds for Australia’s banking system oligopoly were sown in the 1980s by a series of government bank sell-offs. From my reading of the literature, there was little strategy behind these sell-offs with no thought given to the consequences of what the purchase of these assets by larger commercial banks would mean for the banking system. Those changes occurred and are now impossible to undo. Given this, regulators need to look at some changes to implement before the banks’ oligopoly becomes any more dangerous to the economy at large.

The reality is that none of the measures I have suggested here are likely to be given the go ahead (with the exception of higher capital controls and probably only after it is too late). Australia’s banking system is clearly an oligopoly and becoming more entrenched in that position as time goes on. Its regulators and politicians need to force through some changes in the financial industry before it becomes the latest textbook example of how a country whose regulators failed to react to the signs before it was too late.







[1] Taken from: http://www.investopedia.com/terms/o/oligopoly.asp
[2] Meaning that the top 4 producers have a concentration of this amount.
[3] http://blogs.news.com.au/heraldsun/andrewbolt/index.php/heraldsun/comments/bash_the_greedy_scapegoat/P80/
[4] Then Prime Minister of Australia
[5] http://australia.deposits.org/
[6] http://www.tai.org.au/node/1926
[7] http://www.clmr.unsw.edu.au/article/risk/imf-reports-australias-high-compliance-international-standards-raises-concerns-over-market
[8]
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