Policy failure: counting the cost of switching banks
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We all want a healthy banking sector in Australia, but a lack of competition does not build up 'national champions'. (ABC News: Giulio Saggin, file photo)
Since the advent of the US-led credit crunch, speculating about how banks and other lenders will respond to interest rate rises and cuts by the Reserve Bank of Australia (RBA) has become practically a national pastime in Australia.
Australians enjoy the benefits of some significant policy successes in the area of financial regulation. For example, the vesting of power for decisions about raising or lowering the official cash rate in an independent body sensibly removed these decisions from the political sphere, where they were clearly subject to a stronger influence from short-term electoral considerations. Financial deregulation policy led to increased competition against the major banks for home loan business, which the RBA has confirmed has reduced banks' interest rate margins to a greater extent than they have been able to recover from rising banking fee income.
However, in an effective, competitive retail lending market, we would expect to see any rises or falls in lenders' underlying funding costs, including to the RBA-set cash rate, almost immediately reflected in retail costs for home loans (and other products such as credit cards). Any lenders not offering the best deal in the market would lose business to competitors offering a better deal for consumers - this is competition policy 101.
The fact that there is still room for speculation, and doubt, about whether some banks and other lenders will pass on a cut in the official cash rate to ordinary consumers indicates, quite simply, that Australia does not yet have a truly competitive retail lending market.
This is a policy failure for successive Australian governments. We all want a healthy banking sector in Australia, but a lack of competition does not build up "national champions". Instead it allows for easy profits that encourage inefficiency and ultimately reduce our financial institutions' ability to compete successfully as lean and innovative international businesses.
One of the principal reasons for this failure in implementation of competition policy is a failure to understand the role of consumers in markets. Consumers are not just passive beneficiaries of competition, but necessary drivers of that competition.
One of the most important ways in which we can drive competition is by changing to a different lender for our home loan or credit card if we are not happy with our current provider. Unfortunately, most Australian consumers currently face some substantial problems and costs if they want to switch a loan from one lender to another. Leading academic studies have shown that if consumers face search and switching costs, they are less likely to change products, even when "rationally" they stand to benefit from doing so. This in turn means that providers of those products face less pressure to adapt to consumer needs or to lower prices because, once they snare new customers, those customers are unlikely to go elsewhere. It also appears to translate into higher profitability in those industries.
One insidious practice that has crept into our home loan market is the emergence of fees to exit a loan early. Sometimes called "deferred establishment" fees, these exit fees can impose a large penalty on consumers if they decide to pay out their home loan early, for instance by refinancing with another lender. Obviously a lender incurs costs in first establishing a loan - costs that are reasonably incorporated into the price a consumer pays for that loan. However, "deferred establishment" or exit fees, in addition to in many cases being questionable in terms of whether they reflect the financial institution's costs, are bad for competition for two main reasons.
The first is that by imposing a fee upon exit rather than entry, the lender imposes a strong barrier to switching loans, locking the customer into their product with the flow-on effect of dampening competition in the market more broadly. The second reason is drawn from marketing and psychological research which tells lenders it is human nature for consumers to take into account upfront costs but have little to no regard for costs that may or may not occur in the future. Thus, by back-ending the fee and labelling it contingent on a certain event happening (exiting early), consumers are much less likely to take this cost into account in assessing the relative merits of different lending products (if they are even aware of it). As well as leading many individuals to make worse decisions about the best home loan deal for them, this also has a negative impact on competition more broadly because consumers are signaling choices that do not necessarily reflect accurately their desire for the cheaper product. The same phenomenon is often at work when consumers choose credit cards with high interest rates.
The Treasurer recently asked the House of Representatives Economics Committee to inquire into competition in the banking and non-banking sectors. In addition to well-understood supply-side concerns about market power and concentration amongst the major banks, the committee will need to grapple with demand-side issues such as home loan exit fees if its recommendations are to have a genuine hope of leading us towards a more competitive retail lending market - with the result of a fairer and more efficient financial sector for all.
Nicole Rich is director of policy and campaigns at the Consumer Action Law Centre, Melbourne.
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Comments (33)
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Bullfrog:
04 Sep 2008 9:54:51am
Well, I'm for a few more banking licenses being issued - I'm sure there are big international banks that would love to get into the Australian market. A bit more competition (with an appropriate watchdog, as we definitely don't want another sub-prime crisis) would be a good thing.
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Geoffrey_Chaucer:
04 Sep 2008 11:50:12am
"with an appropriate watchdog..."
Therein lies the problem. All our watchdogs tend to be either toothless tigers or blind referees.
For example, after long and costly investigations the ACCC found that oil companies do not gouge petrol price, and more recently it found that there is no problem with the disparity between farmgate prices and prices at the supermarket check-out. It's doubtful that a credit watchdog would perform any better.Agree (0) Alert moderator
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Water:
04 Sep 2008 11:51:43am
The point is that there is plenty of competition in the market already. We don't need any more banks. What we need is for more people to be discerning consumers. Consumers by enlarge need to show banks that they will flock to those with better products not just complain about bad products but take no action. There was an article yesterday about wizard increasing its credit card rate for NEW CUSTOMERS. So what? If we were all discerning consumers it wouldn't make a blind bit of difference. Refinancing should be a topic of discussion with your lawyer BEFORE you take out any product.
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Bullfrog:
04 Sep 2008 1:00:16pm
You are quite correct. There is a huge number of options regarding loan products. However, increased competition, appropriately monitored, might improve the range of 'better products.'
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Lament:
04 Sep 2008 1:58:56pm
Thats what Paul Keating reckons he gave us in 1983; more international competition. There is nothing at all to prevent as many banks as want to come here from setting up shop.
What happened to the competitive effect of those 16 new licences back then? They joined the cartel, kept small and went for the cream of the crop, high net worth individuals with low risk borrowing requirements and plenty of collateral.Agree (0) Alert moderator
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ram:
04 Sep 2008 10:23:12am
These loan "exit fees" are getting to be a problem. Even if a loan did not have a significant exit fee at the time the loan was made the banks seem to be able to change to rules midstream. There does not seem to be anything from stopping them from charging arbitrarly high exit fees.
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RighteousGuru:
04 Sep 2008 10:38:57am
Loan exit fee's are usually associated with the break cost the bank incurs when it repays a borrowers home loan when it is refinanced. This is because the bank usually borrows money itself to lend to the home buyer, the lender of this money will want to make the profit it was expecting to make before the loan was refinanced. If it could not make profit on its terms the loan would never have been offered in the first place. The break cost for a variable rate loan is much lower than a fixed rate so if you want to avoid break fee's, take your chances with interest rates.
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Doh:
04 Sep 2008 10:58:42am
Bollocks. Banks borrow wholesale and lend retail.
There are costs associated with releasing a mortgage and some administrative costs, but the banks have not entered into any guarantee to pay interest whether or not the loan is paid out early.Agree (0) Alert moderator
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Enough Please:
04 Sep 2008 10:59:27am
Call me old fashioned but I would have thought the profit came in the interest charged on the loan no matter how long it ran for???
Exit fees are a cop placed on top of the other fees eg search fees etc. Attendance at a settlement must cost $100 all up even including doc preparation. I have just recently refinanced and the costs were ridiculous for what is a bit of data entry and attendance at one settlementAgree (0) Alert moderator
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MCC:
04 Sep 2008 2:22:33pm
Righteous,
Just to correct you, 'break costs' may not indeed be more expensive for fixed loans than variable rate as it depends on whether the lender can on-lend the monies at a higher rate for the remaining duration of that fixed term, at the time it is repaid. The borrower will pay break fees (usually around $350) plus what is called an "interest adjustment". If the cost of borrowing has actually risen then this interest adjustment for the fixed loan in question may be 'zero'. In my business banking days in the early 90's we actually had some instances where we (the lender) paid the borrower when a fixed rate loan was repaid, & not the other way round. In respect to variable rate loans the 'break costs' in a few instances are nil but most lenders will charge upwards of $700 or a percentage of the initial loan advance. This can sometimes be literally thousands.
I have had 30 years experience in the finance & lending sector.Agree (0) Alert moderator
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cpk:
04 Sep 2008 11:04:33am
its not only the exit fee's that are applied, but when you go with a new bank, also need to pay mortgage insurace fee's, which, as i found out, is only used by the banks if the loan is defaulted on, these fee's are used to pay the fee's for a lawyer to take legal action on the default.
there should be no minimum term on a variable rate, only on a fixed rate, and mortgage insurance should be refunded to customers who havnt defaulted on a mortgage, or, at the very least used as an offset amount as consumer's pay these fee's for a service which may not be renderedAgree (0) Alert moderator
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Doh:
04 Sep 2008 12:09:17pm
No. Mortage insurance is just what it says. It means the bank can recover its losses should it suffer a shortfall when it uses its power of sale in the event of a default.
It won't be the bank's lawyers coming after you but the insurance company (sometimes the same people). Like any form of insurance the insurer has the right to take action to recover the amount it has paid out (if it thinks it can recover).
To a very large extent, this is where the losses have been in the USA.
If you have sufficient equity in your property then you should not be paying mortgage insurace. Talk to your lender.Agree (0) Alert moderator
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Robert:
04 Sep 2008 2:12:28pm
You are completely right about all the mortgage insurance stuff. Most people seem to thing that mortgage insurance means that they are insured, when it is obviously the other way around.
However in regards to the US you are a little off. Firstly, the concept of shortfall doesn't really exist over there. If you buy a million dollar house and its price falls to $10,000 all you have to do is hand the keys back to your bank and walk away as your loan and commitments are over. Thats why banks over there are more worried about people wrecking the houses when they leave as this will further decrease their value.Agree (0) Alert moderator
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Doh:
04 Sep 2008 5:35:45pm
Yes, I should have provided more detail about the US situation. Most people do not realise the difference between the US where the bank owns the property during the mortgage and Australia where the mortgage is a charge on the property.
The other little known difference is that when a bank forecloses in the US it has no right to chase the borrower for the loss. In Australia when your bank sells your property they then have the right to chase you for the loss.
My point about the US in that context is that there were mortgage insurers (by another name) who faced huge losses as a result of the melt down.Agree (0) Alert moderator
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cpk:
04 Sep 2008 3:11:01pm
while i agreed with the idea of the mortgage insurance, as i do understand that the bank, and associated insurer need to recover costs. what is unfair about it is that the insurance price, for a $200k house they charge more than 2% of the value, and this is determined on a house by house basis.
the charges for the cost of recovery should be charged at the point where someone is in default.
i have a mortgage for less that $200K and have re-financed it once, and paid nealy 10k insurance for the bank to recover cost of a mortgage if i default.
why should the consumer pay for the recovery of a defaulted mortgage before we even default on the loan, if at all we do.Agree (0) Alert moderator
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Doh:
04 Sep 2008 5:40:19pm
By having you, and many other (but not all) borrowers pay insurance that risk is removed from the bank and they don't have to charge a premium to allow for the risk of defaulting loans.
The choices are either to have enough equity to be able to sell yourself to a lender as not needing insurance, or put up with the extra payment because one way or the other the lender will want you to cover their risk.Agree (0) Alert moderator
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Flea:
04 Sep 2008 5:40:40pm
"why should the consumer pay for the recovery of a defaulted mortgage before we even default on the loan"
Because the alternative is that Banks start refusing to give loans to people who can't pay a 20% deposit because it is too risky (You only have to pay mortgage insurance if you have less deposit than this).
"the charges for the cost of recovery should be charged at the point where someone is in default. "
If someone defaults on a mortgage and the Bank can't get the full amount back because the house is now worth less than at the time the mortgage war taken out how do you expect them to get their money? I'll tell you how - from the insurance you paiud at the beginning!Agree (0) Alert moderator
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NT boy:
04 Sep 2008 11:06:48am
exit fee's should be abolished, if the banks wish to charge an upfront fee that is held in trust until completion of the load that would be one way to cover any losses they recieve from early opt out clients. and if the loan was paid out as agreed then the customer could receive the money that was held in trust plus interest.. but i doubt this would ever happen.
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insideps:
04 Sep 2008 11:24:09am
All just fiddling around the edges really.
Australian banks today make as much or more (in inflation-adjusted dollars) from "transaction fees" as they did from total banking business twenty years ago.
Why on earth should Australian banks be "competitive" in any sphere when they get our wages before we do, charge our employers to put it into the account, charge us to take it out, charge us a monthly fee just to park it, even, in many cases charge us to look to find out how much we've got.
With a racket like that going all the rest is cream and they will charge whatever they think they can get away with.
Go back to everyone being paid by cheque which can be cashed at the local supermarket for 50 cents - or for free if you are doing the weekly shopping.
See how quickly banks become competitive again when they have to "compete" with each other to get us to deposit SOME of our wages with them, rather than getting the lot up front then charging us for the privilege of spending it.Agree (2) Alert moderator
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Brad:
04 Sep 2008 1:07:33pm
This is why anybody still using a bank needs their head read. My only financial instution for the last 15 years has been a credit union. No fees, no charges, all profit for the benefit of members.
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John Michaels:
04 Sep 2008 2:08:57pm
I used a credit union and got smashed by them for business account keeping fees, debit card extensions, and finally they tried to make me take out an overdraft. Credit Unions are absolutely useless in my opinion. They tried to keep me there even after the Howard Government changed the law to make it easier for people to close their accounts. They tried to give me a 5 or 6 page document to be filled out. Credit unions are absolutely laughable.
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PShaw:
04 Sep 2008 12:23:47pm
Swap your home loan to where? Another Bank?
I think what we really need are (gasp!) a few banking regulations.Agree (0) Alert moderator
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John Michaels:
04 Sep 2008 1:47:55pm
Bank loans are complicated legal documents. The real winner when a customer gets a loan is the bank. They generally make 100 percent on their investment, in other words if you borrow $1 you pay back $2. Add as many zeros as you like. That doesn't take into account the percentage of loss on mortgage and personal loan defaults. In Asia when someone defaults on their mortgage the bank takes a picture of the house/flat/apartment and advertises it for sale in their front window. The bank that lent the money therefore has the responsibility to recoup the money.
Home loans are the premium product that a bank has for their customers. You get a home loan and you get a credit card whether you want one or not. The penalties for paying ahead on a loan seem flawed from a business perspective as they discourage the investment of surplus cash and prevent a build up period for the mortgagee in case there is some unforeseen incident that disables the ability to pay. The exit fee is designed to keep the customer trapped within that institution that they took the loan out with.
About the only ways that the Government can increase competition with the banks is to either create a Government owned bank that moves interest rates in line with the RBA or introduce legislation to force the banks to justify most details of their businesses. I get stung with a hidden transfer fee when I transfer Australian $ from overseas to Australia. At first they tried to say it was a currency transfer fee and then when I told them and showed them that it was Australian currency being transferred to Australia they told me it was an International transfer fee. They don't even show the fee on my statements. If they can't get their story straight on the simplest of things such as a money transfer then how long do you think it will take for them to actually put the customer before the shareholder?Agree (0) Alert moderator
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Lament:
04 Sep 2008 1:54:59pm
I have shopped around, and around, there will only ever be real competition when the 'watchdogs' actually do something to prevent the happy cartel that currently exists.
Given that there is so little difference between the banks perhaps we could give them what they want, size to compete internationally ie mergers. So lets merge them; nationalised and socialised they would be big enough to compete anywhere and then we can have price controlled mortgages, based on the cash rate; uummmmm, no don't want that model either.
Guess we are stuck with the present model but somehow we must force real competition.
Perhaps we should realise that banks will compete for really good low risk business and that too many borrowers have allowed themselves to become high risk/maintenance borrowers and the banks really do not want the business and price accordingly?Agree (0) Alert moderator
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alan:
04 Sep 2008 2:13:51pm
oops but why is the exit issue the thrust of most contributors, the essay is about competition and banking, I think at least.
Competition is generated by having a number of banks all seeking your business and you as a consumer choosing the one that suits your position. So if that is the case then why do we complain when the choice we made is not what it seems, is the banks fault or ours for not choosing properly.
It is our own fault that we have the current situation and we need to redress it, think about banking like buying a new car. You choose the needs for your family, you look around then you haggle for the best deal. You know that they dealer will still make a profit but you haggle over the services, the options and model.
Why not do the same thing with your bank. Your decision to withdraw and go elsewhere might not effect them but one and then two, like the old says you tell some one they tell someone and away we go!Agree (0) Alert moderator
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cpk:
04 Sep 2008 3:33:50pm
the only way to force competition between banks is to boycott a particular bank, and force there hand to take some risks in lowering the costs of there services.
then, in turn people who move there banking to the new bank, will force the hand of the others beter the current offersAgree (0) Alert moderator
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bemused:
04 Sep 2008 3:44:03pm
that, or they'll raise the risks in what they consider "safe" lending. There will always be desperate people looking for credit.
Yay - more bankruptcies.
Although, at the end of the day, that's not really the banks fault. People know what defaulting means. If it gets to the point where it is enforced then that's the individuals fault. And like i said, might mean a bargain or two for the rest of us. Personally, i feel more sorry for their creditors.Agree (0) Alert moderator
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bemused:
04 Sep 2008 3:01:42pm
A point I made on another thread that applies equally here: If banks weren't around doing their thing, how many people would be able to buy their own home? Without them a lot of people would never have any choice but to rent. They offer a service you can choose to use that allows you to do something that would not otherwise be possible for you to do and people scream that the banks are evil? It's not a community service obligation and if people don't like the service can always rent for the rest of their lives.
The everyday/business banking could be called unfair to an extent, sure. But isn't that really societies fault for making themselves dependant on banks?
I know, at the end of the day, I am thankful the banks exist and offer the services they do. Whatever their fees may be will affect which services I choose to use, and from whom, but the use of these services is a privilege, not a right.Agree (0) Alert moderator
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insideps:
04 Sep 2008 3:28:23pm
Sorry but you are wrong on two counts:
First, there are several societies today that manage to finance people into homes without the fee+interest-bearing system of Western banks. Take a look at Libya for instance.
Second, and more to the point of competition, Australians by and large today no longer have any choice in how they receive their wages; the money is paid into a financial institution.
That means the financial institution is going to get the use of that money (as deposits on hand), plus in most cases a monthly fee for the "privilege" of the customer "receiving" their wages, plus in most cases a fee when the customer withdraws funds, plus in many cases a fee when the customer simply queries their bank balance.
As a result banks no longer give a stuff about customers taking their business elsewhere - since "elsewhere" MUST be another bank or financial institution. All the disgruntled customers who leave institution "A" MUST end up at institution "B" or "C" or "D" - those transferring from "B" MUST go to "A", "C" or "D".
Since there is really no difference between what is on offer it just becomes a merry-go-round of disgruntled customers generating even more fees for the banks as they go around the circus ride.Agree (0) Alert moderator
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bemused:
04 Sep 2008 3:53:59pm
But like i said - why is it that all wages go to banks? It started out as a convenience, and then it kept growing. The banks didn't take everyone's employer captive and force them to pay everyone that way. And why should they complain? It's a little unfair to blame them for that one...
And if it was so easy for average joe to buy a house without the banks then why isn't it happening here?
No, seriously, i'd love that as an option so if there is a practical way that could work in australia then please let me know. I don't like paying fees, it's more that I accept that if i want something more than the seller wants to sell it that i can expect to pay a premium. And i don't see anything wrong with that.Agree (0) Alert moderator
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Thomas:
04 Sep 2008 5:26:48pm
just a quick note. there are some banks that don't have account keeping fees at all. eg citibank, bankwest.. only catch is you have to have regular wage going in.
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my_views:
04 Sep 2008 3:17:24pm
"Monopoly Market" if you know the meaning of that word then you will be able to clearly see that Australia as a nation where most of the business does not like compitition, and another issue where our federal gov't backing the big business organization and blocking other business organization to come to Australia which could have helped people to choose more variety and more option and cheaper price. In next 50 years I do not see its happening in Australia. Good Luck.....
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BJ:
04 Sep 2008 5:01:30pm
I downright speak for all Australians when I say that we in this country support our banking system.
Confidence in the banking system in Australia is extremely high. We have on the best banking models in the world when compared to other countries.
I believe Australia has the balance right between business risk and regulation. Let's not forget - they are not charities and never will be.
So c'mon, let's do the Aussie thing and support our hardworking banking industry.Agree (0) Alert moderator
