With soaring mortgage rates expected to strain household budgets, there are calls – including from the Reserve Bank of New Zealand – for the Commerce Commission to investigate bank profits.
But rising profits and the widening margin between lending and borrowing rates mean the Reserve Bank is doing its job as much as it’s a sign of anti-competitive conduct.
The Reserve Bank’s overarching goals are to fight inflation and ensure financial stability. To achieve these, it does two things that the commission would normally frown upon.
First, the Reserve Bank runs the country’s largest legal price-fixing operation.
It does this by setting the official cash rate and by influencing banks’ expectations about its future changes. The official cash rate sets the interest rates on the deposits and loans registered banks have with the Reserve Bank, in turn affecting banks’ own lending and deposit rates.
Raising the official cash rate, and therefore the cost of borrowing, is one of the RBNZ’s principal tools for reducing inflation. However, higher interest rates can increase bank profits, not least because a low official cash rate shrinks profit margins by making it harder for banks to reduce the interest rates paid on deposits.
If ordinary competitors manipulated prices like this, the commission would investigate them for price fixing.
Price fixing to avert a meltdown
Until the 2008 Global Financial Crisis (GFC), deposit rates were closely in step with the official cash rate. When the Reserve Bank responded to the crisis by slashing the rate, mortgage and deposit rates followed suit.
But during the same period, deposit interest rates continued to track higher than the official cash rate and margins between lending and deposit rates fell significantly.
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When COVID-19 stuck in early 2020, the official cash rate fell to historic lows. But deposit rates fell harder than lending rates, with banks’ lending margins jumping dramatically.
Soaring house prices bolstered demand for loans. Meanwhile, the banks’ need to offer competitive deposit rates was dampened due to the Reserve Bank’s support of cheap wholesale funding.
Hence the Reserve Bank’s price fixing averted financial meltdowns by, in part, preserving bank profitability.
Clamping down on competition
The second thing the Reserve Bank does that the commission normally dislikes is that it restricts the entry of another competitor, by setting and enforcing the rules on which entities are able to operate as banks.
The Reserve Bank also imposes conditions on how banks operate, such as requiring them to maintain minimum levels of capital.
That way the Reserve Bank limits risk in the financial sector by stopping unsafe operators from becoming banks and ensuring existing operators operate prudently.
As in other sectors, limiting competitive entry can make existing banks more profitable. The required minimum reserves of capital can also increase profits. Indeed, limiting bank sector competition has long been, until recently at least, considered important for financial stability. It reduces banks’ incentive to boost profits by taking risky bets using depositors’ money.
As for price fixing, the commission would normally take enforcement action if an organisation deliberately restricted competitive entry. But, as discussed above, the RBNZ has solid policy rationales for its approach.
Providing a ‘reference price’
In this regard, the Reserve Bank is not alone. Governments fix medicine prices to ensure accessibility and set minimum wages to support low-wage workers. The competitive impact of pricing focal points – such as those created by minimum wages or the official cash rate – can also be seen in other sectors.
In 2017, I co-authored a study into fuel pricing that recommended a reference fuel price published on one firm’s website be removed, which promptly happened. The commission subsequently undertook its own fuel sector study, providing evidence that removing this reference price resulted in reduced fuel margins.
The official cash rate is similarly a reference price for banks to use to set their own interest rates rather than openly compete for customers. So its use by the Reserve Bank can be expected to affect banks’ profit margins.
Finding a balance
Clearly a balance is required between effectively fighting inflation and maintaining financial stability on the one hand, and promoting greater competition on the other. Strengthening bank sector competition should lead to sharper interest rates. But it will also affect how official cash rate changes feed through to wider interest rates and could lead banks to take greater risks.
So, before the commission is charged with scrutinising bank competition, consider the following questions. First, are growing bank profits due to banks acting anti-competitively, the Reserve Bank fighting inflation and preserving financial stability, or both?
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Second, if bank profits are indeed excessive and due to anti-competitive behaviour, are there measures the commission could recommend and practically implement that would improve outcomes?
Finally, if bank profits are excessive, and at least partly due to the Reserve Bank doing its job, would interventions by the commission to improve competition worsen financial stability or frustrate the fight against inflation?
Answering these questions will need both the commission and the Reserve Bank to have serious conversations about how competition policy and banking regulation can be made to work together to achieve better outcomes for both bank customers and the wider economy. Little would be gained by improving bank competition if that reduces financial stability or worsens inflation.
