Global Financial Crisis, Competition and Loan Pricing in Australia. Ming-Hua Liu a, Dimitris Margaritis b* Zhuo Qiao c. Abstract

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1 Global Financial Crisis, Compeiion and Loan Pricing in Ausralia By Ming-Hua Liu a, Dimiris Margariis b* Zhuo Qiao c Absrac In his sudy, we examine he impac of he global financial crisis on he pricing of four ypes of loans in Ausralia: morgages, residenially secured small business lending, nonsecured small business lending and personal loans. We find ha afer he onse of he crisis, here has been a shif in he loan pricing mix; he markup has increased and here has been a drop in boh shor and long-erm pass-hrough from funding coss o lending raes. Closer analysis indicaes ha he drop in shorerm pass-hrough is due o he slower response of banks o increases in funding coss. We also find asymmeries in he way banks adjus lending raes in relaion o funding coss in he long-run for non-secured small business lending and personal loans. The evidence shows ha banks in Ausralia ighened lending sandards and compeed less aggressively for loans bu more for deposis in response o heighened defaul risks following he global financial crisis. JEL classificaion: G21; E43 Key Words: Ausralian banks, Error correcion model, Global financial crisis, Morgages, Personal loans, Small business loans a Faculy of Business and Law, Auckland Universiy of Technology, New Zealand. b Universiy of Auckland Business School, New Zealand. c Faculy of Business Adminisraion, Universiy of Macau, Macao, China. * Corresponding auhor. Tel.: Ex ; Fax:

2 Global Financial Crisis, Compeiion and Loan Pricing in Ausralia Absrac In his sudy, we examine he impac of he global financial crisis on he pricing of four ypes of loans in Ausralia: morgages, residenially secured small business lending, nonsecured small business lending and personal loans. We find ha afer he onse of he crisis, here has been a shif in he loan pricing mix; he markup has increased and here has been a drop in boh shor and long-erm pass-hrough from funding coss o lending raes. Closer analysis indicaes ha he drop in shorerm pass-hrough is due o he slower response of banks o increases in funding coss. We also find asymmeries in he way banks adjus lending raes in relaion o funding coss in he long-run for non-secured small business lending and personal loans. The evidence shows ha banks in Ausralia ighened lending sandards and compeed less aggressively for loans bu more for deposis in response o heighened defaul risks following he global financial crisis. 1. Inroducion On 12 December 2010, he Ausralian governmen announced a banking reform package aimed a boosing compeiion in he banking indusry afer he counry s four larges lenders raised home morgage raes well in excess of he 25 basis poins (bps) hike in he official cash rae in November The objecive of he reform package was hreefold: (1) o empower cusomers o ge a beer deal from heir banks, (2) o suppor small lenders so ha hey can compee more effecively wih he big banks, and (3) o secure he long-erm safey and susainabiliy of he financial sysem so ha loans o Ausralian households and small businesses can be reasonably priced. Effecive 1 July 2011, exi fees on new home loans were banned. And in Augus 2011, he Ausralian Governmen announced ha hey would fully implemen wihin one year all recommendaions of a 1 Reacing promply o he morgage rae increase announcemen, Ausralian Treasurer Wayne Swan said ha banks had a culure of arrogance and needed o be reined in. In heir reply he Ausralian Bankers Associaion jusified he banks decision o lif raes by almos double he official move on he grounds ha banks marginal funding coss were building up a 2 bps each monh for nearly a year since hey las moved ineres raes. 2

3 repor prepared by former Reserve Bank of Ausralia (RBA) Governor Bernie Fraser, o encourage greaer bank accoun porabiliy by cusomers of banks and oher financial insiuions. The reform package was passed in ligh of a long sanding debae abou compeiion in he marke for banking services and, in paricular, he marke for home morgages. The relaionship beween he cash rae se by he Reserve Bank of Ausralia, he counry s cenral bank, and morgage raes se by lenders had come under more inense scruiny since he onse of he crisis. In response o he global financial crisis, he cenral bank cu he official rae by a subsanial margin, from 7.25% in Augus 2008 o 3% in May However, banks did no pass on cash rae cus o borrowers in full, leading o an oucry from cusomers, commenaors and poliicians. Even he Ausralian Prime Miniser, Ms Julia Gillard, ook excepion o Ausralian bank pracices saing ha: People who are he cusomers of banks are eniled o be very angry if hey don' see ineres rae reducions passed on. A similar view was expressed by Treasurer Wayne Swan, who said ha "I hink cusomers would be righly angry if heir bank decided o wihhold any cu." Banks were also criicized by senior opposiion poliicians. According o Mr Warren Truss, leader of he Naional Pary, Home owners are painfully aware ha when ineres raes go up he banks show remarkable dexeriy in passing on he rise - in full and immediaely - bu when raes fall hey are nooriously ardy in providing relief. Greens MP, Mr Adam Band, said ha he would inroduce 3

4 new laws o o require banks o offer morgages ha will pass on any RBA ineres rae cus in full. Banks responded o he criicism arguing ha heir funding coss had increased subsanially relaive o he cash rae during he global financial crisis, and herefore, i would be misleading o compare lending raes and he official policy rae se by he cenral bank. According o he Ausralian Bankers Associaion (ABA), banks in Ausralia have a responsibiliy o ensure ha he banking sysem remains safe and o persuade foreign invesors o lend money o Ausralian banks. Oherwise, banks in Ausralia will no have enough money o lend o households and small businesses. The chief execuive of he ABA, Mr David Bell, commened ha a srong banking sysem requires solid levels of profiabiliy and ha if Ausralian banks credi raings are lowered by raing agencies, he banks mus pay a higher risk premium for funding. Inernaional daa show ha he pass-hrough from official o bank ineres raes has come under a lo of pressure during he financial crisis. Large drops in pass-hrough raes have been observed widely, especially in counries where widespread bank failures or naionalizaions have seen bank raings being downgraded and access o long-erm funding severely resrained. In conras, wih sronger balance shees Ausralian banks have been more resilien in heir lending pracices. For example, during he second half of 2008, he RBA cu he official cash rae by a oal of 300 basis poins, and he average morgage rae fell by 200 basis poins. On he oher hand, in he period Augus 2007 o December 2008, he U.S. Fed cu he federal funds rae by 500 basis poins during, bu he average morgage rae decreased by a mere 15 basis poins. 4

5 To shed more ligh on he loan pricing debae, in his paper, we examine how banks in Ausralia price he four main ypes of reail lending in response o changes in he cos of funds. The four ypes of loans are floaing morgages, small business loans secured by propery, non-secured small business loans and personal loans. Specifically, we examine: (1) he long-erm relaionship beween lending raes and he cos of funds; (2) he shorerm pass-hrough from changes in funding coss o lending raes; (3) wheher here is an asymmery in boh he shor and long-erm response of banks lending raes o changes in heir cos of funds; and (4) he impac of he global financial crisis on he long- and shorerm relaionship beween lending raes and he cos of funds. In he lieraure, several sudies have examined he relaionship beween bank lending raes and deposi raes se by banks and official policy raes se by he cenral bank (see for example, Heffernan (1997), Hofmann and Mizen (2004), Sander and Kleimerier (2004), Kleimerier and Sander (2006), Payne (2007), De Graeve e al. (2007), Liu e al. (2008), Chong (2010)). Some sudies have examined he relaionship beween bank reail raes and wholesale marke raes (e.g., Hannan and Berger (1991), Newmark and Shape (1992), Chong e al. (2006), Wang and Thi (2010)), while oher papers have examined he relaionship beween lending raes and he cos of funds (e.g., Scholnick (1996), Sorensen and Werner (2006), Liu e al. (2011)). Ye he evidence so far for analyzing he effecs of he global financial crisis on ineres rae pass-hrough behavior by banks appears o be limied o a few cenral bank sudies focusing on he adjusmen of reail bank ineres raes o changes in official policy raes (see ECB (2009)). 5

6 Our resuls show ha he global financial crisis has had an effec on he way Ausralian banks se lending raes; markups have increased, he degree of long-erm pass-hrough has fallen for all ypes of lending we consider, and he degree of shorerm pass-hrough has also decreased, especially for small business loans and personal loans. Closer analysis reveals an ineresing paern in he response of banks o changes in heir funding coss. Prior o he crisis, banks passed a large chunk of funding coss increases immediaely o heir cusomers bu very lile of cos reducions while mainaining relaively low markups. This pracice appears o have been reversed during he financial crisis. Banks responded o a squeeze in ne ineres margins early in he financial crisis by raising markups. Our analysis shows ha higher markups have provided banks wih exra cushion o accommodae funding cos pressures. By mainaining higher markups banks have been able o pass on a larger (smaller) fracion of official rae cus (hikes) o heir cusomers. 2 This pracice is more eviden in he more compeiive and high profile segmen of he lending marke (i.e. morgages). I is marginally significan for business lending, and i is no significan in he leas compeiive marke segmen (i.e. personal loans). We also find differences in he equilibrium adjusmen speed of lending raes in relaion o funding coss. Banks adjus business lending raes faser when hey are below equilibrium in relaion o heir funding coss raher han when hey are above equilibrium. On he oher hand, hey adjus personal loan raes faser when hey are above raher han below equilibrium. Overall hese resuls are indicaive of how banks are compeing across 2 Presumably such pricing mix should prove useful for banks o sem public opinion and poliical pressures abou heir lending policies. 6

7 differen segmens of he lending marke; he residenial morgage segmen being he mos compeiive and personal loans he leas compeiive. The res of he paper is organized as follows: Secion 2 provides some background informaion on he Ausralian banking sysem. Secion 3 oulines he mehodology used in his sudy. Secion 4 discusses he daa and empirical resuls. Secion 5 concludes he paper. 2. The Ausralian banking sysem In 2010, he World Economic Forum s financial developmen repor ranked Ausralia 5 h among he world s 57 leading financial sysems. The Ausralian banking sysem, wih 56 banks and oal asses of A$2.7 rillion, is dominaed by he four big banks; Ausralia and New Zealand Bank (ANZ), Commonwealh Bank of Ausralia (CBA), Naional Ausralia Bank (NAB) and Wespac Banking Corporaion (WBC). They accoun for over 77% of banking asses in Ausralia while he oher eigh domesic banks accoun for abou 9%. Foreign banks are well represened, as a 2010 here were 9 foreign subsidiary banks and 35 foreign branch banks, accouning for abou 13% of banking asses. While a number of hem are acive in he reail banking secor, he majoriy are in commercial banking and invesmen banking (see Ausralian Trade Commission (2011)). The op four foreign banks are ING Bank (Ausralia), Ciigroup, HSBC Ausralia and Rabobank Ausralia. Ausralian banks are among he mos profiable, healhy and leas affeced by he global financial crisis in he world. Among he Top-100 banks in he world (ranked by asses), 7

8 only nine banks are raed AA or higher by Sandard & Poor s and four ou of he nine banks are from Ausralia. Consumer loans have been growing rapidly in Ausralia over he pas few decades. As a Sepember 2010, oal consumer credi amouned o A$1.1 rillion, accouning for 70% of all bank loans and advances in Ausralia. The consumer loan marke is dominaed even more by he big four banks, wih a marke share of 87%. The oher domesic banks accoun for abou 7% and foreign banks for 5% of consumer loans exended by banks. The majoriy of consumer lending is morgage lending, accouning for 89% as a Sepember Housing loans have grown a an average rae of 15% per year over he wo decades o 2007 and by 8% afer he onse of he global financial crisis. The range of morgage producs has also expanded rapidly. They include home equiy loans, low-doc loans, high loan-o-value raio loans, ineresonly loans as well as niche producs such as non-conforming, shared appreciaion and reverse morgages. Sub-prime equivalen morgages accouned for less han 2% of morgages in 2007 and almos all were issued by non-bank financial insiuions (see RBA (2010), (2011)). Securiizaion accouned for over 20% of new housing loans as a 2007 (RBA (2010)). I is mainly used by non-bank lenders such as morgage originaors as a source of funding since hey do no have a balance shee or a capial base o finance heir lending. Afer he onse of he financial crisis, business models relying on securiizaion were no longer viable. As a resul, some non-bank financial insiuions eiher sopped lending or were 8

9 acquired by larger insiuions. However, heir wihdrawal had lile impac on he housing loan marke as he major banks were able o fill he gap and increased heir marke share o over 75%. Unlike many oher counries, housing loans in Ausralia are priced mosly on a variable rae of ineres. Hisorically, 75% of morgages are wrien under a floaing rae and mos of he remaining morgages have raes fixed for less han five years. Fixed-rae morgages have almos always come wih resricions on prepaymens whereas floaing-rae morgages provide homeowners in Ausralia wih greaer flexibiliy in making prepaymens. The araciveness of his flexibiliy is furher enhanced by he fac ha ineres paymens for owner-occupied propery are no ax-deducible (see RBA (2010)). Small businesses in Ausralia, like elsewhere, rely on banks and oher ypes of financial insiuions for deb financing as hey have no access o capial markes. Mos small business lending in Ausralia is secured by residenial propery. As here is no proper definiion of small business lending, he wo measures adoped by he Reserve Bank of Ausralia are: (1) lending o unincorporaed enerprises; and (2) loans wih an iniial value of less han A$2 million. I is assumed ha loans more han A$2 million are exended o larger businesses whereas loans less han A$2 million are made o small businesses. Using hese wo measures, official saisics show ha lending o small business grew seadily over recen decades o 2008, and he ousanding amoun has remained virually unchanged afer

10 As a Sepember 2010, he amoun of all business loans smaller han A$2 million was abou A$200 billion, accouning for around 30% of oal bank loans o business. Once again, he big banks accouned for he majoriy (86%) of small business lending, he smaller banks accouned for mos of he remaining loans. Foreign banks marke share is insignifican as hey do no have a sizable branch nework (see RBA (2011)). Mos of he lending o small businesses (67%) is done hrough commercial bills and oher loans wih floaing ineres raes, while he remaining 33% of lending is priced a fixed raes wih an original mauriy beween one and five years (RBA (2011)). In erms of funding, banks in Ausralia rely on deposis as well as on domesic and inernaional capial markes; and he funding mix was quie sable before he crisis (see Brown e al. (2010)). Table 1 shows he composiion of banks funding in Ausralia. The able shows ha in response o he global financial crisis, boh regional banks and he major banks in Ausralia have reduced heir reliance on shorerm capial marke borrowing and securiizaion and increased heir domesic deposis and long-erm capial marke borrowings. This is especially rue for he regional banks and, o a lesser exen, for foreign-owned banks. [INSERT TABLE 1 ABOUT HERE] Deposis and long-erm deb are ypically regarded as more sable albei more expensive sources of funding han shorerm deb. As a resul, compeiion for deposis, erm deposis in paricular, has inensified in Ausralia since mid-2008, leading o a significan increase in deposi raes relaive o he policy rae se by he cenral bank, he cash rae. 10

11 Before he onse of he global financial crisis, deposi raes were abou 150 basis poins below he cash rae. During he crisis, he cos of banks new deposis was only slighly below he cash rae. For example, he average erm-deposi special rae -- he mos relevan rae for erm deposi pricing (Brown e al. (2010)) -- was over 70 basis poins above he benchmark raes for deb of equivalen erms in lae 2010, compared wih 60 basis poins prior o he financial crisis. For acall savings deposis, he average rae was 40 basis poins below he cash rae in lae 2010, compared wih 100 basis poins below he cash rae prior o he financial crisis (see RBA (2010)). Banks lending raes have also risen relaive o he cash rae during he crisis, wih increases being he larges for business and personal loans (see Brown e al. (2010)). Abou wo-hirds of business loan raes are ied o he bank bill swap rae (Deans and Sewar (2012)). 3. Mehodology In his paper, we examine he relaionship beween four ypes of lending raes and he cos of funds boh in he long run and in he shor run, wih paricular emphasis on he effecs of he global financial crisis on bank pricing behavior in Ausralia. Firsly, he long-erm relaionship beween he lending rae and he cos of funds is specified as follows (see Scholnick (1996) and Chong e al. (2006)): y * 0 1x 2D 3D x (1) where y is he lending rae; x represens he cos of funds; and D is a dummy variable for he recen global financial crisis. I is equal o 0 for he period prior o he bankrupcy of Lehman Brohers in Sepember 2008 and 1 for he period afer. is he error erm. 0 measures he markup and 1 measures he degree of he long-erm pass-hrough. 11

12 When 1 is equal o one, he long-run adjusmen is complee (see Rousseas (1985)). 2 measures he change in he mark-up and 3 capures he change in he slope, i.e. he change in long-erm pass-hrough afer Sepember Secondly, o sudy he shorrun relaionship beween he various lending raes and he cos of funds, we use he sandard wo-sep Engle-Granger error-correcion model (ECM). The ECM represenaion is as follows: y x D * x D * (2) where denoes he firsdifference operaor; 1 is he residual of he long-erm relaionship given by Equaion (1) and i represens he degree of disequilibrium a ime 1 ; D is a dummy variable for he global financial crisis as menioned above; and is he disurbance erm. 1 measures he response of lending raes o changes in he cos of funds in he shor erm (i.e., wihin a one-monh period), and 2 capures he error correcion adjusmen speed when raes are away from heir long-erm equilibrium level wih he cos of funds. 3 measures he change in he degree of pass-hrough in he shorerm and 4 capures he change in he equilibrium adjusmen speed during he crisis period. Thirdly, we exend he error-correcion model o incorporae asymmeries in lending rae adjusmens. We assess he shorerm response of lending raes o changes in funding coss, separaing funding cos increases from decreases, for boh periods before and afer he onse of he financial crisis. And we examine if here is a significan difference in he 12

13 adjusmen speed when lending raes are above han below heir long-erm equilibrium relaionship wih he cos of funds. The asymmeric dynamic adjusmen model for lending raes is expressed as: y x x (1 ) x D x D (3) where 1 measures he impac response o increases in funding coss ( x ); 1 measures he impac response following decreases in funding coss ( x ); and 3 and 3 assess if here are any changes in he associaed impac responses afer Sepember measures he error correcion adjusmen speed when he lending raes are above heir equilibrium relaionship wih funding coss; measures he error correcion adjusmen speed when he lending raes are below heir equilibrium relaionship wih funding coss; and is a dummy variable se equal o 1 if he residual error ( 1 ) is posiive and 0 oherwise. We use Wald ess o es for asymmeries in he relevan response coefficiens, 2 i.e., 1 = 1 (equaliy of shorerm pass-hrough for he period before he crisis), (equaliy of shorerm pass-hrough during he crisis) and 2 = 2 (equaliy of equilibrium adjusmen speed). 4. Daa and analysis of resuls 4.1 The daa The monhly ineres rae daa on he four ypes of lending raes (sandard floaing-rae morgage rae, secured and non-secured small business variable lending raes for erm loans, variable personal lending rae for erm loans) and various funding coss (average erm-deposi rae, average erm-deposi special rae, 6-monh overnigh indexed swap 13

14 rae) were downloaded from he Reserve Bank of Ausralia s daabase. The average ermdeposi rae is he average rae of A$10,000 erm deposis across all erms offered by he five larges banks in Ausralia, including boh he adverised special and regular raes. The average erm-deposi special rae is a weighed average rae of he five larges banks' special raes on A$10,000 erm deposis of all erms. As he average erm-deposi raes of all erms are only available from February 2002, our sampling period is from February 2002 o July 2012, covering a ime span of abou 11 years. The sample size is 126 monhs. To measure he impac of he global financial crisis, we examine bank lending behavior over February 2002 Sepember 2008 (i.e., prior o he bankrupcy of Lehman Brohers) and Ocober 2008 July 2012 (i.e., afer he bankrupcy of Lehman Brohers). 3 Figure 1 presens a ime plo of he daa series over he sampling period. [INSERT FIGURE 1 ABOUT HERE] Table 2 provides descripive saisics for he daa over he enire sample period. As expeced lending raes for floaing-rae morgages are he lowes and for personal loans are he highes. Residenially-secured small business loans have lower borrowing cos han hose of non-secured loans. [INSERT TABLE 2 ABOUT HERE] 3 ZivoAndrews uni roo ess (no repored in he paper) confirm ha a srucural break in he series occurred in Ocober

15 The average erm-deposi rae over he sampling period is 4.00% per annum. The average special erm-deposi rae is much higher a 5.46% while he average six-monh fixed swap rae is a 5.09%. 4 In comparison, he average lending raes are 7.31% for floaingrae morgage raes, 7.91% and 8.57% for secured and non-secured small business loans, respecively, while he average rae for personal loans is he highes a 13.16% per year. Funding coss have generally been lower during he crisis period. 5 For example, he average erm-deposi rae during he crisis period a 3.89% per annum is 17 basis poins lower han he rae prevailed prior o he crisis. The special erm-deposi rae a 5.44% during he crisis period is 2 bps lower han he rae before he crisis. During he crisis period he six-monh swap rae a 3.79% is 176 bps lower han he rae before he crisis. On he lending side, he average floaing morgage lending rae during he crisis is 36 bps lower a 7.08% han he average rae prior o he crisis. Bu he spread wih he cash rae has increased from 121 bps prior o he crisis o 292 bps during he crisis. The average lending raes for small business and personal loans are much higher in he second period, a 64bps, 78 bps and 222 bps for secured small business lending, non-secured small business lending and personal lending, respecively. The pair-wise correlaion coefficiens beween he four ypes of lending raes and cos of funds measures are shown in Table 3. Among he lending raes, he floaing morgage 4 The average cash rae se by he Reserve Bank of Ausralia over he sampling period was 5.12% and he median rae was 5.25% per annum. The mean and median for he cash rae for he periods prior o and during he crisis are 4.16% and 4.5% per annum, respecively. 5 To save space, we do no repor he descripive saisics for he wo sub periods in Table 1. 15

16 rae has he sronges correlaion wih he hree measures of cos of funds. The correlaion coefficien beween he secured small business lending rae and he hree measures of cos of funds is slighly higher han ha for he non-secured small business lending rae. [INSERT TABLE 3 ABOUT HERE] 4.2 The long-erm relaionship To analyze he long-erm relaionship beween he cos of funds and he four ypes of lending raes, we esimae Equaion (1) using fully-modified OLS (FMOLS) and repor he resuls in Table 4. 6 Panel A repors resuls using he swap rae as a measure of funding coss. Panel B repors resuls using he special deposi rae as a measure of funding coss whereas Panel C repors resuls using boh he swap rae and special deposi rae as measures of he cos of funds. [INSERT TABLE 4 ABOUT HERE] Table 4 shows ha he markup for all four ypes of lending raes has increased as a resul of he global financial crisis, wih he larges increase esimaed for personal loans. For small business loans, he increase in markup for non-secured loans is slighly higher han for secured loans. The increase in markup afer he onse of he global financial crisis is saisically significan for all four ypes of loans. 6 Preliminary analysis using a baery of ess -- i.e. uni roo ess (ADF, Saikkonen and Lükepohl (2002)), Granger causaliy, and coinegraion ess (Engle-Granger, Johansen, Saikkonen and Lükepohl (2000)) indicaed ha: (a) changes in he cos of funds cause lending raes o change; (b) all ineres rae series are uniroo I(1) processes; and (c) all lending raes are coinegraed wih he cos of funds. In carrying ou his analysis we have allowed for srucural change using a shif dummy. The resuls of hese ess are no repored here bu are available from he auhors upon reques. 16

17 Before he financial crisis, he markup for secured business lending was lower han ha for morgages. However, afer he onse of he global financial crisis, he opposie is rue. The difference in markup beween morgage raes and he secured small business lending raes has increased, ranging from 171 o 198 bps (171 bps in Panel A, 198 bps in Panel B and 181 in Panel C). This is consisen wih an esimae of 180 basis poins by he Reserve Bank of Ausralia as a lae According o he Reserve Bank of Ausralia, he fac ha lending raes on residenially secured small business loans are higher han lending raes on residenially secured housing loans is a common concern of small businesses in Ausralia (RBA (2011)). The difference in markup beween home morgages and he oher ypes of loans reflecs he more risky naure of lending across he differen segmens of he marke. And as small business lending and personal loans became riskier during he financial crisis, his discrepancy accenuaed furher. Prior o he global financial crisis, banks in Ausralia compeed aggressively for morgages and small business loans. Afer he onse of he global financial crisis, he non-performing small business loans as a share of banks oal small business loan porfolio increased from under 1% beween 2005 and 2007 o 2.5% in Sepember In response, banks began o ighen lending sandards, reduce he loan growh rae and increase risk margins. 7 For example, banks imposed higher loan-o- 7 Alhough lending o small businesses and individuals may involve more non-ineres expenses han morgages, he exra expense is ofen recovered hrough fees ha banks charge when processing he loan applicaion. Due o daa limiaions, we could no include such fees in our sudy. 17

18 valuaion raios, required more sringen collaerals and higher ineres coverage raios. As a resul, he oal amoun of small business loans, wih a size of less han A$2 million, remained lile changed a A$200 billion and he amoun of loans exended o unincorporaed businesses remained a abou A$100 billion beween early 2008 and Sepember The slowdown in credi growh o small businesses also refleced demand facors. Higher uncerainy abou he fuure of he global economy and demand for heir producs and services led small businesses o reduce heir capial expendiures and financial leverage. In 2009, 82% of small businesses surveyed by PwC/Eas & Parners Business Baromeer were concerned abou he availabiliy of credi, bu by 2010, his number dropped o 37%. Small businesses were more concerned wih revenues, fuure cash flows and he global economic oulook insead of he availabiliy of credi according o various surveys (RBA (2011)). Anoher reason for he difference in he markup beween home morgage and secured small business loans is he higher economic and/or regulaory capial ha banks mus se aside for such loans. Small business loans have higher expeced losses as well as unexpeced losses. Higher expeced losses will lead o higher provision for loan losses and higher unexpeced losses will lead o higher economic capial and/or regulaory capial ha banks mus se aside o proec hemselves from bankrupcy. According o RBA (2011), he probabiliy of defaul of small business loans is more han wo imes higher han ha of sandard morgages. Furher, he loss given defaul rae for small 18

19 business loans is close o 30% of he loan s value versus 20% of housing loans. According o he BIS capial adequacy requiremen, morgage carries risk weighing of 50%, whereas oher ypes of lending have a 100% risk weighing in erms of credi risk. In Ausralia, commercial banks ypically hold abou hree imes as much economic capial agains small business lending as agains residenial morgages (RBA (2011)). Similar argumens can be reasonably made for he difference in markup beween residenially secured morgage raes and unsecured small business lending raes, as well as for he markup difference beween residenially secured morgage raes and personal loan raes. Prior o he financial crisis, he degree of pass-hrough for he four ypes of loans we consider is esimaed o be abou one. Panel C of Table 4 shows ha he relaive beween he swap rae and special deposi rae range from 0.84 and 0.23 for morgages o 0.39 and 0.73 for personal loans. Similarly he relaive conribuion of he swap rae and special deposi rae o pass-hrough are 0.81 and 0.34, respecively, for secured business loans and 0.78 and 0.36 for non-secured business loans. These resuls show ha banks in Ausralia price differen ypes of loans agains differen measures or benchmarks of cos of funds. The floaing-rae morgages and small business lending (secured or non-secured) are priced more on he basis of he six-monh swap rae whereas personal loans are priced more on he basis of he average erm-deposi special rae. 19

20 Afer he onse of he global financial crisis, he degree of he long-erm pass-hrough has decreased for all four ypes of loans. The drop in pass-hrough is greaer for secured and non-secured small business loans and for personal loans as compared o morgages. This is consisen across all measures of cos of funds in Panels A, B and C. 8 The degree of long-erm pass hrough depends on he degree of marke power of lenders (see De Bond, 2002). Berger and Hannan (1989) and Pilloff and Rhoades (2002) show ha in markes where a low degree of marke power exiss, loan raes and/or bank profis are also lower, and vice versa. The decrease in he long-erm pass-hrough rae for all ypes of loans in he crisis period may reflec a he margin he lower degree of compeiion among banks as hey ighen lending sandards and rejec loan applicaions and rely more heavily on fixed markups in heir loan pricing mix in he face of increased credi risks. The finding ha he decrease in pass-hrough during he crisis was lowes for morgages shows ha banks in Ausralia ypically have a lower degree of marke power in his segmen of he marke. Morgages are popular for boh banks and non-bank financial insiuions, big or small. As a plain-vanilla produc, morgages are much easier o evaluae in erms of he crediworhiness of he borrower as well as he value of collaeral. Our resuls are consisen wih he observaion by he Reserve Bank of 8 This finding is also consisen wih he view of RBA (see RBA (2010)) ha afer he onse of he global financial crisis and as a resul of a significan increase in banks exposures o liquidiy and credi risks here has been some lessening in he degree of compeiion on he lending side bu compeiion o arac funds has increased. 20

21 Ausralia (2010) ha he supply of credi in Ausralia, paricularly lending for housing, has generally remained adequae. On he oher hand, small business and personal loans are less aracive as a resul of heir uncerain cash flows and high ransacion coss. Our empirical resuls suppor he view by he Reserve Bank of Ausralia ha compeiion for small business lending eased afer he onse of he global financial crisis (RBA (2011)). According o RBA, compeiion in lending ends o be cyclical. When he economy is growing srongly, banks are more likely o compee aggressively for business lending by relaxing lending sandards and reducing heir margins. On he oher hand, when uncerainy abou he economic oulook increases and loan losses sar o increase, banks are more likely o adop a more conservaive approach. Afer he onse of he global financial crisis, funding became a main concern for banks worldwide. Reflecing he global rend, in Ausralia, banks appeared o have also swiched from compeing aggressively for loans o compeing for core deposis (see also foonoe 8 above). While funding coss have decreased in absolue erms as discussed before, hey have increased relaive o he official cash rae. Table 5 shows ha he spread beween he rae for bonus savings accouns and he cash rae increased from 185 bps per annum o 0 bps beween December 2007 and December Similarly, he spread beween he special erm-deposi rae and he cash rae 21

22 increased from 0 bps in December 2007 o 240 bps in December 2009, before dropping o 140 bps in December [INSERT TABLE 5 ABOUT HERE] 4.3 The shorerm relaionship The shorrun dynamics are modeled by an error-correcion model (ECM). The resuls for he symmeric ECM (Equaion 2) are repored in Table 6. 9 [INSERT TABLE 6 ABOUT HERE] Table 6 shows ha prior o he global financial crisis, he degree of shorerm passhrough (combined effec of he swap and erm-deposi special raes) is very similar for all four ypes of lending. The effec of he erm-deposi special rae change is only significan for personal loans. In his case, he magniude of he special erm-deposi rae effec is greaer han he effec of he swap rae. Afer he onse of he global financial crisis, he shorerm degree of pass-hrough has deceased for personal loans and for boh ypes of small business loans, bu has remained unchanged for morgages. These changes are consisen wih a reassessmen of credi risks across differen segmens of he marke by banks afer he onse of he global financial crisis. 9 We only repor resuls for a model ha uses boh he swap rae and he special deposi rae as measures of bank coss. We allow for shorerm response coefficiens o be differen beween he wo periods bu limi his o he response of he special deposi rae. There was no saisical suppor for allowing changes in he response of boh measures of funding coss across he wo periods. We have no allowed changes in he error correcion adjusmen coefficiens beween he wo periods as here was no saisical suppor for differen adjusmen speeds. We also included lagged changes of x and y in he specificaion of Equaion (2) bu hey were no saisically significan. We conclude ha our empirical specificaion is sufficien in erms of capuring he dynamics of bank adjusmen coss in he pricing of he various ypes of loans. 22

23 Due o significan informaion asymmeries presen in small business lending and personal loans, banks ypically encouner boh adverse selecion and moral hazard problems if hey decide o increase lending raes in response o rising funding cos pressures (see Sigliz and Weiss, 1981). Afer he onse of he global financial crisis, he uncerainy abou he global economy has increased enormously and small businesses have been grealy concerned abou he demand for heir producs and services and heir cash flows. Faced wih higher borrower defaul probabiliy and loss given defaul, banks have been relucan o raise lending raes significanly over a shor period of ime. Insead, lenders are more likely o raion he amoun of credi exended when here is an increase in credi risks. This is consisen wih he fac ha lending o small business has remained almos unchanged during he crisis period. Thus confroned wih increases in non-performing loans and uncerainy abou he global economic oulook, banks have no been as aggressive as before he crisis in lending o small businesses. RBA (2011) concludes ha lower lending by smaller banks and nonbank financial insiuions is likely o have been he main reason for reduced compeiion in he marke for small business loans. Loans exended by non-bank financial insiuions decreased by almos 50% afer he onse of he global financial crisis and lending by smaller banks was much lower han is peak in The major banks in Ausralia, however, coninued o increase heir lending o small business, resuling in a significan increase in heir marke share in he secor. 23

24 Furher, he price elasiciy of demand for morgages is ypically higher han ha for small business loans and personal loans. Anecdoal evidence indicaes ha home loan applicans are very sensiive o even sligh variaions in morgage raes and end o bargain hun. On he oher hand, he search and swiching coss for small business and personal loan borrowers are much higher. Afer he onse of he global financial crisis and wih he exi of small banks and non-bank financial insiuions from he small business loan marke, small business borrowers were lef wih less choice when i comes o shopping around for he bes deals. The range of ineres raes charged for small business loans has widened afer he onse of he financial crisis. In June 2007, he spread beween he highes and lowes rae charged by he major Ausralian banks was 35 bps, compared wih 120 bps in January 2011, providing furher evidence of non-price compeiion in his marke segmen (RBA, 2011). Lending fees on loans and bank bill faciliies increased by abou 24% in he 2009 financial year and fees on undrawn faciliies increased significanly as banks aemped o re-price heir exposures o credi and liquidiy risks. In comparison, bank fee income from businesses, small and large, increased by 13% during he 2009 financial year. As lending fees accouned for abou half of oal fees on businesses, i mean ha oher fees such as merchan service fees and fees on deposi accouns remained more or less unchanged. Table 6 shows ha, as expeced, he esimaes of he error correcion coefficien are negaive and saisically significan for all four ypes of loans. Lending raes are mean- 24

25 revering o heir long-run equilibrium relaionship wih he cos of funds; i.e., hey end o adjus upwards when hey are below he long-erm equilibrium level and adjus downwards when hey are above heir long-erm equilibrium level. The speed of adjusmen o equilibrium is faser for morgages compared o he oher ypes of lending. We find no evidence of significan changes in he speed of adjusmen afer he onse of he global financial crisis. 4.4 Asymmeric adjusmen The resuls of he asymmeric adjusmen model (Equaion 3) are repored in Table They reveal some ineresing paerns in banks pricing behavior. For he period prior o he crisis we find ha banks were quick o raise lending raes when he cos of funds was going up bu very slow o lower hem when he cos of funds was going down. The difference in he asymmeric response of banks o funding cos changes is saisically significan (a 5%) for all he four ypes of lending we consider. Bu his paern appears o have been reversed during he crisis period. We find ha banks appear o be a lo slower in responding o funding cos increases and much faser in passing on funding cos reducions o heir cusomers. And his difference in response paern is saisically significan for morgages (a 5%) and for secured and non-secured business lending (a 10%). However, i is no significan for personal loans. This finding indicaes ha he drop in pass-hrough during he crisis period we repored earlier is predominanly driven by he (slower) response of banks o pass on increases raher han decreases in funding coss o heir cusomers. 10 We repor resuls for a model ha uses he special deposi rae as a measure of funding coss for personal loans and he swap rae as a measure of funding coss for he oher hree ypes of lending. There was no saisical suppor for using boh measures of funding coss in he specificaion of he asymmeric model. 25

26 Regarding he asymmery in he long-run adjusmen of lending raes o changes in funding coss, we find evidence of saisically significan asymmeric adjusmen speed for non-secured small business lending and personal loans bu no for morgages or residenial morgage-secured small business lending. Adjusmen appears o be slower when non-secured loan raes are above equilibrium in relaion o funding coss han when hey are below, indicaing ha banks adjus faser lending raes up han down over he long-run. The opposie is rue for personal loans. In his insance, banks are closing he gap beween acual and desired lending raes faser when raes are above raher han below heir desired level. These asymmeries are saisically significan a 10% level of significance. [INSERT TABLE 7 ABOUT HERE] Our findings are indicaive of he compeiion among banks for marke share in he highly popular residenial morgage marke. 5. Conclusion In his paper, we have examined how banks in Ausralia price heir loans, focusing on changes in pricing behavior ha may have occurred afer he onse of he global financial crisis. In paricular, we examined: (a) changes in he pricing mix, markup versus passhrough, beween he wo periods; (b) he long-erm pass-hrough from cos of funds o 26

27 lending raes; (c) he shorerm pass-hrough of changes in funding coss; and (d) asymmeries in loan pricing adjusmen speed and shorerm pass-hrough. We find ha afer onse of he global financial crisis, he markup has increased, he degree of long-erm pass-hrough has fallen for all four ypes of lending we consider, and he degree of shorerm pass-hrough has remained unchanged for morgages, bu has decreased for small business loans and personal loans. Closer analysis indicaes he drop in pass-hrough during he crisis period is concenraed in he slower response of banks in passing on increases in funding coss. The drop in pass-hrough is parly offse by banks faser response in passing on reducions in funding coss o heir cusomers. Alhough he RBA has reduced he policy rae significanly since he onse of he global financial crisis, boh he banks funding cos relaive o he official policy rae and lending risks have increased. Banks appear o have absorbed increases in heir cos srucure by lifing he markup in heir loan pricing mix early in he crisis period. The global financial crisis has reduced availabiliy of funds o banks. Wih securiizaion ou of he quesion, banks in Ausralia, like hose in oher counries, were forced o compee more aggressively for core deposis and less aggressively for lending, especially for small business lending and personal loans, as hey ighened heir lending sandards and deleveraged by increasing heir equiy capial. Neverheless, our findings show ha he global financial crisis had he leas impac on morgage raes, bu a much greaer impac on small business lending and personal loans. 27

28 Our resuls show ha among he four producs, morgage raes are more compeiively priced in comparison o small business loans and personal loans. Overall, we find mixed evidence in suppor or oherwise of saemens made by governmen officials in Ausralia regarding he lack of compeiion and fair pricing in he marke for home morgages and small business loans. 28

29 References Ausralian Trade Commission, 2011, Ausralia s Banking Indusry. Berger, A. N., Hannan, T., The price-concenraion relaionship in banking. Review of Economics and s 71, Brown, A., Davies, M., Fabbro, D., Hanrick, T., Recen developmens in banks funding coss and lending raes. RBA Bullein, March Quarer, Chong, B. S., Liu, M.-H., Shresha, K., Moneary ransmission via he adminisered ineres rae channel. Journal of Banking and Finance 30, Chong, B. S., 2010, Ineres rae deregulaion: Moneary policy efficacy and rae rigidiy. Journal of Banking and Finance 34, Deans, C., Sewar, C., Banks funding coss and lending raes. RBA Bullein March Quarer, De Bond, G.J., Reail bank ineres rae pass-hrough: New evidence from he Euro area level. Working paper No.136, European Cenral Bank Working Paper Series. De Graeve, F., De Jonghe, O., Venne, R. V., 2007, Compeiion, ransmission and bank pricing policies: Evidence from Belgian loan and deposis markes. Journal of Banking and Finance 31, ECB (European Cenral Bank), Recen developmens in he reail bank ineres rae pass-hrough in he Euro area. ECB Monhly Bullein (Augus). Hannan, T.H., Berger, A.N., 1991, The rigidiy of prices: Evidence from he banking indusry, American Economic Review 81, Heffernan, S.A., 1997, Modelling Briish ineres rae adjusmen: An error correcion approach, Economica 64, Hofmann, B., Mizen, P., Ineres rae pass-hrough and moneary ransmission: Evidence from individual financial insiuions reail raes, Economica 71, Kleimerier, S., Sander, H., 2006, Expeced and unexpeced moneary policy impulses and ineres rae pass-hrough in Euro-zone reail banking markes, Journal of Banking and Finance 30, Liu, M.-H., Margariis, D., Tourani-Rad, T., 2008, Moneary policy ransparency and pass-hrough of reail ineres raes, Journal of Banking and Finance 32,

30 Liu, M.-H., Margariis, D., Tourani-Rad, T., 2011, Asymmeric informaion and price compeiion in small business lending, Journal of Banking and Finance 35, Neumark, D., Sharpe, S.A., 1992, Marke srucure and he naure of pricing rigidiy: Evidence from he marke for consumer deposis, The Quarerly Journal of Economics 107, Payne, J.E., 2007, More on he moneary ransmission mechanism: morgage raes and he federal funds rae, Journal of Pos Keynesian Economics 29, Pilloff, S. J., Rhoades, S. A., Srucure and profiabiliy in banking markes, Review of Indusrial Organizaion 20, RBA (Reserve Bank of Ausralia), Senae Economics references commiee inquiry ino compeiion wihin he Ausralian banking secor. RBA (Reserve Bank of Ausralia), Parliamenary join commiee on corporaions and financial services inquiry ino access for small and medium business o finance. Rousseas, S., A markup heory of bank loan raes. Journal of Pos Keynesian Economics 8, Saikkonen, P., Lükepohl, H., Tesing for he coinegraing rank of a VAR process wih srucural shifs, Journal of Business and Economic s 18, Saikkonen, P., Lükepohl, H., Tesing for a uni roo in a ime series wih a level shif a unknown ime, Economeric Theory 18, Sander, H., Kleimeier, S., 2004, Convergence in Eurozone reial banking? Wha ineres rae pass-hrough ells us abou moneary policy ransmission, compeiion and inegraion, Journal of Inernaional Money and Finance 23, Scholnick, B., Asymmeric adjusmen of commercial bank ineres raes: Evidence from Malaysia and Singapore. Journal of Inernaional Money and Finance 15, Sorensen, C.K., Werner, T., Bank ineres rae pass-hrough in he Euro area: A cross counry comparison. European Cenral Bank Working Paper Series No Sigliz, J., Weiss, A., Credi raioning in markes wih imperfec informaion. American Economic Review 71, Wang, K. and Thi, T. (2010), Asymmeric Pass-Through and Risk of Ineres Rae: An Empirical Exploraion of Taiwan and Hong Kong, Applied Economics 42,

31 Table 1 Composiion of Ausralian banks funding (% of funding liabiliies) Major banks Regional banks Foreign-owned banks Jun-07 Oc10 Jun-07 Oc10 Jun-07 Oc10 Domesic deposis Shorerm capial marke deb Long-erm capial marke deb Equiy Securiizaion Source: Reserve Bank of Ausralia (2010). 31

32 Table 2 Descripive saisics (whole sample) Term deposi rae Term deposi special rae Sixmonh swap fae Floaingrae morgage rae Secured small business loans Nonsecured small business loans Personal loans Mean Median Maximum Minimum Sd. Dev Skewness Kurosis Observaions

33 Figure 1 Ineres raes of Ausralian banks Noes: SB-secured = Residenially secured small business lending rae SB-non-secured = Non-secured small business lending rae Morgage = Floaing-rae morgage lending rae Personal = Personal loan lending rae Swap rae = six-monh fixed swap rae Term-deposi rae = average erm-deposi rae of all erms Sepcial rae = average erm-deposi special rae of all erms 33

34 Table 3 Correlaion coefficiens Term-deposi rae Term-deposi special rae Swap rae Floaing-rae morgage rae Secured small business loans rae Non-Securedsmall business loans rae Personal loans rae Termdeposi rae 1 Term deposi special rae Sixmonh swap rae Floaingrae morgage rae Secured small business loans rae Nonsecured small business loans rae Personal loans rae

35 Table 4 Long-erm relaionship beween lending raes and funding coss y x D D * x Morgages Panel A: Six-Monh Swap Rae as he cos of funds Secured small business loans Non-secured small business loans Personal loans Consan Swap rae Dummy Dummy *Swap Adj. R-sq 84.6% 85.3% 86.7% 92.1% Panel B: Average Special Term-Deposi Rae (Dep_Spec) as he cos of funds Morgages Secured small business loans Non-secured small business loans Personal loans Consan Dep_Spec Dummy Dummy *Dep_Spec Adj. R-sq 77.9% 81.1% 83.3% 94.1% Panel C: Swap Rae and Average Special Term-Deposi Rae (Dep_Spec) as cos of funds Morgages Secured small business loans Non-secured small business loans Personal loans Consan Swap rae Dep_Spec Dummy Dummy* Dep_Spec Adj. R-sq 86.2% 87.7% 89.1% 94.7% 35

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