You are not happy. You’re at a business networking event and the conversation turns to banking. A few of your peers have all but disclosed some incredibly sharp margins, while another chirps in with a story about the unbelievable improvement in margin they achieved from a recent banking tender. You wonder how you missed this memo.
The idea of a better margin is tempting.
You consider the idea of a bank tender; the friction with your bank, the potential of offers that are not quite what you’d hoped for, the documents and the briefings. There are not many major banks, and you don’t have the time to research the market any deeper, but you know that refinancing is a move that should be played strategically and infrequently.
If only bank offers could be readily sourced, easily compared and heavily automated.
That fantasy is the world of ‘perfect competition’, used by mainstream economists to build models and analyse markets and behaviour. Yet unsurprisingly it is entirely unrealistic.
In a perfectly competitive market, firms make the minimum profit required to keep them in the market. Conversely, the tell-tale sign of a market that isn’t working properly, is that players can make “supernormal” profits. Much has been said over the past decade about the Australian banking oligopoly and the Big 4’s so called ‘super profits’ which have consistently (and significantly) outperformed their international peers.
What is a perfect market?
- The market has many buyers and many sellers
- Firms can enter and exit the market easily, meaning the market can adjust easily to changing conditions.
- All firms sell an identical product (the product is a ‘commodity’ or ‘homogeneous’)
- Buyers have perfect information about products and prices both now and for the future.
- All buyers and sellers are price takers (no player can individually change the market price).
But it’s very hard to find any examples of perfect competition, especially as goods and services become more complex, the world globalises and markets become dominated by multinational giants. Perhaps a traditional fruit and vegetable market still fits the bill, but even then, we’ve all experienced buying an avocado or watermelon only to discover it is bad inside, suggesting the information wasn’t perfect!
Where perfect markets break down
The model has numerous problems, which are found across many sectors, especially in banking.
The market has many buyers and sellers
Many markets are dominated by a few players, such as groceries, computing, cars, oil, telecoms. Banking in Australia is the same, it’s dominated by the Big 4, who together control 70.4% of the banking market (and 74% of the lending market!).
Some markets only have a few buyers (a monopsony market). The classic example is defence hardware. The problem doesn’t arise in banking, but because there are only a few huge players on the other side, it becomes a David and Goliath struggle for customers.
Firms can enter and exit the market easily
Entering and leaving markets is not easy. No one ever got into vehicle manufacturing, the electricity market or mobile phones easily, cheaply or quickly.
Similarly in banking, it is a highly capital-intensive industry, with complicated regulation and licencing, and where scale is critical. One only needs to follow the journeys of the several challenger banks currently establishing a foothold in the Australian market to understand the difficulty enter the market.
And for customers, we all know switching banks presents enormous transaction costs in terms of being time consuming, stressful, difficult and uncertain.
All firms sell an identical product
The model says there is an identical product, but businesses strive to differentiate their products. Think about the numerous options in mobile phones or clothing or conditions attached to banking facilities. Even producers of bread or milk try to differentiate their products. Not many of us want a world of identical products anyway!
Buyers have perfect information
Information is rarely perfect, and as products and the economy get more complicated, the problem worsens. Whilst the range of lending products may be relatively short, it’s the additional terms such as covenants and other restrictions that end up making the offers extremely complex, technical, and pricing based off internal ‘black box’ models. This is known as asymmetric information.
As financial markets have become more globally interconnected, they have become more complex, straying away from the days of Medici Bank.
All buyers and sellers are price takers
In markets dominated by a few players those players tend to be price setters rather than price takers. It never feels like petrol companies or tech giants are price takers.
The same can be said about negotiating with your bank and the ‘Golden Rule’ previously referenced: whoever has the gold, makes the rules. Banks know their power and use it to their advantage well.
Realistic predictions with unrealistic assumptions?
Despite these problems, defenders of the perfect competition model quote Milton Friedman who argued that a model shouldn’t be judged on the realism of its assumptions but its ability to predict. Many heterodox economists say if the model better reflected reality, we could come up with better economic and public policy. It’s an open question how useful that model of perfect competition really is, but modern economics was built on it.
Whether we should build the whole of economics on this model or not can be debated elsewhere.
So, what for the Banking Market?
In terms of bank customers, the model is a useful tool to help analyse banking relationships. Individual businesses can’t do much about most of these, but they can influence some of them, especially information problems.
Banking is a complex business. And whilst it is all just ‘dollars and cents’, it is the cost efficient and regulatory compliant sourcing, prudent risk mitigation and appropriately pricing lending of these dollars that makes the need for better information so crucially important.
Imperfect markets: why bank tenders are hit-and-miss
Few sellers result in a diminished ability to test the market.
The most simplistic method to establish margin information transparency is to see what the market has to offer. Whilst this is relatively straight forward for retail home loans and deposit accounts, the SME business owner and mid-market business CFO will find this exercise much harder. And, unless guided by tendering experts who will add a significant additional transaction cost, will most likely end up disappointed over the medium term.
When you have four main banks, it is difficult to elicit genuine margin feedback. Each facility offer will have varied conditions attached and be subject to final credit approval. And you can be sure indicative pricing will be exactly that – until things get serious. This is fair enough given the resource intensive new business and credit approval process for a mid-market customer and that no business wants to be used solely as a price checker.
You also have a corporate reputation to be mindful of and sensitive financial and business information that will need to be shared.
Improving market fairness: the purpose behind BankEdge
The BankEdge Margin Review approach was built after seeing countless businesses disadvantaged by a lack of information and market transparency.
A bottom-up, data-driven approach utilising the same risk-based pricing principals combined with industry pricing models removes reliance on the imperfect market for pricing feedback. It provides an efficient, low risk solution to SME owners and CFOs to review their lending margins.
Almost all modern markets fail some or all the criterion of perfect competition. The banking industry in Australia has its structural challenges that will persist despite the best efforts of APRA and the ACCC to drive competition for the mid-market business segment. The best (and only) solution to counteract the failings is to improve information access and understanding of the bank margin marketplace.