The impact of the global financial crisis on mortgage pricing and credit supply

https://doi.org/10.1016/j.intfin.2014.01.001Get rights and content

Highlights

  • Examine the effect of GFC on changes in banks’ pricing and sales, and identify sources that drive these changes.

  • Solid deposit support enable banks responding sluggishly to policy shocks and sell more.

  • Banks with more liquid assets are conservative in pricing during the GFC but more aggressive afterward.

  • Big banks enjoy greater market power and expand faster after the GFC.

  • The comparison to Canada reinforces the importance of deposit funding and asset liquidity in crisis resilience.

Abstract

This paper studies the pricing and sales of home mortgages in Australia, focusing on the global financial crisis (GFC). It shows that the crisis significantly changed banks’ pricing behavior and its impact varied across banks, depending on their asset sizes, deposit sources and liquidity profiles. Big banks led in price setting and responded promptly to both upward and downward adjustments of the cash target rate before and during the GFC. Albeit cutting their prices sluggishly after the GFC, they still enjoy greater market power and are expanding faster. Banks with solid deposit support became slower in responding to policy shocks during the GFC and sold more than their counterparts. Interestingly, banks in a better liquidity position tended to be more conservative in pricing during the GFC, i.e. reacting quickly when the cash rate moved up but slowly if it fell, but became more aggressive thereafter.

Introduction

The demise of the US sub-prime residential mortgage market was the catalyst for the global financial crisis (GFC), leading the world economy into a period of turmoil unprecedented since the Great Depression. The GFC forced governments and central banks in developed economies to be increasingly active in reinforcing regulation and tightening their supervision in the lending channels (Moshirian, 2011). Effective policy implementation requires a fast and complete response to policy initiatives by the banking system, which is the primary conduit of monetary policy. Understanding the transmission mechanism and its dynamic evolution provides insights into banking regulation and policy implementation. Furthermore it has important implications for financial stability and consumer welfare.

There is a broad consensus that Australia's banking system showed increased resilience compared with most developed countries during the GFC. The strength of Australian Financial Institutions (FIs) can be largely attributed to the less competitive structure of the banking market due to the “four pillars” policy1 and the lucrative domestic mortgage lending opportunities in the 2000s (Davis, 2011). This paper focuses on the Australian residential mortgage market from 2002 to 2011 and seeks to answer the following questions. Firstly, how do different FIs adjust their mortgage rates in response to monetary policy changes? Secondly, have the pricing strategies of the FIs changed since the onset of the GFC? If so, how has this occurred? Thirdly, what are the main factors determining FIs’ pricing behavior and how are these factors related to credit supply before and after the GFC?

To address these questions, we first employ the traditional error correction model to investigate the pass-through of monetary shocks by Australian FIs. Based on regimes determined by the data, we explore how the onset of the GFC altered lenders’ pricing decisions. Then, we identify the factors that determine cross-sectional variations in banks’ pricing behavior and the sources that prompted banks to change pricing strategies during the GFC. An ordered probit model is applied, which relates the sequences of mortgage rate adjustments to bank balance sheet information. After that, we examine the relationship between a bank's home mortgage sales and funding support at different stages of the GFC. We also include mortgage prices and a proxy for banks’ pricing strategy as an explanatory variable to capture the effect of price on the quantity of home mortgage supply. Finally, by comparing the Australian mortgage market with its most comparable international peer – Canada, the study reinforces the importance of solid funding sources and regulatory supervision in maintaining financial stability.

Several important findings emerge from this analysis. Firstly, as demonstrated by empirical results from the error correction model and the probit model, big banks lead the price setting in home loan markets and these banks extended their dominant role during the GFC. They moved much more sluggishly when the Reserve Bank's target rate fell again after the GFC but gained greater market expansion than the smaller banks. Secondly, the effects of mortgage price and pricing strategy on mortgage sales were more profound during the crisis period. Thirdly, we find that a bank with a higher proportion of liquid assets has more conservative pricing policies, as was particularly the case during the GFC. This is consistent with the argument that banks are more risk averse and increase cash accumulation during financial distress. Substantiating this argument, this study shows that higher liquidity is associated with smaller loan supply and slower sales growth during and immediately after the GFC and the effect is strongly significant. Finally, banks with solid deposit funding are found to respond sluggishly to policy shocks during the GFC. Household deposit-to-asset ratios and financial deposits contribute positively to the home loan supply, especially in an unstable economy, suggesting that banks with more solid funding support tend to have a larger credit supply. However, deposits from nonfinancial companies contribute negatively to a bank's mortgage sales.

Significant attention has been drawn to the banking system and the lending market since the GFC triggered widespread financial instability. Relevant to our analysis, Ivashina and Scharfstein (2010) study the amount of credit supply in the US corporate sector during the GFC and find that banks with better access to deposit financing are able to offer more new lending. Puri et al. (2011) analyze individual loan applications and loans granted by German savings banks. They conclude that the GFC induced a contraction in the supply of credit, particularly for smaller and more liquidity constrained banks. Santos (2011) investigates banks’ pricing behavior and shows that banks that incurred larger losses in the GFC became riskier and raised their corporate loan rates more than other banks. Unlike these studies, this paper contributes to the literature by jointly examining the pricing and capacity of banks’ credit supply.

This paper also contributes to the monetary policy transmission literature, emphasizing FIs’ asymmetric responses and heterogeneous behavior. Previous studies show that reactions to monetary shocks appear to be asymmetric, depending on whether the shock is positive or negative, whether the interest rate is above or below its equilibrium level (Kleimeier and Sander, 2004), or whether the policy is expansionary and contractionary (Kishan and Opiela, 2006). Well-capitalized banks with better access to alternative funds are perceived to be less risky and they react sluggishly to monetary policy shocks (Kishan and Opiela, 2000, Gambacorta and Mistrulli, 2004). For example, Ashcraft (2006) shows that affiliated banks respond less to monetary policy shifts because they have better access to alternative funding. They are also more able to smooth the effect of policy changes than stand-alone banks. Additionally, banks with higher liquidity or a larger capital buffer are more able to protect their loan portfolio against monetary tightening (Kashyap and Stein, 2000). They change their prices less and are able to charge higher markups (Gambacorta, 2008). The findings of monetary policy transmission in this paper are consistent with the aforementioned studies. However, the data we have used are of higher frequency (weekly), which is arguably able to more accurately capture the responses of commercial FIs to a policy change of the central bank.

Finally, the literature on the monetary policy transmission for the Australian banking sector is very limited. Existing studies use aggregated market level data, which may mask the banks’ heterogeneous behavior (Brinkmann and Horvitz, 1995). Lim (2001) reviews quarterly business loan and deposit rates and concludes that the adjustments to the benchmark rate are asymmetric in the short-run but quite symmetric in the long-run. Examining Australian financial markets from 1998 to 2006, Kim and Nguyen (2008) find that interest rates tend to respond more strongly to unexpected rate increases than rate decreases. Lim et al. (2010) perform a joint analysis of US and Australian financial markets and show that the rate pass-through tends to be higher on the deposit side for the US, but higher on the loan side for Australian banks. In contrast to these studies, this paper investigates the heterogeneity across Australian FIs using firm-level weekly observations. It further examines the impact of the GFC on Australian banks’ pricing behavior and extends the analysis to their credit supply.

The rest of the paper has five sections. Section 2 outlines the Australian banking sector and home mortgage market. Section 3 specifies the pricing model and documents the impact of the GFC on mortgage pricing. Section 4 explores the key determinants of banks’ pricing strategies and home loan supply and how these FIs varied over the GFC. Section 5 extends the discussion by comparing the Australian and Canadian mortgage markets. The final section concludes this paper with a summary of its main themes and findings.

Section snippets

The Australian banking industry: deregulation and the “four pillars” policy

Until the end of the 1970s, the Australian financial system was heavily regulated, with a focus on direct business control methods rather than open-market operations. However, economic growth, technological advances and the internationalization of financial markets during the decades before deregulation enabled banks to find ways to circumvent government controls. Innovative financial products, less controlled nonbanking subsidiaries and mutual financial intermediaries emerged, resulting in a

The impact of the global financial crisis on mortgage pricing

The mortgage rates offered by financial institutions are set or adjusted periodically when changes occur in the monetary policy or economic environment. To investigate the pricing decisions made by different FIs in the home loan market, we track the firm-level mortgage rates following each adjustment in the RBA's cash rate target. An effective way of analyzing the monetary transmission mechanism is through the Error Correction Model (ECM) (Engle et al., 1987, Hendry, 1995), which is specified

The determinants of pricing strategies and mortgage sales

The pricing strategy of the same bank is subject to change when the economic environment varies. During a long period of growth with appreciating home values and adequate funding sources, banks are less risk averse and set mortgage rates aggressively to compete for market share. Consequently, they may delay their responses to positive shocks to the cash rate but speed up adjustments to negative shocks. However, if there is a serious economic recession or financial crisis like the GFC, liquidity

Mortgage pricing and liquidity supply: Australia and Canada

While Australian banks are widely acknowledged for their ability to weather the storm of the GFC much better than their peers in the US and the EU, the banking industry in Canada is another outstanding performer that was well protected against the GFC. The two countries have many aspects in common; for example, both have a relatively small population but a large continent, a resource-based and primary production concentrated economy, and are of similar economy size and level of GDP per capita.

Concluding remarks

This paper empirically examines the monetary policy transmission in Australia and seeks to identify the sources that drive the variations in banks’ pricing strategies. The study shows that all financial institutions raise loan rates faster than they decrease them. The short-run corrections to positive monetary shocks are large and prompt, leaving small gaps between the retail rates and their long-run equilibrium values. In a downward rate trend, FI's contemporary short-run adjustments are much

Acknowledgements

We gratefully acknowledge helpful comments and suggestions from the editor, an anonymous referee, David Prentice and the participants of 2nd Conference on Financial Markets and Corporate Governance. We also thank Andrew Svensson from Canstar Pty Limited for making the data available to us. The financial support from the Faculty of Business, Economics and Law, La Trobe University is greatly appreciated.

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