Is Westpac admitting collusion

Apologises for my long delay from the blog – I am afraid that it will continue for the next couple of weeks. I am on an economics adventure, trying to fight the beast of recession with sketchy logic and econometrics 😉

However, I had to say something about this recent Westpac article on bank funding (ht Rates Blog).

At the end Westpac says that it, and other banks, have been pricing at average cost instead of marginal cost – so they have been pricing based on the cost of credit to them, not the cost of sourcing additional credit to make loans.

Now, according to Westpac the average cost is higher than the marginal cost, and all banks have seemingly agreed to do this even though since the marginal cost of credit is below the current “price” an individual bank could “defect” and make some money. Is it me, or has Westpac blatantly admitted to collusion here?

Westpac has said that it, and other banks, have implicitly agreed to set interest rates at a higher level than marginal cost – which I presume must be closer to the collusive price than marginal cost as otherwise it wouldn’t stick.

Now I didn’t think the banks were colluding, but if Westpac is willing to go ahead and admit it then …

[Note: to be fair I think long run marginal cost, which banks would actually need to set fixed rate loans based on, will be higher than marginal cost – and this would explain much of the difference. However, this isn’t what Westpac said.  Also, I’ve ignored market power and the prevalence of fixed costs – again if they wanted to make these arguments go ahead, but do they really want to say that they used market power to keep prices above the marginal cost of credit 🙂 ]

  • “At the end Westpac says that it, and other banks, have been pricing at average cost instead of marginal cost – ”

    So P=AC which implies AR=AC which implies zero profits. Thus, What market power?

    “according to Westpac the average cost is higher than the marginal cost”

    But if AC>MC does this not mean AC is declining? Which implies natural monopoly????

  • “So P=AC which implies AR=AC which implies zero profits. Thus, What market power?”

    Indeed. However, I would assume that when they “set price according to AC” they are doing so with some implied margin – implying that they are agreeing to some P>AC. As P>AC>MC in this case, and they are using an implicit rule between firms to set P I’d take this as collusion.

    “But if AC>MC does this not mean AC is declining? Which implies natural monopoly????”

    In a static sense indeed, as it would imply that fixed costs are very large.

    However, I am not sure that their definition of AC and MC are in the static fashion. The AC is the average cost of finance for all clients they have served, the MC is the extra cost of finance for a new client. In that case, current price should equal MC not AC – the AC is really irrelevant for current market pricing methinks.

  • @Matt Nolan

    Just to be clear here, P is a function of time and so P=AC at time t won’t imply zero profits given that P is different in other time periods.

  • Michael Gordon

    Actually one of my colleagues raised that same point. But you’re closer to the mark in your first reply Matt – it’s not AC in the static sense, but the average of MC over time. You can argue that it’s irrelevant for current market pricing, but the fact is that’s the way banks do it (for retail lending anyway – wholesale loans are more likely to be priced at MC). It’s no different from a business that values its inventory using average cost rather than LIFO.

    Our point was that if banks were strictly using MC pricing then we would have seen even less passthrough from the OCR to lending rates in late 2008, when funding was at its most expensive (remember that back in the early days of the easing cycle the RBNZ didn’t seem all that confident that OCR cuts would be passed on). Instead, due to AC pricing (perhaps should be smoothed pricing?), we saw a high degree of passthrough at first and less so in recent months.

    Michael Gordon
    Markets Economist, Westpac

  • Fighting the beast of recession with econometrics? Sounds like you really like a challenge 😀

    *visions of Matt dressed in tights and a big E on his chest, applying augmented Dicky Fuller to Godzilla*

    Not to defend Westpac but marginal cost pricing for banks is a lot simpler to do than average cost given the myriad of funding sources. It is in fact an industry standard practice both here and overseas so if it is collusion then it is tacit.

  • Matt in tights, be careful what you wish for!

  • @Michael Gordon

    Hi Michael,

    Fundamentally I DO NOT believe that the banks are colluding. Even if there was some incentive to, I thought that the purpose of Kiwibank (and the significant government investment involved) was to make this type of collusion different. With Kiwibank not offering significantly lower rates I am not convinced in collusion at all.

    However, I just found it a bit unusual that the document discussed short-run marginal costs, when expected long-run marginal costs should be the primary determinant of rates. The main purpose of this post was to illustrate why I thought that discussion was a bit inappropriate – I wasn’t really aiming to say there was collusion 😛

  • @Dismal Soyanz

    Econometrics is the only way to fight a recession – as it gives you something sufficiently time consuming to do until the recession naturally runs out of puff 🙂

    On the collusion, it would have to be tacit – I just didn’t think that a discussion of short-run marginal costs was appropriate for discussing fixed mortgage rates.

  • steve

    price can be above marginal cost in a cournot market. I’m guessing there is no collusion and that the cournot model would explain current market prices. Particularly during the credit crunch, I would say banks are more likely to compete by choosing quantity than by choosing price.

  • @steve

    Indeed, price can be above marginal cost in a cournot market – although in that case it is because of market power.

    However, my point was that Westpac said it and other banks were setting price wrt an arbitrary price target above marginal cost – that sounds like tacit collusion.

    Now I don’t actually believe that story – it was just able to be made given how it was framed in the document.

  • Michael Gordon

    Matt Nolan :@steve
    However, my point was that Westpac said it and other banks were setting price wrt an arbitrary price target above marginal cost – that sounds like tacit collusion.

    Actually if you read the paper again it says just the opposite: through the worst of the credit crisis, the average cost was below the marginal cost. If there was ever a time for banks to collude and raise their prices based on whichever pricing model suited them best, that would have been it – and they didn’t. If anything we’ve disproved collusion. 🙂

  • @Michael Gordon

    Well again this depend on when you think the collusion takes place – maybe we have a situation where collusion holds more strongly when “demand is high” (ala Green and Porter), which would imply that the current situation is an example of tacit collusion.

    Of course, this would imply that the structure of the market has changed substantially from 2003-05, when price wars appeared to occur during periods of high demand.