RDP 9315: The Provision of Financial Services – Trends, Prospects and Implications 1. Introduction

In the past decade or so there have been significant changes in the financial system and the financial structure of households and firms. These developments were related. The financial system has grown rapidly and offers a wider range of services as a result of deregulation, globalisation and financial innovation. Competition within the financial system has increased as national financial markets have become integrated internationally and as the functional differences between banks, other intermediaries and the securities markets have blurred. This has enabled households and firms to expand and restructure both sides of their balance sheets. Heightened innovation and the push towards deregulation, however, have not occurred independently of the shifting financial needs of households, firms and the government. Indeed, in many ways, it is the factors that have driven these shifting demands that have proved the catalyst for the broader changes in the financial system.

These changes have had profound effects on the behaviour and performance of banks, the institutional core of the system. Increased competition on both sides of bank balance sheets has reduced their profitability and has led some to question their continued importance:

‘An implication of a conclusion that banks have lost much if not all of their specialness is that banks … no longer have a natural competitive advantage … if our financial markets and institutions were being created for the first time in 1990, banks might not be among the surviving institutions.’^[1]

Such a pessimistic assessment seems unwarranted. While it is true that banks have lost much of their ‘specialness’ in performing certain functions, they do have a natural competitive advantage in some areas of their business. There are limits to the extent to which other forms of finance can substitute for funding through deposit-taking financial intermediaries in general, and banks in particular. These limits arise because some borrowers have difficulty raising funds in direct credit markets, and banks have advantages in pricing and monitoring loans to these borrowers. On the liability side of their balance sheets, prudential requirements ensure that bank deposits are at the low end of the risk spectrum. An analysis of the cross-country behaviour reveals the continuing importance of banks even in the most developed and innovative markets such as in the US. It is this resilience of banks in the face of rapid financial change which suggests that the fundamental role of banks is difficult to replicate fully in other financial institutions or instruments.

This paper will explore the structural changes that have occurred in the Australian financial system and link these as far as is possible to the changing financial demands of the non-finance sector. Discussion of experiences in other countries will also be provided to put the Australian experience in context and highlight some of the main issues addressed in the paper. The focus will be on the changing role of banks and the likely prospects for banks in the future.

The ongoing structural changes have had a mixed effect on Australian banks. They have gained from them in two important respects. First, the changes that have taken place have facilitated an increase in household and corporate demand for financial services. While alternatives to bank assets and liabilities proliferated, the expansion of financial markets supported an increase in the volume of bank activity. Second, deregulation has allowed banks to compete more effectively against non-bank financial intermediaries (NBFIs) in the provision of traditional intermediation services and has permitted a broadening of the range of services that banks provide. Nevertheless, bank profitability has fallen and banks have lost market share in some of their traditional markets.

The rate of growth of financial markets in the 1980s was exceptional and will probably not be repeated. Ongoing competitive pressures faced by banks may thus exert a greater influence on their performance in the future. The extent to which banks remain the core of the financial system will depend on a range of factors such as their ability to undertake information-intensive lending more effectively than other institutions. Securitisation and the institutionalisation of lending could encroach on some areas of bank lending in which loans are relatively homogeneous and easy to price but they will have difficulty capturing more idiosyncratic loans. It will also depend on the extent to which banks continue to broaden their activities.

Footnote

Edwards (1993, p. 33). [1]