RDP 9315: The Provision of Financial Services – Trends, Prospects and Implications 5. The Future

The 1980s was a period of significant change in the Australian financial system. Looking back, it appears that banks benefited in many ways from the changes. While they faced more competition on both sides of their balance sheets, the changes that occurred resulted in a substantial increase in the private sector's demand for financial services, and deregulation allowed banks to face that competition with a more aggressive response than previously. Banks were able to win back market share from NBFIs in the market for household deposits and intermediate the bulk of the increase in funds raised by the private sector. In doing so, they had to compete more vigorously, which directly and indirectly reduced their profitability.

It is likely that the forces shaping the financial environment in the 1990s will be different in many ways to those of the 1980s. One can characterise the financial deregulation of the 1980s as having both income – from the expansion in demand for financial services – and substitution – from heightened competition – effects on banks. Some of the positive factors stemming from these changes are likely to be absent in the 1990s. Reintermediation has run a considerable way and the pace of expansion of household and corporate balance sheets should be much slower. As the 1990s proceed, the ongoing competitive pressures facing banks are likely to come to the fore.

The financial system is unlikely to expand as rapidly in the 1990s. Many of the factors driving the expansion of corporate balance sheets and indebtedness in the 1980s are unlikely to be repeated. Part of the increase was an adjustment to a more liberal financial environment. Part was due to the overall macroeconomic environment, particularly the restoration of the profit share and persistently high inflation, and the structure of the tax system at the time. Many firms clearly over-borrowed and the balance sheet restructuring we have seen over the past few years has been an attempt to wind back excess gearing.^[33]

Over time, firms may continue this process or be more cautious in their use of debt. Dividend imputation has removed any tax-induced bias toward debt; therefore, the optimal level of gearing is somewhere below where it was in 1987. Firms may be still adjusting to this fact. For some firms, particularly those borrowing above prime rates from banks, real after-tax borrowing rates remain relatively high, encouraging them to economise on debt. The shift to low inflation and growing community confidence in the fact that inflation should remain low could also encourage more conservative use of debt. Lower inflationary expectations will discourage borrowing to purchase assets in the hope of capital gains. The success of monetary policy in keeping down inflation will thus be an important influence on financial structure.

The speed and nature of the rise in household financial assets is also unlikely to be repeated in the 1990s. After being relatively stable for two decades, household financial assets rose from just under 60 per cent of GDP in the early 1980s to over 90 per cent of GDP in the early 1990s. Much of this was due to sharp increases in the price of assets underlying their claims on equity and superannuation funds and, related to this, the high earning rates on superannuation fund assets. In a more stable financial and macroeconomic environment these developments are unlikely to be repeated.

The evolution of household saving, and thus acquisition of new financial assets, is likely to become a more important influence on the path of household financial portfolios. Government policies to encourage greater saving for retirement are likely to have an important bearing on the outcome. Recent estimates suggest that the ratio of superannuation funds' assets to GDP could double in the coming decades under current policy arrangements.^[34] Recommendations to broaden the coverage of the Superannuation Guarantee Levy and increase the rate of contributions, if adopted, will boost these figures further.^[35] The potential growth of the superannuation industry is one of the major competitive challenges likely to confront banks in the 1990s. Concerns have been expressed that the likely increase in household financial assets held in superannuation funds will inhibit banks' ability to raise funds directly and increase the cost of funds raised and that this, in turn, may affect the cost of bank lending.

While the form and extent of financial innovation is difficult to predict, it is likely to continue apace in the 1990s. The catalysts of future innovations will be different to those in the past. Many occurred in response to the interaction between inflation and regulations, the niches created by regulations, asset price volatility and the profits available to those who develop products that help ‘complete’ markets.^[36] The move towards a more competitively neutral financial system and the fall in inflation have eliminated some of these catalysts. But ongoing technological advances will continue to reduce the costs of financial transactions, increase the liquidity of assets, allow more easy diversification of the portfolios of small investors and hence enable investors to increase and broaden their use of financial services. The increasingly global nature of financial markets will continue to provide a competitive impetus for innovation.

If the international experience is anything to go by, the expansion of the superannuation industry itself will provide a catalyst for innovation.^[37] In the US, the UK and Canada, the growth of pension funds is widely recognised as having spurred innovation in the financial markets, in particular by increasing the demand for liquid, marketable assets into which pension funds can invest. As noted earlier, a feature of the Australian financial system is the fact that direct raisings of debt by the corporate sector appear small relative to their overall funding requirements and experience overseas. An expansion of the role of institutional investors could provide a catalyst for further growth in these markets and in the market for securitised lending.

So far there has been relatively little securitisation in Australia. That which has occurred has largely been organised by merchant banks and its scope has been limited. To date it has only involved the sale of short-term paper backed by one or a combination of: residential mortgages, the stream of receivables from publicly provided services (such as water rates), rental streams from government-owned properties and store card debts. There has been no significant securitisation of domestic banks' assets. Several plans to launch asset-backed securities more recently have failed to get off the ground.

What will be the net effect of these developments on banks? Should the pace of expansion of the financial system slacken, then bank balance sheets are likely to grow less rapidly than they did in the 1980s. The main question that arises is whether, as a result of greater competition, banks expand less rapidly than the system overall and whether their profitability is eroded.

Heightened competition has probably had the biggest impact on banks' liabilities. This is partly because the function provided by bank liabilities – a repository for the liquid assets of households – is the most easily replicable by other institutions or instruments. Many of the innovations of the past decade or so have enabled households to access liquid, high-yielding assets outside the banking system. The growing sophistication and wealth of households will encourage further innovations in these areas.

The potential growth of assets in superannuation funds may also attract household funds away from banks. However, for households who are not towards the end of their working life, the very different nature of bank deposits (and other assets) available at short notice and the long-term nature of assets in superannuation funds suggest that the degree of substitution could be limited.^[38] Moreover, if the policy underlying the SGL is to be successful in providing retirement income, any reduction in other forms of household saving in response to higher superannuation saving will have to be less than one for one. Some of the increase in superannuation fund assets will also be recycled through the banking system. At present, banks receive about 7 per cent of their funding (debt and equity) through life offices and superannuation funds.

Banks do retain some competitive advantages on the liability side of their balance sheets due to their key role in the payments system and the fact that bank deposits are at the low end of the risk spectrum. Both stem from the existing rules and prudential arrangements governing the financial system. The reduction in inflation may also assist banks in one respect. Deposits in banks and other financial institutions are taxed more onerously than other forms of saving and the extent of the bias is related to the inflation rate. Low inflation will reduce this tax bias making deposits a relatively more attractive form of saving. However, to offset this, the benefit to banks of having low interest paying deposits is reduced in a low inflationary environment. On balance, banks are probably going to have to compete more vigorously for funds, raising the cost of those funds and broadening their funding base.

On the asset side of bank balance sheets, there are limits on the extent to which other forms of funding can replace funds intermediated through banks. Banks have historically had a comparative advantage in the provision of loans to borrowers who, because of their characteristics, have been unable to access securities markets directly. This could account for the relative resilience of banks in the face of the profound changes that have occurred. The analysis of international and Australian developments showed that banks were able to expand their liabilities and assets at least as rapidly as the rest of the economy, if not as rapidly as the overall financial system, despite the increased competition and innovation that has occurred in the past two decades. Even after all these changes, the intermediation function of banks remains a pivotal aspect of the financial system.

While securitisation and direct issues of corporate debt could continue to grow in Australia, the international experience does not seem to indicate that it will substantially reduce the role played by banks. Securitisation will be limited to relatively homogeneous easily-priced loans. While this could remove high-quality assets from bank balance sheets it will not necessarily encroach on the core lending functions of banks. More generally, debt funding through securities markets can provide an important alternative source of income to banks since credit or liquidity back up facilities provided by banks enable many securities to be issued.^[39] Thus, banks' off-balance sheet activities could continue to increase relative to their on-balance sheet activities.

Banks can respond to these developments in a number of ways. The preferred alternative would be for them to undertake their traditional lending business more efficiently, thus offsetting the higher funding costs that they may face. Policy can encourage this outcome by maintaining a competitive banking environment, discouraging banks from simply passing on higher costs to borrowers who could not raise funds elsewhere.

Banks will have to actively take advantage of those factors which provide them the comparative advantage in the provision of banking services – economies of scale and scope, branch networks, historical relationships with customers, experience in evaluating and monitoring loans, customer convenience and regulatory benefits – and will have to be aggressively innovative in new markets. The banks have already responded to the competition by broadening the services they provide, for example by introducing their own superannuation-type products (Figure 16). This process is likely to continue and the functional differences between banks and other institutions will decline but will not be eliminated. Differences will remain and these differences will turn on banks' ability to fulfil their traditional lending role:

‘… the really important distinction between banks and other financial intermediaries resides in the characteristics of their asset portfolio … It is these … differences … that will maintain in future years the distinction between banks and non-bank financial institutions.’^[40]

Footnotes

See Mills, Morling and Tease (1993) for a discussion of balance sheet restructuring. [33]

FitzGerald and Harper (1992a,b). [34]

FitzGerald (1993). [35]

See BIS (1986), Merton (1990), Miller (1986) and Mishkin (1990). [36]

Bodie (1989) and Ross (1989). [37]

Though for those near retirement – who hold the bulk of the superannuation fund assets – the substitutability is higher. [38]

Corrigan (1987) discusses the US experience. [39]

Goodhart (1988, p. 102). [40]