RDP 9605: The Evolving Structure of the Australian Financial System 5. Conclusions

A feature of the historical experience reviewed in this paper has been a widening of competition between banks and other suppliers of financial services. Developments in financial regulation have been an important, and familiar, part of the story. Regulatory constraints contributed to the loss of the banks' initial dominance of financial intermediation, and the removal of those constraints stimulated some of the important subsequent trends – a recovery in banks' market share, a general expansion in the volume and range of financial activity and stronger competition from new entrants. But to a significant degree, regulatory policies were responding to pressures for change rather than being an initiating force, and they were arguably more important in shaping the speed and timing of structural changes than their underlying direction.

The deeper underlying forces for change have been developments in technology, which transformed supply conditions in the industry, and their interaction with the cost and pricing structures of traditional intermediation. The net effect can be viewed as a general shift in the nature of the ‘production technology’ of financial services. Traditional banking involves a joint-production technology that produces deposit, lending and transactions services within a given institution. This structure has faced an increasing challenge from separate-production technologies: that is, from specialist enterprises that efficiently produce a single line of financial service, such as cash management accounts, payment services or securitised mortgages. Similarly, financial market trading can be seen as a specialist product that does not need to be part of a full-service banking operation.

This separation of basic product lines has had important consequences for the competitive position of the major banks. Already single-service providers have been able to compete vigorously with banks in key lines of business and, although banks retain a large share of deposit and loan markets, this competition has clearly begun to affect their interest margins. Competition has also put pressure on banks to reduce the cross-subsidisation of payments services, in turn contributing to the general trend towards separate pricing and production of individual services. The separation of product lines also affects the nature of the core business of banking. In contrast to the traditional structure, where the core business was readily identifiable as the joint production of deposit, loan and transactions services, there can increasingly be seen to be several separate core products, not all of which need to appear together in any one institution. In this sense, the special position of banks, at least within the financial intermediation sector, is becoming less easy to define.

It is important not to exaggerate the extent to which these trends have already progressed. The major banks continue to run large traditional deposit and lending businesses which still account for the bulk of their profits and for most of the assets of the financial intermediation sector. Securitisation is much less advanced in Australia than in several countries with otherwise comparable financial systems. Nonetheless, there has been a growing functional overlap between different providers of financial services, which can be seen as taking place on three levels.

The first level, and the one that is furthest advanced, involves competition between banks and other intermediaries. Although banks dominate the intermediation sector in terms of balance-sheet size, there is strong competition with other intermediaries and a high degree of overlap between the activities of the main groups of institutions – banks, building societies, finance companies and merchant banks. This has been amply testified by the ease with which business could move back and forth between these groups of institutions over the past few decades, reflecting the shifting advantages conferred by changes in regulatory policy.

The second level of the evolving competitive scene involves competition between intermediaries and funds managers. This is much less advanced than competition within the intermediaries sector but, in a number of respects, the traditional functional separation between intermediaries and funds managers has been breaking down. One aspect of this has been the growth of banks' own funds-management operations (although these remain separated from banks' on-balance sheet activities). At the same time there has been an increasing involvement of funds-management institutions in intermediation activities like mortgage lending. Also important has been the provision of short-term investment facilities by both banks and funds managers, which bring funds-management products more directly into competition with bank depository services.

Finally, there is a third level of potential development involving competition between financial and non-financial businesses. This has not occurred to any significant degree in Australia although there are a number of examples in overseas markets of non-financial businesses entering the market as financial service suppliers.^[44]

All this raises the question of where are the remaining natural boundaries (if any) between the different suppliers of financial services. An important lesson from earlier regulatory policy experience was that regulations tended to break down where they placed artificial constraints on competition between institutions performing essentially similar functions. The analysis presented in this paper suggests that there has been a tendency for functional overlaps between institutions to increase but that, in a number of important areas (the second and third levels outlined above) this process has not yet gone very far. How far the process continues in the foreseeable future will depend importantly on the regulatory policy response, and particularly on whether policies are aimed at removing remaining institutional distinctions or reinforcing them.

Footnote

See Llewellyn (1996) for a discussion of this trend. [44]