RDP 9605: The Evolving Structure of the Australian Financial System 3. Financial Intermediation and Securities Markets

Within the intermediaries sector, two main trends have been important in shaping the competitive environment. The first, already outlined in Section 2, was the development of financial regulatory policy and its interaction with performance of the different groups of intermediaries. In broad outline, banks lost market share up to the mid 1980s but regained it rapidly once deregulation allowed them to compete for business on more equal terms. As is evident referring back to Table 1, banks now dominate the intermediation sector to an extent not seen since the 1950s and 1960s, accounting for almost 80 per cent of the total assets of this group of institutions. But it is worth underlining the ease with which business could move back and forth between banks and non-bank intermediaries as competitive advantages shifted.

The second trend, to be elaborated further below, has been the unbundling of the banks' traditional product mix. This refers to the increasing capacity for new entrants to bid separately for components of banks' traditional business without offering a comprehensive range of banking services. This trend has potentially far-reaching consequences for the financial sector since it suggests that, even in an environment where banks are not hampered by regulatory constraints, there may be increasing competitive pressure on the most profitable parts of banks' traditional business base.

3.1 The Bank Product Mix

As was argued earlier, the traditional mix of products provided by banks can be viewed in broad terms as comprising three elements – deposit-taking, lending and providing transactions services. This of course has never been the complete picture and in recent years bank activities have expanded well beyond the traditional product range, as evidenced by the growing proportion of banks' income arising from fee-related activities as opposed to net interest earnings. Nonetheless, net interest income continues to provide the bulk of the aggregate profits of Australian banks, indicative of the fact that traditional intermediation services remain a central part of their overall business.^[11]

An important issue to be addressed in relation to the basic economics of the banks' product mix concerns the extent to which the joint products within the mix are inherently separable. In other words, to what extent can the markets for these services be competed for separately rather than delivered jointly by ‘full-service’ institutions? Historical trends suggest that there has always been at least some scope for specialist institutions to compete with banks on a partial range of services. Important examples in the 1960s and 1970s were the building societies and finance companies, which could be thought of as offering limited ranges of deposit and lending services independent from the more comprehensive services, including transaction facilities, available from banks. These institutions grew rapidly in those decades (Figure 5), although the growth was much more a result of their ability to operate outside of key regulatory controls than to the specialist characteristics of their product lines.

A much more important spur to competition for specialist lines of business came with the growth in size and liquidity of securities markets in the late 1970s and early 1980s. This allowed specialist institutions either to finance their lending activities by raising funds in liquid securities markets, or to operate effectively as retail deposit-takers while investing their funds in securities rather than loans. In other words, the development of securities markets helped to make possible the provision of deposit and lending services by separate institutions.

Three examples can be cited as illustrative of the process.

First, on the deposit side, was the growth of cash management trusts, the first of which was established in 1981. Although these are, strictly speaking, funds-management rather than deposit-taking institutions, they offer a service that from the point of view of the customer is akin to a short-term retail deposit offering close to wholesale rates of interest. Cash management trusts remain relatively small in aggregate (currently with around $7 billion in total assets, or around 3 per cent of aggregate household deposits) but have had an important impact on competition for the marginal depositor, and hence on the pricing of banks' own deposit services. In this way they have contributed to the competitive pressures that have seen a steady erosion of banks' low-cost deposit base.

A second example, on the lending side, was the growth of merchant banking. This occurred in two distinct phases – one in the late 1960s and early 1970s, and the other in the 1980s (see Figure 5). Asset price inflation and an expanding demand for credit played a role in both episodes, with these institutions being active lenders at the more speculative end of the risk spectrum. Regulatory constraints on banks also clearly played a big role in the earlier episode but it is significant that merchant banking activity continued to expand rapidly in the mid 1980s after those constraints on banks were removed. The merchant banking sector engages in a wide range of financial activities but an essential characteristic of much of their activity is to provide loans to businesses, funded by borrowing in domestic financial markets or from non-residents. In this way, they perform the lending and credit assessment functions associated with traditional banking without engaging in retail deposit-taking. Merchant bank assets expanded to a peak of around 13 per cent of the financial intermediaries sector in 1988 but then contracted sharply for several years. They nonetheless remain a significant presence as the largest of the non-bank intermediary categories, currently accounting for just under 10 per cent of total intermediaries' assets.

The third and more recent example of specialist competition is the growth of mortgage managers. These have been in existence since at least the 1970s but it is only in the past few years that they have grown dramatically and emerged as a significant, though still small, competitor to banks in the housing loan market. They currently account for about 8 per cent of new housing loans, compared with a market share of less than 1 per cent only a few years ago (Figure 6). Mortgage managers arrange housing loans largely funded by the issue of mortgage-backed securities that are in turn mainly held by institutional investors. The growth of this market provides a good illustration of the potential for separation of lending from deposit-taking functions in the financial intermediation sector, and also illustrates the role that funds managers can play as providers of funds to specialist institutions.

The market opportunity for mortgage managers arose from a number of factors, discussed in more detail below, that contributed to a widening of the gap between standard housing loan rates and money-market interest rates; this was particularly evident in 1992 and 1993 when the gap was around 4 percentage points, though it has since narrowed considerably (Figure 7). By comparison, rough estimates suggest that mortgage managers can deliver a residential mortgage product at the bank bill rate plus around 150 to 200 basis points. The widening of the banks' interest differential in this area could be argued to have been partly a cyclical phenomenon; banks typically smooth out the path of mortgage interest rates relative to money-market rates and this means that the difference between the two is likely to be largest at the bottom of the interest rate cycle. But there is also an important structural dimension to this issue (discussed in detail below). Increasing competition for deposits, and a desire to preserve average profit margins, have meant that the overall structure of bank interest rates on both the deposit and lending sides have moved up relative to money-market interest rates. This created the opportunity for specialist lenders, funding themselves at money-market related rates, to undercut the banks and put pressure on banks to lower margins.

It should be noted that the process of disentangling traditional banking products by specialist institutions or entities is still in its infancy in Australia. In the United States, where disintermediation has been a feature of the financial system for a decade or more, almost two-thirds of residential mortgages and half of the outstanding credit card receivables are now funded through the wholesale markets via securitisation programs. Other entities, such as state and local authorities, are increasingly looking beyond the banking system to fund their activities via the issue of securities backed by their receivables (water, electricity, gas etc). These practices have the potential to erode further the traditional market for bank funding in the United States and there is no reason to believe, in principle, that a similar process could not take hold in Australia. The issue, essentially, is the efficiencies which can be derived out of the intermediary structure as opposed to the efficiencies of separately producing each of the services implicit in the intermediation process.

3.2 Competition and Margins

An important influence on these competitive developments has been the traditional pricing structure of the banks' joint product mix. This has typically involved very low fees for transactions services, with bank revenue essentially coming from the net interest margin, a system often described as one involving ‘implicit’ interest payments to deposit holders in the form of free or low-cost transactions services. This pricing structure was sustainable as long as there were reasonably strong natural barriers to the separate production of banks' core services, which was essentially the case up to the 1970s. As noted above, the absence of well-developed securities markets meant that lending and deposit services could not be separately provided, and there was little scope to provide transactions services independently of deposit-taking facilities. The key subsequent development is that, to an increasing degree, separate production of these services is now possible and, as illustrated earlier, the new ‘production technology’ for basic deposit and lending services is increasingly one which does not require extensive branch networks. To the extent that this is the case (and the trend is still at an early stage) it means that the economic function of branch infrastructure should be viewed as being related primarily to transactions rather than intermediation services. This in turn suggests that, under the prevailing price structure, the provision of transactions services by banks is essentially loss-making and has to be cross-subsidised from net interest earnings.

The pricing structure described above is clearly not one the banks would ideally want. There is a strong economic logic to pricing transaction services more in line with costs, and indeed a wide range of transactions fees have been introduced by banks in recent years. These appear however, to remain well short of full cost recovery.^[12] The low-price regime on transactions services is essentially inherited from history and banks have faced strong public resistance to changing it. Nonetheless, the situation seems unlikely to be sustainable indefinitely, and changes are occurring. Banks will be unable to compete with specialist institutions while they are required to cross-subsidise payments services which their competitors do not offer.

The need to cross-subsidise transactions services and maintain an expensive infrastructure network have important implications for banks' competitive position, particularly when viewed in conjunction with another development, the decline in banks' low-cost deposit base (Figure 8). Low-cost deposits – defined here as non-interest-bearing accounts, statement savings accounts and passbook accounts – currently represent about 12 per cent of the major banks' total liabilities. This is down from over 50 per cent in 1980 and from even higher levels in the 1960s and 1970s. The trend can be attributed to a number of longer-term factors including the effect of periods of high inflation in sensitising depositors to differences in rates of return, as well as competition from non-bank competitors. This shift in the composition of deposits has been an important source of upward pressure on banks' average cost of funds relative to money-market interest rates.

Another factor influencing this relative cost of funds in the past few years has been the decline in inflation and the consequent fall in average nominal interest rates. Since the ‘low’ interest rates referred to above had little or no scope to fall further, the general fall in market interest rates has necessarily compressed the margin between low-cost and market rates. In other words, the cost advantage derived from a given volume of low-cost deposits has declined at the same time as their share of total deposits has fallen. In a low-inflation environment, there is no reason to expect a significant reversal of this trend.

Against this background it is useful to look at what has happened to margins between deposit and lending rates. The Campbell Committee expected that deregulation would lead to reduced margins by increasing overall competition and removing constraints that had channelled competition into non-price areas such as the extension of branch networks (Valentine 1991). There has been considerable debate as to whether these and other expected benefits of financial deregulation have been realised, and some borrower groups such as small businesses have expressed concerns recently about high margins.^[13] These concerns partly reflected the fact that key lending rates fell less than one-for-one with cash rates during the extended period of cash-rate reductions in the early 1990s, which was in turn related to banks' tendency to smooth their main lending rates over the course of a cycle. There was also concern that heavy loan-losses incurred by banks made them reluctant to cut gross margins.

The data presented in Figure 9 summarise a number of aspects of these issues. They suggest that average margins have been fairly stable although showing some tendency to fall since the early 1980s. Two features of the data seem particularly striking. The first is the way that average deposit rates and average lending rates have moved together over the course of a number of interest rate cycles. These averages seem much more closely related to each other than to developments in general securities-market interest rates such as the 90-day bill rate. Secondly, abstracting from cyclical movements, both deposit and lending rates have moved upward relative to the bill rate over a period of time. This is true both for the averages depicted in the upper panel of Figure 9 and for the main indicator lending rates. Similar behaviour has been observed in a number of other OECD countries that deregulated their financial systems.^[14]

In the light of the preceding discussion this behaviour can be interpreted as consistent with a form of joint-product pricing that aims to preserve average margins. With competition having been stronger on the deposit than on the lending side, average deposit costs have moved upward, and the cost of cross-subsidising transactions services has effectively been shifted from depositors to borrowers. It is this pricing structure that is now under pressure from specialist lenders.

The banks have been responding to these pressures on a number of fronts. In the housing loan market, banks have substantially narrowed the gap between their standard mortgage rates and the bill rate in the past two years, first by raising mortgage rates less quickly than the bill rate during 1994, and more recently by interest rate reductions that were a direct response to the competitive pressures outlined above. They also introduced reduced-rate loans like ‘honeymoon’ loans and ‘no-frills’ loans. More generally, the retail banks seem to be adopting marketing strategies that emphasise the full-service nature of their products, aiming thereby to differentiate themselves from more specialist institutions. In this regard the ability to smooth interest rates gives standard bank loans a potentially attractive characteristic compared with the new securitised loans.

Banks have also sought to reduce costs through measures to increase operating efficiency, particularly through reductions in branch and staff numbers. Increased account fees can also be thought of primarily as a cost-containment measure, since these fees are still pitched well below cost and appear to be designed mainly to discourage excessive use of transactions facilities. Particularly important has been the structuring of fees to encourage a shift to electronic payment methods. There has been considerable expansion of the ATM network and the number of EFTPOS terminals in recent years (Figure 10), and these and other card-based payment systems now account for more than half the volume of remote payment transactions.^[15] A byproduct of this technology, however, and of banks' relatively low transaction charges, has been a greatly increased capacity for bank customers to make low-value transactions. To an important degree the result has been to stimulate demand for additional transactions services rather than significantly displacing demand for over-the-counter transactions at bank branches.^[16] Thus, the general logic for higher transactions charges remains powerful.

Against the background of these developments, banks have also set their eyes increasingly on the burgeoning superannuation and funds-management sector as a potential long-term offset to these pressures. Aggregate funds under management currently total over $300 billion and, on latest estimates, banks already control around 25 per cent of that total. Growth of banks' activities in this area has been rapid over the past five years (Table 4). The question of how banks (narrowly defined) can effectively insulate themselves (and their depositors) from the activities of their funds-management subsidiaries will be one of the ongoing issues facing supervisors and regulators. Another is the extent to which banks should be permitted to offer, or conceivably could offer, superannuation products of some form through their own balance sheets.

It should be emphasised that the competitive pressures, and potential responses analysed in this section are still emerging. Bank profits, on the whole, remain high if judged by recent results and the real pressures would appear to lie ahead.

3.3 Impact of Foreign Banks

Only two foreign institutions operated continuously as authorised banks in Australia in the postwar period prior to 1985.^[17] The absence of a wider foreign banking presence reflected the moratorium on foreign bank entry, discussed earlier, that had effectively applied in Australia since the war. Despite these restrictions, foreign banks did participate in the Australian financial sector via three main channels – through correspondent banking arrangements with Australian banks, through lending to Australian borrowers facilitated by the presence of representative offices and, most importantly, through the activities of foreign-owned or partially owned merchant banks. The merchant banking sector accounted for about 5 per cent of the assets held by intermediaries by the late 1970s and much of that related directly to the activities of foreign-owned institutions.

The emergence of a ‘foreign bank presence’ in Australia in the absence of ‘authorised foreign banks’ represents what, with hindsight, appears to have been a novel approach to the definition of banks and non-banks within the Banking Act 1959. Section 11 of the Act, for example, draws a distinction between those ‘persons’ wishing to ‘carry out banking business’ and those wishing to ‘carry out the general business of banking’. The latter required a formal banking authority while the former could be exempted from that requirement. Nowhere, however, were the activities which constituted the ‘general business of banking’, as distinct from the ‘business of banking’, specified. Those institutions successfully seeking an exemption under section 11 became part of the non-bank sector. Large numbers of foreign banks entered the Australian market by this mechanism.^[18]

A more formal opening of access to the domestic banking system was an important focus of the Campbell Committee. In outlining the case for foreign bank entry, the Campbell Committee argued that foreign banks would add to the competitiveness of the system. The Committee also warned that the contribution foreign banks could make to improved competition should not be exaggerated, given that they were already present in the market. There was a strong sense however, that, as banks, such institutions could provide a more comprehensive array of banking services (especially in the retail area), could structure themselves in more efficient ways, and could generally be more competitive than as non-bank entities.

The relaxation of foreign bank entry announced in 1984 saw a limited number of pre-existing non-bank institutions convert to bank status in response to an invitation from the government. There was, in addition, an injection of a number of genuinely new banking entrants and an expansion in the number of foreign banks operating as merchant banks.^[19] One feature of the entry requirement was that foreign banks assumed a subsidiary rather than a branch structure. This was based on a view that to engage in the full range of banking activities in the Australian market, which encompassed both wholesale and retail activities, it was desirable from a prudential perspective to require capital to be held locally. In addition, it was felt that capital should also be set at a relatively high absolute level to encourage applicants with sufficient financial standing.^[20]

The experience of foreign banks from the mid 1980s to the end of the decade, and their impact on the Australian banking system, proved to be mixed. At one level, the introduction of new banks, and the perception of the competition they would bring to the market, brought a new competitive focus to the entire banking system. There were some concrete examples of that process relatively early on. Some of the innovations in retail banking in the mid 1980s, for example, such as the payment of interest on current accounts and improvements to credit card facilities, flowed from the foreign banking sector and were quickly taken up by Australian banks. On the wholesale side, foreign banks continued their ‘merchant banking’ activities and in that sphere were innovative in product development and in financial and derivative markets. In terms of overall assets, however, the picture was less noteworthy. As a group, foreign banks quickly established around a 10 per cent share of total banking system assets, as assets were shifted from the non-bank to the banking sector, and that proportion was broadly maintained over the remainder of the decade. With only very minor exceptions, foreign banks were not able to make an impact on the dominant position of the Australian banks in the retail and commercial market, where large customer franchises had been established through extensive branch networks.

A second round of foreign bank entry began in 1992 when a generally more open-ended policy was adopted. In contrast to the position taken in the mid 1980s, foreign banks were encouraged to apply for authorisation at any time and in any number and, provided they met the entry requirements, they were permitted to adopt either subsidiary or branch structures. Where a branch structure was chosen, the bank was not permitted to participate in retail finance activities on the grounds that full local supervision and the depositor protection arrangements of the Banking Act could not realistically be applied.^[21] A number of foreign banks strongly challenged this view but the policy was maintained and remains in force.

The number of foreign entrants increased significantly from 1992 (Table 5). Overall, however, the activities of foreign banks remained relatively small compared to the long-established Australian banks. Their share of banking system assets rose to 14 per cent by 1996 as a result of new entries but, with only minor exceptions, their activities remained heavily focused on wholesale or institutional markets.^[22]

3.4 Financial Markets

Growth of financial-market activity has been a major feature of financial-sector development since the 1970s. Important early developments were the freeing of the CD rate in 1973, subsequent growth of the CD and commercial bill markets, and the introduction of a bill futures market in 1979.^[23] Additional impetus came from the introduction of market tenders for treasury notes (1979) and government bonds (1982) and the float of the exchange rate and removal of exchange controls in 1983. New foreign bank entrants after 1985 further stimulated growth and innovation. Another important factor has been the growth of the funds-management sector and the associated demand for risk-management and financial-trading services. In a sense, the increasing liquidity of the main financial markets created a momentum of its own by making it increasingly possible to compare funds managers' performances over short periods and thereby stimulating competition among them as to comparative rates of return. This in turn generated demand for high-frequency financial trading and for new instruments of risk management. Financial-market volatility was itself also a factor in stimulating trading activities and demand for risk-management products.

Important areas of growth were in the markets for foreign exchange and interest-rate products, where turnover grew dramatically in the late 1980s. The other area to expand rapidly was that of financial derivatives, including foreign exchange and interest rate futures, forwards, swaps and options. In many of these areas, the Australian market is quite large in international terms. Australia has the ninth largest foreign exchange market and the sixth largest interest rate futures market in the world, ahead of a number of countries with much larger economies. The markets have also become increasingly sophisticated, though the products most heavily traded have been at the simpler end of the spectrum. Issuance and trading of corporate bonds remain relatively small, however, underlining the point that the growth of financial markets has been primarily related to the risk-management function of these markets, rather than to any shift to securitisation of financial flows to the business sector. Growth of the main markets is summarised in Table 6.

Much of the development and innovation in these markets occurred within the banking system. Similarly, trading activity in the new financial markets has been largely dominated by banks. For example almost 90 per cent of foreign exchange dealing and around 80 per cent of over-the-counter interest-rate derivatives dealing fell to these institutions.^[24] Figure 11 shows the rapid expansion in banks' derivative activities, especially over the latter part of the 1980s. Financial market growth has thus provided an important field for banks to expand their activities during the post-deregulation period.

Financial market trading is highly competitive and margins on established products generally thin. This has been increasingly the case in recent years. Good returns can be obtained if new products or new financial markets can be exploited but growth and profitability potential decline as the ‘product cycle’ matures. This phenomenon is clearly evident in the two largest financial markets (foreign exchange and bill futures) illustrated in Figure 12, although to some extent the recent slower growth may be related to more stable trading conditions and a consequent reduction in demand for risk-management products. A number of major market players have reduced their financial trading activities or withdrawn from particular segments where profitability is lowest. Since 1994, many banks have greatly scaled down their proprietary trading (active position taking).

This characteristic of the product cycle suggests that future profitability of financial market activities will depend on continued growth and innovation in these markets. On that score, prospects for growth are likely to be supported by continuing growth of the funds-management sector (see Section 4). The scope for continued product innovation, however, is hard to predict. Equity and commodity-related derivatives are gaining in interest amongst the more specialist market players and the more sophisticated institutions have begun to investigate the potential offered by the development of other new markets, such as the emerging market for electricity in a number of Australian states. There is also a very tentative examination of the scope for developing credit derivatives by some institutions, an innovation that is still in embryonic form even in the United States. Many institutions are looking also at the use of derivatives to differentiate and add value to their balance-sheet products via the use of swaps and options, a potential growth area for derivative activities. The question remains, however, as to whether the next generation of developments within the financial markets will offer anything like the same potential for growth in revenues as occurred in the 1980s.

3.5 Profits, Productivity and Efficiency

Although banking was highly regulated prior to the 1980s, with controls over most lending rates and various controls over the composition of bank asset portfolios, entry was also tightly restricted. While the former influence acted to limit profitability of the banking sector, the latter would have tended to enhance it. Available data suggests that profitability of banking in Australia, in fact, grew steadily over the 1960s and 1970s, probably reaching a peak by the early 1980s (Figure 13). At that point, profitability in banking appeared to be well above the average of other Australian industrial sectors (Table 7).

The structural shifts to the financial system that followed deregulation saw some of the assumptions underlying banking in Australia begin to break down. Profitability stabilised, albeit at a relatively high level, in the first half of the 1980s as the combination of increased freedoms within the system interacted with greater potential for price competitiveness and, around the middle of the decade, increased competition from new entrants to the market. Over this period, Australian banks sought to expand their operations both domestically and internationally in the search for new sources of revenue and comparative advantage. For some banks, this process has continued to the present time. For others, the process of overseas expansion was halted and reversed in the early 1990s (see below). There were tentative signs by the middle years of the 1980s, however, that profitability in banking may have begun to ease a little from the high points of earlier years.

Further interpretation of the effects on profitability of the structural changes in the financial sector was complicated greatly in the late 1980s and early 1990s by the effects of the first post-deregulation cycle in the banking sector (and the most significant cycle in the banking system since the 1930s). Profitability in the banking system fell sharply with the collapse of the asset boom which had fuelled much of the speculative lending activity of the late 1980s, and the recession of 1990/91. While the timing of losses varied, all the main groups of banks – major, state and others – registered overall losses at some point between 1990 and 1992. Foreign banks as a group were the hardest hit with losses amounting to 30 per cent of their capital in 1990 alone. Between 1986 and 1990, aggregate foreign bank losses absorbed an amount equal to their original start-up capital. State banks lost heavily over the period (with concentrated effects in Victoria and South Australia) and some major banks suffered large losses in the early 1990s. Similar episodes of losses, in some cases more severe, were experienced in the non-bank sector (particularly amongst merchant banks) as well as in the banking systems of other countries over a comparable period.^[25]

The response to the downturn in profits around the turn of the decade was a process of rationalisation which continues today. Costs, which had risen over the 1980s, became a new focus as did the viability of many of the overseas operations which had expanded in the previous decade. Domestically, the major banks especially sought to reduce the number of branches and to reduce staff levels, which had expanded rapidly between 1985 and 1989. These factors, together with improved economic conditions, and the eventual rundown in stocks of problem loans, saw profit levels in banking rise again to levels previously seen in the early to mid 1980s. Nonetheless a question mark remains concerning the extent to which banks will be able to maintain these levels of profitability as competitive forces become more pronounced in the period ahead. The widespread presumption, and one of the key themes of this paper, is that underlying banking profitability is on the wane, and it is this factor which has driven much of the debate on where the banking and financial system is headed in the longer term.

A more general question, and one that has been the subject of considerable debate, concerns the nature and extent of net public benefits from financial deregulation. The broad outlines of this debate are well known.^[26] Financial deregulation was expected to bring a variety of efficiency gains, and a convincing argument can be made that many of these have been delivered – for example, increased diversity of choice for buyers of financial services, increased product innovation including a wide range of new retail banking services, higher returns to depositors and removal of non-price credit rationing induced by regulatory constraints. Moreover, as alluded to above, there are good reasons for thinking that reductions in lending margins are likely in the years ahead. The costs usually cited as coming from deregulation are those associated with the financial cycle that followed the deregulation period – the lowering of credit standards, excessive credit expansion and the resultant loan-losses and balance-sheet contraction that contributed to the severity of the early 1990s recession. Whether these transitional costs could have been avoided by alternative approaches to macroeconomic management or to financial regulatory policy is another question.^[27] As far as regulatory policy is concerned, it is not clear that some sort of transition to a deregulated system could have been avoided, given the shrinkage of the regulatory base that was occurring under the old system. Of course, none of this debate is unique to Australia.

One reason that this debate has tended to be inconclusive is that there is no agreed method of measuring the financial sector's output and efficiency. Essentially two types of approaches are available – what might be termed the output and the income approaches.^[28] Output-based approaches attempt to measure the production of services directly using indicators of the volume of services performed, such as transactions processed or assets under management. These measures are subject to the criticism that they do not necessarily capture the real value of output to the consumer – the argument that deregulation has induced greater financial turnover but that it is not particularly productive.^[29] Income-based approaches aim to solve this problem by defining output as the real net revenue that financial intermediaries earn.^[30] The problem with this is that it fails to distinguish price and volume movements – deregulation can be expected to have reduced the cost but raised the volume and quality of financial services supplied, and revenue measures do not separate these components.

For what they are worth, simple output indicators such as the one depicted in Figure 14, based on total assets, suggest that major increases in financial-sector productivity have occurred since the early 1980s. Here it is noteworthy that, after an initial period of growth in the mid 1980s, financial-sector employment has contracted considerably, notwithstanding the continuing growth in financial activity. Moreover, in one important sense, that growth is understated by asset measures because off-balance sheet services have grown even faster. Other direct measures of productivity such as transactions processed per employee, ATM and EFTPOS facilities and the like, would similarly show major increases.

Footnotes

Currently around 60 per cent of banks' income is accounted for by net interest. This figure understates the importance of intermediation business since it excludes bill acceptance fees, which are really a form of intermediation income. [11]

The Prices Surveillance Authority (1995) concludes that bank transaction services are priced significantly below cost on the basis of allocations of infrastructure costs in line with standard accounting principles. See also Burrows and Davis (1995) for a discussion of the economics of cost allocation for joint products. [12]

For a discussion of these issues in an Australian context, see Fraser (1994) and the papers in Macfarlane (ed.) (1991). See also Edey and Hviding (1995) for a discussion of other OECD countries' experiences. [13]

See Edey and Hviding (1995). [14]

See Mackrell (1996). [15]

Prices Surveillance Authority (1995), p. 179. [16]

The Bank of New Zealand and Banque Nationale de Paris. The Bank of China also operated up to 1972, re-opening in 1985. [17]

The Financial Corporations Act 1974 provided that all institutions satisfying the definition of ‘money market corporations’ (merchant banks) automatically gained a section 11 exemption under the Banking Act. [18]

The decision to allow an increase in the number of merchant banks operating in the market was against the background of the decision that only a limited number of new banking authorities would be issued. In all, 16 applicants for banking authorities were accepted of a much larger number that applied. [19]

A minimum Tier 1 capital requirement was set at $20 million, and subsequently increased to $50 million. [20]

For these purposes, retail activities were defined in terms of retail deposit-taking. In brief, branches were not permitted to take deposits from customers unless the initial deposit amount was $250,000 or more. Any deposits taken within foreign bank branches were not extended the benefits of the depositor protection provisions of the Banking Act. [21]

The noteworthy exception was Citibank which established a highly innovative retail operation. It was very small, nonetheless, relative to most of the established banks. [22]

This was the first interest rate contract offered on an exchange outside the United States. [23]

For a review, see Reserve Bank of Australia (1996). [24]

Similar experiences occurred in a range of different countries over a comparable period (the United States, Japan, parts of Europe and Scandinavia). This suggests that the processes which led to the cycle in the banking sector in Australia were not unique and may have been derived from basically similar underlying causes (Macfarlane 1989; Borio 1990; and BIS 1993). [25]

See Perkins (1989), Harper (1991), Phelps (1991) and Edey and Hviding (1995). [26]

Concerning issues of macroeconomic management, and specifically monetary policy, see Macfarlane (1991). [27]

For further discussion of these conceptual issues, see Colwell and Davis (1992). A third approach, where output is measured by the volume of inputs, essentially assumes zero productivity growth. [28]

See Stiglitz (1993). [29]

This is essentially the approach taken in the national accounts. [30]