RDP 9605: The Evolving Structure of the Australian Financial System 2. Overview of the Main Trends

2.1 The Starting Point: The Financial System in the 1950s and 1960s

While the 1950s might seem a remote starting point for analysis, the period provides a good stylised model of what might be called the ‘traditional’ financial system, and many of the important trends to be analysed can be traced back to that time. In the discussion that follows we make use of a basic distinction between the financial intermediaries sector, comprising those institutions whose core functions involve borrowing and lending,^[2] and the managed-funds sector, comprising mainly life insurance and superannuation funds along with other investment vehicles like unit trusts. It will be argued that this represents a reasonably natural distinction and that competition within each of the two sectors has generally been more important than competition across sectors. Emerging areas of competition and functional overlap between the two areas are discussed in Section 4.

Table 1 illustrates long-run trends in the structure of the financial intermediaries sector. It can be seen that, until the 1950s, financial intermediation was largely synonymous with banking. In 1953, banks accounted for 88 per cent of the total assets of this sector while the next largest group, pastoral financiers, had only 4 per cent. A summary balance sheet for banks at around the same period (Table 2) shows the main elements of what might be regarded as the traditional bank product mix. Deposits were raised mainly from low-cost sources, with non-interest-bearing cheque accounts and low-interest savings bank deposits together funding around 85 per cent of the balance sheet. Fixed deposits represented most of the remainder. On the asset side, almost half the balance sheet was invested in government securities or held in SRDs, and around 40 per cent accounted for by loans. With interest rate controls in place, bank loans were rationed and available only to the most creditworthy of borrowers. Banks faced little competitive pressure from other institutions, which had not yet begun their rapid development, and the system was not open to foreign bank entry or to offshore transactions. Banking business was essentially a low-risk proposition conducted at regulated prices.

The other main part of the system was the managed-funds sector, which in terms of assets was around one-third the size of the banks. This comprised principally life offices and superannuation funds, which offered very different services from banks in the form of long-term, highly tax-favoured saving plans. There was some overlap with banking functions in the provision of mortgage lending by life offices, which helped to satisfy the demand for mortgages unmet by banks. This area of lending activity was quite substantial in the 1950s and 1960s but subsequently declined, for reasons discussed in Section 4.^[3]

From this sketch we can summarise the three elements of what might be called the traditional bank business mix; namely, lending, deposit-taking and the provision of transactions services.^[4] An important question that recurs through this paper is the extent to which these three services need to be provided in a single institution. In this respect a central part of the developing story concerns the emergence of new financial products and new institutions that can compete separately for profitable lines of business, without taking on the whole of the banking product mix. This sort of competition was not possible in the 1950s and 1960s when securities markets were undeveloped and separation of deposit and lending functions, as is now exemplified by cash management trusts and mortgage managers, was not possible.

2.2 Development of Financial Institutions

Overall growth of the financial system and its institutional subsectors is illustrated in Figure 1. System assets more than doubled as a ratio to GDP between the 1960s and 1990s, with much of that growth occurring in the immediate post-deregulation period in the second half of the 1980s. This has been followed by a period of slower growth but the long-term trend still appears to be upward, consistent with patterns in other countries and with theoretical notions of ‘financial deepening’ as an economy grows. That is, the demand for financial services, broadly defined, tends to increase faster than the increase in income.

Banks went through an extended period of declining market share during the 1960s and 1970s, when corresponding gains were made by non-bank financial intermediaries, particularly building societies, finance companies, merchant banks and, later, unit trusts (trends that will be elaborated further below). This trend reflected the competitive disadvantage that financial regulations placed on banks. In particular, interest rate controls tended to keep the entire structure of bank rates below market-clearing levels, with a consequent rationing of bank funds and the emergence of a ready market for funding at higher rates. To some extent, the banks became involved in this market by creating new non-bank subsidiaries to conduct this business ‘outside’ the bank itself and, therefore, outside regulatory constraints. But there was also a substantial growth of non-bank financial institutions (NBFIs) not affiliated to the domestic banking sector. In a number of cases, these institutions were owned by foreign banks that sought a financial presence in Australia but were precluded from establishing a formal banking operation by the effective moratorium on new foreign banking authorities before 1985. In other cases, non-bank institutions were joint ventures between domestic and foreign banks.

A strong reverse trend in these market shares has been observed in the post-deregulation period as the banks' ability to compete with NBFIs improved. In addition, banks reabsorbed non-bank affiliates onto their balance sheets and there were a number of prominent non-bank institutions, particularly building societies, which found it advantageous to convert to banks in the late 1980s and early 1990s. A one-off easing of restrictions on foreign bank entry in the mid 1980s, and the more open entry policy adopted in the early 1990s, saw the foreign bank presence increase, in part at the expense of the merchant bank sector.

A critical factor shaping the recent history of the financial system, and widely analysed elsewhere, was the credit boom which followed financial deregulation. This phenomenon, and its interaction with macroeconomic developments in the 1980s, contributed to growth of the financial sector in a number of ways. Most importantly, it gave the system the capacity to satisfy long-standing, repressed demands for finance. This had the predictable (in a qualitative sense) effect of allowing a one-off expansion of the financial sector relative to its historical trend. Related to this, the expansion in the availability of finance contributed to an asset price boom which further fed back into credit growth. Rising asset prices and expectations of continued asset price inflation fed the demand for credit and also provided increased collateral to support debt-financed asset acquisition. Finally, rising real asset prices and the high real interest rates that followed deregulation meant that the managed-funds sector generated exceptionally high rates of return in the 1980s. Since these funds tended to be locked in (particularly in superannuation funds) and automatically reinvested, the high rates of return contributed substantially to growth in these institutions' assets. The net result was a near doubling of the size of the financial sector relative to GDP in little more than a decade.

The shifting market share of banks vis-à-vis other financial intermediaries is illustrated more starkly in Figure 2, which shows banks' assets as a share of the total financial intermediation sector. This declined steeply to a low point of 57 per cent in 1982 before recovering equally dramatically to almost 80 per cent by 1994, comparable to banks' market share in the 1960s. The pattern of decline and recovery is exaggerated somewhat by the growth and subsequent reabsorption of NBFI subsidiaries by banks, but the qualitative picture remains valid; on a consolidated basis, banks' asset share fell to a trough of 61 per cent in 1981, still a substantial reduction in the market share of consolidated banking groups from the levels of the 1960s and 1970s. On the other hand, the recovery in banks' aggregate market share during the subsequent period was substantially boosted by the entry of new banks, particularly through the conversion of existing non-bank intermediaries. When new and pre-existing banks are shown separately, it is apparent that banks already existing in the mid 1980s largely did not recover the market share lost in earlier decades. This may be one indicator of the increasingly competitive environment faced by banks, a theme that will be discussed in greater detail below.

2.3 The Non-Financial Sectors

Before turning to a more detailed analysis of competitive forces within the intermediation sector it will be useful to look at trends in the financial demands of the other parts of the economy which are the financial sector's clients. This is done in the next three subsections covering the government, corporate and household sectors.

2.3.1 Government

Developments in government finance have exerted a powerful influence on the financial sector throughout the postwar period. The federal government entered the postwar period with a substantial volume of debt, amounting in 1950 to more than 100 per cent of GDP. This ratio was steadily reduced until the late 1970s and underwent a further major reduction in the second half of the 1980s, reaching a trough of 15 per cent of GDP in 1990/91. This trend has meant that holdings of government debt have necessarily represented a diminishing proportion of the balance sheets of financial institutions, and particularly of banks, which had held a large part of the outstanding supply in the 1950s. The reduction in government security holdings in turn allowed banks to expand their lending to the household and corporate sectors, thereby gradually changing the structure of banks' balance sheets. Between the early 1950s and the early 1990s, public sector securities and SRDs fell from over 50 per cent to under 10 per cent of banks' total assets.

The combination of higher deficits and higher inflation in the 1970s had important consequences for the financial system in general and for the marketing of government securities in particular. High and variable inflation meant that the demand for government securities became more unpredictable at the same time as the flow of deficits to be financed increased. This in turn generated difficulties of monetary control that led to pressure for the introduction of market-based mechanisms to ensure that government financing requirements could be met. Important responses to these pressures were the introduction of treasury note tenders in 1979 and bond tenders in 1982, replacing the previous systems of administered interest rates on these instruments. The move to market-determined rates on these securities in turn stimulated a whole range of other financial developments as well as intensifying the pressure to deregulate deposit and lending rates of banks, a process described in detail by Grenville (1991).

2.3.2 Corporate sector

By international standards, leverage within the Australian corporate sector has traditionally been relatively low, and this remains the case despite a substantial increase in corporate borrowing in the late 1980s. Average debt-equity ratios of Australian companies appear broadly similar to those in the United States and Canada but significantly below those in the United Kingdom, other European countries and Japan (Table 3).^[5] As is elaborated by Prowse (1996), differences in leverage and other aspects of the corporate funding mix reflect a wide range of differences in the structural characteristics of the respective economies. One important dimension of this is the distinction often drawn between ‘Anglo-Saxon’ and ‘universal-banking’ financial systems, which differ in the extent to which their institutional characteristics favour intermediated rather than direct financing of business activities. Prowse argues that there is some tendency for these divergent systems to become more similar, a result of ongoing financial innovation and internationalisation of financial systems.

The Australian historical experience seems broadly consistent with the pattern of increasing corporate debt observed in other low-leverage systems, particularly in the United States and Canada. Starting from a low base in the 1950s and 1960s, the average debt-equity ratio in Australia has been on a sustained upward trend, accelerating sharply in the second half of the 1980s before the subsequent period of debt reduction observed more recently (Figure 3). The spike in leverage in the late 1980s is in fact understated by the data in Figure 3, based on a continuous sample of companies, since many of the companies whose leverage increased most dramatically at that time did not survive the period and are therefore excluded from the continuous sample.^[6] Notwithstanding the substantial debt reductions that took place in the early 1990s, the volume of corporate debt outstanding remains considerably higher relative to GDP than was the case in the early 1980s, and the most recent data suggest that corporate borrowing has again begun to increase.

An important characteristic of the debt component of Australian corporate financing is the limited use made of direct borrowing through the issue of corporate securities. Corporate borrowing demands in Australia have traditionally been met mainly by financial intermediaries – that is, by banks, merchant banks and finance companies, with the largest part of the market being accounted for by banks. Currently only around 10 per cent of the aggregate corporate balance sheet is financed by debt securities.^[7] In this respect the pattern of corporate financing in Australia differs from those in the larger English-speaking countries, particularly the United States and the United Kingdom, where debt security issuance has historically represented a sizeable proportion of overall corporate sector funding.^[8] A possible explanation is the smaller size of the Australian economy and the relatively small number of Australian companies that would be considered large on an international scale. Direct security issuance is clearly likely to be more viable the larger the company (other things equal), since large companies are more likely to have well-established reputations as well as being able to spread the cost of information over a larger volume of capital to be raised.

The fact that direct forms of financing have not been favoured to date, however, provides little guide to the future. There is a strong belief within banking circles that a number of underlying factors are generating conditions which could lead to an expansion in the corporate debt market. One factor is the increased sophistication of institutional investors and increased demand from that source for good quality debt. In Australia, the expected expansion in the funds-management and superannuation sector could be an important catalyst in this regard. The potential for growth could be further enhanced if attempts to rein in the growth of government debt are successful in the years ahead, as there could then be an increase in demand for alternative securities.

These observations concerning direct and indirect funding have an important bearing on the larger question of the long-term role of banks. An important part of the core business of banks, and of financial intermediaries more generally, has been the funding of businesses through non-marketable loans. Intermediaries earn income in this line of business through the application of expertise in credit assessment and from their store of detailed knowledge about individual borrowers. The question arises as to whether this line of business, or some segment of this business, will continue to represent a growth market for financial intermediaries, as it has over much of the historical period reviewed above.

One view, put for example by Bisignano (1991), is that technological improvement is continually reducing the information costs associated with direct financing, even for relatively small companies. Goodhart (1988) takes a somewhat contrary view arguing that banks (or financial intermediaries more broadly defined) seem likely to retain at least that part of lending linked to the small to medium business sector, where the practical difficulties of assessing creditworthiness are much greater, technological improvements notwithstanding, than for larger companies. It could, of course, be argued that the issue is more involved than suggested by either of the above authors. Corporate demands for finance tend to be diverse, with required borrowings linked variously to long-term capital investments at one extreme or to the need for shorter-term standby and liquidity facilities on a day-to-day basis. While direct forms of financing could be an efficient means of obtaining longer-term funds, a role could still exist for intermediated forms of financing in satisfying shorter-term requirements, even where the largest borrowers are concerned. It could also be argued that, even if there is a significant shift towards direct forms of financing, banks would be well placed to provide the associated services of origination, underwriting and distribution.

2.3.3 Households

The data in Figure 4 illustrate the household sector's position as a net holder of financial assets and show that both sides of the aggregate household balance sheet have undergone a trend expansion over several decades. Notwithstanding this trend, and the fluctuations in some of the balance-sheet components, an immediately striking feature of the asset side of the balance sheet is the relative stability of household deposit holdings. These currently stand at just under 40 per cent of GDP and have shown only minor fluctuations around a very gradually rising trend since the early 1960s. There seems to be reasonably close substitutability among deposits of competing intermediaries, suggested by the fact that the trend in total deposits is much more stable than either the bank or non-bank components of that aggregate. This could be argued to be consistent with a fairly stable level of desired deposit holdings relative to income, driven essentially by transaction and short-term saving requirements, with the institutional split between banks and non-banks being influenced by the relative attractiveness of their interest rates.^[9] This behaviour can be contrasted with the much greater variation in household assets held with life insurance and superannuation funds, which did not appear to give rise to any offsetting fluctuations in deposit holdings. In other words, household behaviour seems to make a clear distinction between deposits with intermediaries and balances with funds managers.^[10]

On the other side of the balance sheet the most important item is lending for housing, which accounts for around three-quarters of personal sector borrowing. Growth in overall borrowing by the household sector shows no sign of abating and, as in other areas of financial intermediation, banks have gained a strong recovery in market share since the mid 1980s, although very recent developments are putting that share under pressure.

Footnotes

The main groups are banks, merchant banks, finance companies, building societies, credit unions and pastoral financiers. [2]

More recently, life offices have again become active in the mortgage market. [3]

A fourth element, the passive holding of government securities, is best thought of as something separate and only incidentally important in the early post-war period, rather than being part of the core business of banking; it was a product of regulation and of the high levels of government debt incurred during the war. [4]

Some caution is needed in comparing balance sheet ratios across countries because of differences in accounting practices. [5]

See Mills, Morling and Tease (1993). [6]

This figure excludes bank bill finance. [7]

Data presented by Tease and Wilkinson (1993) suggest that, in flow terms, security issuance provided funding of comparable magnitude to bank loans for the corporate sectors of both countries in the 1980s. [8]

This view is consistent with more detailed evidence presented by Dilnot (1990). [9]

A separate question concerns the substitutability between superannuation and other non-deposit stores of household saving, which is not addressed here. See Morling and Subbaraman (1995). [10]