RDP 1999-05: Trends in the Australian Banking System: Implications for Financial System Stability and Monetary Policy 5. Conglomeration and the Competitive Fringe

In this section we briefly consider the impact of conglomeration and the rise of the competitive fringe on the efficiency and stability of the banking sector.

5.1 Conglomeration: Efficiency and System Stability

The trend towards the formation of large conglomerates has implications for both the efficiency and stability of the financial system. There are a number of arguments to suggest that conglomeration can lead to efficiency gains, whereas in terms of stability there are two opposing forces, the net effect of which is unclear.

There are three reasons why conglomeration is likely to lead to efficiency gains: increased convenience, increased competition and reduced information costs. First, conglomerates can deliver efficiency benefits by providing customers with the convenience of ‘one-stop shopping’ facilities – that is, a multitude of related financial products provided in a single location. Indeed, the marrying of a number of financial products is consistent with the trend towards financial deepening, and the demand for a greater variety of increasingly sophisticated financial products.

Second, the forces leading to conglomeration have the potential to provide efficiency benefits in the form of greater competition. Just as banks are diversifying into non-bank products such as insurance and superannuation, large non-banks are expanding into banking products. For example, the Australian Mutual Provident Society (AMP) formed a banking arm in 1998 and the Colonial Mutual Life Assurance Society Limited purchased the State Bank of New South Wales in 1994.

Third, information sharing across different types of business activities within the conglomerate may help to reduce costs. For example, customers may have just one account and file with the conglomerate, helping to cut costs and enable the conglomerate to tailor its range of products to individual needs.

There are two offsetting factors to consider when determining the impact of conglomeration on the stability of the banking sector. These are diversification, which will reduce the probability of individual bank failure, and contamination, which can lead to contagion flowing from failures in non-core banking activities. Institutions which are involved in a range of business activities should be less likely to fail because of the benefits of diversification. Mishkin (1998) emphasises that banks' diversification into non-core activities is a way of supplementing bank profits which are being eaten into by niche players.

In contrast to diversification, contamination reduces stability. It may be that losses in one arm of the business will impair the ability of the conglomerate to undertake its core-banking activities. Because of this, regulators might force the conglomerate to construct ‘firewalls’ in an attempt to separate the different activities into individual business units – in part, the motivation behind these regulations is to restrict the safety-net provisions of explicit depositor-protection schemes (or implicit central bank support) to the area of banking business. However, effective firewalls will also lead to a reduction in the benefits of diversification.

Experience with firewalls between banks and related finance companies has reinforced the popular perception that all too often firewalls are ineffective.^[27] So even if new and effective regulations are put in place to prevent cross-contamination within conglomerates, these firewalls may lack credibility. Without credible firewalls, the risk of brand-contamination remains – that is, there could be a run on an essentially healthy banking unit within a conglomerate because of a fear of contamination from a financially distressed non-banking unit.

5.2 The Competitive Fringe: Efficiency and System Stability

We have already argued that technological change and deregulation have combined to increase the contestability of the banking sector. In particular, innovations which have allowed unbundling and re-bundling of financial products have helped to increase the degree of competition from smaller ‘fringe’ financial firms.

These developments imply greater efficiency; however, they also imply that large banks will suffer from lower margins across a range of products as a result of a more competitive fringe. This is consistent with the evidence of falling lending margins over recent years. Smaller banks and non-banks have naturally tended to encroach upon the lower risk and higher profit activities. Offsetting this effect is the potential for expansion and diversification when banks shift into non-core financial activities previously dominated by non-banks.

The development of new financial products – in part driven by technological progress – has increased the ability of non-banks to participate in the process of financial intermediation. One notable innovation has been securitisation, which has offsetting implications for the stability of the system. On the one hand, as securitisation transfers the loans off the balance sheets of banks, in the event of an increase in loan defaults, banks' balance sheets will not be directly affected so the intermediation process should not be greatly impaired. This should serve to increase financial system stability. On the other hand, there may be a tendency for the securitisation of only high quality assets, thereby weakening banks' balance sheets and reducing the stability of the banking system. Furthermore, some might argue that the investors who buy the securitised loans may not be as well placed as banks to absorb the impact of a rise in defaults, with possible adverse consequences for wealth and spending. However, the net loss of wealth is the same regardless of who is the end holder of the security, whether they are holders of bank shares, or investors (some of whom may be offshore) in the institutions that purchase the securitised loans.

Footnote

In Australia, well known examples include the problems of the Financial Corporation of Australia affecting the Bank of Adelaide in the late 1970s (Stanford and Beale 1988), and the problems of the Australian Guarantee Corporation affecting Westpac in the early 1990s (Carew 1997). [27]