RDP 1999-05: Trends in the Australian Banking System: Implications for Financial System Stability and Monetary Policy 3. Trends in the Financial System

In this section of the paper we review recent trends in the Australian financial system and the factors driving these changes.^[4] The main factors that we identify are financial deepening, globalisation, technological progress and deregulation.

3.1 Forces of Change

3.1.1 Financial deepening

As real incomes of households have increased, there has been an increasing demand for a greater variety of sophisticated financial products. This has led to general financial deepening. The pressure for change in this regard has been ongoing for a long time, but was not realised under the financial repression prior to the early 1980s. In Australia there have been additional factors that have fostered greater financial depth including legislative changes affecting compulsory superannuation and a growing realisation of the need for individuals to self-fund their retirement, rather than rely entirely on the public provision of pensions.

Figure 1 illustrates the extent of financial deepening that has occurred since the deregulation in the early 1980s (a description of the data and sources for this and other figures and tables is contained in the Appendix). The rise in household financial assets held in the form of superannuation is particularly apparent.

3.1.2 Globalisation

Globalisation has both demand and supply-side effects. First, on the demand side, liberalisation of the capital account, the floating of the Australian dollar, and increased trade openness have caused non-financial firms to demand more sophisticated financial products and services to help them compete in the global market for general goods and services, and particularly to help them manage risk (Lowe 1995).

Domestic financial institutions have also made increasing use of foreign sources of funds (Figure 2). Deposits remain the major source of bank funding; however, when new sources of funding opened up following deregulation, the proportion of liabilities accounted for by Australian dollar deposits fell from a peak of nearly 75 per cent to less than 60 per cent. Funding decisions are now made on the relative costs across a wide spectrum of potential sources, both domestic and foreign, which serves to increase the efficiency of the intermediation process.

On the supply side, domestic financial firms now have to compete with foreign financial firms – both in the domestic marketplace and in the world marketplace for financial services. Before 1985, the Australian financial system was essentially closed to foreign entrants. In 1985 and 1986 fifteen foreign banks began operations in Australia. Further liberalisation and entry occurred from the early 1990s, to the point where today, there are no limits on the number of foreign bank branches or subsidiaries operating in Australia.^[5] However, foreign bank branches can only take deposits in the wholesale market.

Table 1 shows the increased presence of foreign banks in the Australian financial market, in terms of numbers. However, their share of business, after an initial surge, has increased only gradually. Some foreign banks have subsequently exited, while more recent growth has come about through new entrants.

To date, globalisation appears to have had a bigger (more visible) impact on the wholesale market. On the whole, foreign entrants into the domestic financial market have utilised their experience with international markets to participate in large wholesale transactions, rather than in retail transactions. Large non-financial corporations are also more able to access foreign markets directly in their financial dealings.

Foreign entrants have the potential to reduce the risk of systemic instability because they are diversified globally. Consequently, their balance sheets should be better placed to withstand any idiosyncratic shock to Australia, and thus reduce the probability that they pose a risk to the system. On the other hand, their exposures to other countries may result in them importing troubles in foreign financial systems into the Australian system.

3.1.3 Technological advances

Advances in information technology have reduced the cost of transmitting, processing and storing information. This has reduced the costs of providing a range of financial services and transformed the way in which these services are produced and delivered. Advances have also been made in the development and pricing of complex financial products used for risk management – in part this is closely related to improvements in computer power, but also related to the application of more sophisticated financial and mathematical methods, and the use of more highly trained personnel in the field of finance.

One obvious manifestation of technological advance is the increased use of derivative products. Figure 3 shows that banks' derivative activity in Australia has almost tripled over the past 10 years.

Other technological developments that have delivered cost savings to banks and thereby increased the efficiency of intermediation include the geographical separation of back- and front-office operations and the increased use of Automatic Teller Machines (ATMs) and Electronic Funds Transfer at Point Of Sale (EFTPOS).

3.1.4 Deregulation

The impact of the above three factors on the structure of the financial system would have been significantly curtailed in the absence of the deregulation of the system which began in the early 1980s.

Prior to the 1980s, banks were regulated in terms of the types of products they were allowed to offer and the prices they were allowed to charge. Credit was rationed through direct controls, and banks competed for business through the provision of extra services such as extensive branch networks, rather than on price. Non-bank financial institutions (NBFIs) were less heavily regulated and were increasing their share of the market at the expense of banks. This made the implementation of monetary policy, which primarily relied on control of the banking sector, problematic. As a proportion of the financial system, banks' market share declined over the 1960s and 1970s (Table 2).

The main transformation of the financial system followed from the report of the Campbell Committee in 1979. The primary reasons put forward for deregulation were to increase monetary policy effectiveness and reduce the inefficiencies in the financial system created by the differing regulatory treatment of banks and NBFIs.

Initially, interest rate ceilings on bank deposits were removed. The restrictions on minimum and maximum terms of deposit were also progressively removed from 1980, with the process completed by 1984. On the asset side of the balance sheet, the quantitative controls on the growth in banks' advances were formally ended in 1982, with the last credit directive issued in September 1981 (Grenville 1991). Other important regulatory changes which affected the composition of banks' balance sheets and their cost structure were the replacement of the Liquid Government Securities (LGS) ratio with the Prime Assets Ratio (PAR) in 1985 and the replacement of statutory reserve deposits in 1988 with the requirement to hold non-callable deposits that paid a market rate of interest.^[6]

Following deregulation the banks regained market share in the financial system (their share rose from 41 per cent to 46 per cent over the decade to 1995).^[7] However, this did not occur at the expense of a decline in assets of other financial institutions. Rather, the banks gained a larger share of the increasing depth of the financial system.

3.2 Developments in the Financial System

In general, the above four factors have worked in concert to bring about changes in the structure of the financial system. Technological innovations have made it possible for banks to convert some of their activities into ‘commodities’ which can then be shifted onto the wholesale market (for example, securitisation of home loans), which in turn can potentially lead to the globalisation of this business. Volatility in financial variables such as exchange rates and interest rates, and increased exposure to international trade has led to an increase in the demand for risk management services. Technological change has played a role in meeting this demand.

The combination of these forces helped underpin the asset price bubble that developed in Australia in the late 1980s. Macfarlane (1989, 1990) discusses the relative roles of demand and supply factors that contributed to the bubble. On the supply side, there was a large expansion in credit (Figure 4) as the banks took advantage of their new-found ability to respond to the competition from NBFIs, and simultaneously the new foreign banks also sought to establish their presence in the market. Furthermore, there was increased direct access to overseas sources of funds to finance speculative asset purchases.

On the demand side, the interaction of the tax system with relatively high rates of inflation encouraged individuals to invest in assets to hedge against inflation. The deregulation of the financial system removed the constraint that had existed on this behaviour in the past.

The replacement of a quantity mechanism with a price mechanism in allocating the supply of credit also contributed to the emergence of the asset price bubble. The price mechanism took longer to have an impact in the face of high and increasing rates of return. As long as the growth in asset prices persisted, lending seemed profitable even at high real rates of interest. In the past, the direct quantitative restrictions limited such developments, although asset price bubbles did occur in the early 1970s. At that time, as quantitative restrictions applied to the banking system, the speculative lending associated with the earlier episodes of asset price inflation was confined primarily to the non-bank sector.

The recession of the early 1990s saw the bursting of the asset price bubble and a move to a low-inflation environment. A number of banks were left in a substantially weakened position, in part due to earlier expansion on the back of weak credit assessment techniques. Impaired assets rose substantially, and the returns on equity dropped sharply (Figures 5 and 6).

The banks attempted to rebuild their balance sheet positions by maintaining relatively high margins. This helped provide opportunities for new players to enter the market. These firms competed successfully with banks through specialisation in the provision of only one or two product lines. This unbundling of services was also aided by technological innovations.

Unbundling occurred across many types of services, including the provision of mortgage finance, payment services (through credit cards) and deposits (for example, cash management accounts with cheque facilities). This process was aided by the globalisation trend – many of these techniques were ‘imported’ from overseas – as well as innovations in information technology. Although not large in volume terms, specialist new players appear to have had a significant impact by increasing the degree of contestability and thereby acting to reduce bank margins and unwind cross-subsidisation of bank services. For example, in the housing loan market, mortgage managers currently account for around 9 per cent of new housing loan approvals.^[8] This has placed downward pressure on housing loan interest rate margins, with the margin between the standard rate paid on mortgages and the cash rate having fallen from around 4 per cent in 1992 to just over 1½ per cent in August 1998.

The weak state of some banks' balance sheets in the early 1990s resulted in some consolidation. The largest example of this was the merger of a state-owned bank (that was at the time the fifth largest bank in terms of assets) with one of the major banks in 1991. Further, each of the four major banks has acquired at least one smaller bank over the 1990s.^[9] In addition, some large NBFIs have converted to banks. The net outcome of this process has seen the maintenance of a high degree of concentration in the banking system over the 1990s – the four majors holding two-thirds of total bank assets – after a slight drop in the 1980s.

Over the 1990s, there has been a reduction in banks' branch networks and staffing levels. In part this reflects pressures for rationalisation driven by technological advance and a reversal of earlier over-expansion which had been a way of attracting customers in the heavily regulated environment.

Looking forward, there are three principal pressures on the financial system. First, there is pressure for mergers among the largest banks. Second, there is pressure for financial institutions to increase their scope through the formation of large conglomerates, combining a traditional bank with other financial institutions such as life offices or superannuation funds. Third, counterbalancing these first two pressures, technological developments are significantly reducing the costs of unbundling financial services, creating opportunities for smaller niche institutions. Each of these three forces for change has an impact on the efficiency and the stability of the financial system.

In response to the significant developments and current pressures in the financial system that we have outlined above, in 1996 the Australian Government initiated the Financial System Inquiry (commonly referred to as the Wallis Inquiry). The Inquiry documented many of the changes that we have discussed above. In broad terms the Inquiry's recommendations sought to create a flexible regulatory structure more responsive to the current forces for change, with the goal of promoting greater efficiency in the financial system. One of the problems highlighted was the increasingly difficult task of distinguishing between the activities of banks and non-banks, coupled with diversity in the ways in which different types of financial firms were regulated. The Inquiry's recommendation in this regard was to establish an independent supervisory authority (outside of the central bank), with the task of overseeing a wide range of deposit taking financial institutions, insurance companies, life offices and superannuation funds. In addition, the Inquiry recognised the need for greater competitive neutrality across the financial system. The Australian Government accepted this recommendation and established the Australian Prudential Regulation Authority (APRA) which commenced operations on 1 July 1998. This saw the responsibility for supervising banks and protecting depositors move from the Reserve Bank of Australia to APRA.

At the same time as the establishment of APRA, the Reserve Bank of Australia gained extensive regulatory powers to help ensure payments system stability and efficiency. These powers are exercised by the newly formed Payments System Board within the Reserve Bank. In addition, the Reserve Bank maintains the responsibility for ensuring that shocks to any part of the financial system do not ultimately threaten the stability of the Australian economy (Reserve Bank of Australia 1998, p. 7).

Footnotes

For a more detailed discussion see Edey and Gray (1996) and Reserve Bank of Australia (1996). [4]

Nevertheless, applicants for a banking authority have to satisfy the criteria set down in the Australian Prudential Regulation Authority's Prudential Statements J1 and J2 that they ‘make a worthwhile contribution to banking services in Australia, and not merely add to the number of banks’. [5]

For more detail on the process of deregulation see Grenville (1991) and the appendix in Battellino and McMillan (1989). [6]

The figures in Table 2 are influenced by the conversion of NBFIs (particularly building societies) to banks following deregulation and also the reabsorption of non-bank affiliates onto bank balance sheets (Edey and Gray 1996). [7]

Mortgage managers provide housing loans which are funded by mortgage-backed securities rather than deposits. [8]

National Australia Bank acquired a number of banks overseas. [9]