Submission to the Productivity Commission Inquiry into Competition in the Financial System 1. Introduction

The Reserve Bank welcomes the opportunity to provide a submission to the Productivity Commission's Inquiry into Competition in the Financial System. The scope of the Terms of Reference is broad and so this submission focuses on those areas that most closely relate to the Bank's mandate. In particular, it largely draws on a view of the financial system gained by the Bank through its monitoring of financial intermediation and the promotion of financial stability. As a consequence, the focus of much of the submission is the banking system as a whole. In line with the specific markets highlighted in the Terms of Reference, the submission examines mortgage lending, consumer deposits and small and medium enterprise (SME) lending in more detail.

The Bank (and its Payments System Board) is also the primary regulator of the payments system in Australia. The submission provides some perspectives on competition in the payments system and describes the Bank's activities in this area.

The Australian banking system is relatively concentrated by international standards, but in line with countries such as Canada and Sweden. The major Australian banks are more profitable than many of their peers internationally, though this partly reflects the more favourable economic conditions that prevailed in Australia in the period following the global financial crisis and a comparatively simple asset mix, with lower exposure to trading and institutional banking. Net interest margins are, however, higher than in a number of other countries. On some measures, the Australian banks also appear to operate more efficiently than many overseas banks.

The major banks have generally been more profitable than smaller authorised deposit-taking institutions (ADIs) since the global financial crisis, but the gap has narrowed recently. This partly reflects the lower funding costs of the major banks, with the difference narrowing recently through a combination of an easing in financial conditions and regulatory changes.

Competitive influences and conditions vary from market to market. In particular:

• Even though there have been no significant new entrants in recent years, competition in deposit markets has been relatively strong since the financial crisis as ADIs have sourced a greater share of funding from deposits rather than wholesale debt securities. Regulatory changes have also encouraged this trend. While the effects have varied between deposit products, average deposit rates relative to the cash rate have risen, while average account fees have fallen; competition has also occurred through related services, such as payments technology.
• The major banks gained market share in the mortgage market in the aftermath of the crisis, in part reflecting their better access to funding (as non-bank lenders in particular lost access to low-cost wholesale funding markets) along with mergers by two of the majors with smaller institutions. However, even though there have been no new major entrants, a narrowing of funding cost differentials, increased use of brokers and consolidation among smaller institutions appear to have boosted competitive pressures more recently. There is some evidence that competition led to some weakening in lending standards in the period leading up to the end of 2014, but an increased regulatory focus has seen this reversed; smaller lenders have gained market share as a result.
• While there has recently been strong competition for large business lending as a consequence of the entry of new foreign banks and expansion in activity by some existing foreign banks, competition appears to be less vigorous for small business lending – reflecting the complexity of this market. There is potential for government initiatives on open banking and comprehensive credit reporting to influence this market.

Competition in the retail payments system, in which financial institutions are significant players, is reasonably strong. Nevertheless, in some areas of the payments system competition can result in perverse outcomes. The Bank has therefore taken regulatory action over the past 15 years to address some of these anomalies and it continues to monitor competition closely.

A number of themes in this submission are likely to be relevant to the Commission's work:

• Periods of heightened competition in the Australian financial system have typically been driven by new entrants rather than established players. The entry of mortgage originators, foreign banks offering online deposit accounts and, recently, Asian banks offering large business loans have all had a significant effect on competition in their respective markets.
• Smaller banks experienced a rise in funding costs relative to the major banks through the financial crisis, but this has narrowed in recent times.
• Bundling of products can be convenient for consumers, but can make switching of individual products difficult and, by obscuring the pricing of individual products, it can support cross-subsidisation between more and less competitive markets.
• Information problems – both in relation to lenders' knowledge of the riskiness of potential borrowers and customers' awareness of alternative products – inhibit competition. Measures aimed at open banking and comprehensive credit reporting are likely to be beneficial, along with measures to increase transparency of interest rates.
• Differential pricing between customers, particularly in favour of new customers, is relatively common. Differential pricing can reflect risks, but it is also likely that some customers are not sufficiently aware of the possibility of a better deal or are reluctant to switch providers. Measures to increase transparency or reduce switching costs could help to address this.
• Financial technology (fintech) providers have the potential to increase competition in a variety of ways, including by competing directly in under-served markets, facilitating greater transparency and reducing the cost of switching providers. However, at this stage fintech firms generally remain small and their performance is untested over a full cycle. Significant efforts have been made by the government and the Australian Securities and Investments Commission (ASIC) to facilitate these providers.

The remainder of this submission consists of the following sections. Chapter 2 revisits the Financial System Inquiry and identifies developments since that time. Chapter 3 makes some general observations about the nature of competition in the finance sector, highlights some of the complexities in assessing competition, and presents some high-level indicators relevant to assessing competition. Chapter 4 discusses several important recent influences on competition, while Chapter 5 examines the mortgage, deposit and lending markets. Chapter 6 discusses competition in the payments system and the role of the Reserve Bank as regulator. Chapter 7 draws together some key themes.