Submission to the Financial System Inquiry Appendix A: Trends in the Australian Financial System

Published as Occasional Paper No. 14

Introduction

  1. Like other industrial countries, Australia has experienced major changes to its financial system in recent decades. The net effect has been a transformation in the system from a relatively closed, oligopolistic structure in the 1950s and 1960s, based predominantly on traditional bank intermediation, to a more open and competitive system offering a much wider variety of services from an array of different providers. This process of financial system evolution, while driven largely by market forces, has been assisted by prevailing regulatory and supervisory arrangements.
  2. Among the range of influences on financial-sector development, three main forces can be highlighted. The first has been the role of financial regulatory policy which, to an important degree, shaped the broad trends in banks' market shares in recent decades – the extended period of decline up until the early 1980s and subsequent recovery in the post-deregulation period. Secondly, technological developments have been important in reducing the cost of many information-intensive financial activities and in making available a wide range of new products and delivery systems. A third influence arises from the interaction of these first two factors with the historical cost and pricing structure of traditional intermediation, and in particular with the traditional cross-subsidisation of payments services by banks. The persistence of elements of this pricing structure has created opportunities for growth of specialist low-cost financial-service providers which have become an increasingly important source of competitive pressure on banks.
  3. The section that follows has a general overview of the main trends in the financial sector and relates those trends to the changing demands of the users of financial services: the government, household and business sectors. The remaining sections deal in more detail with banks and other credit institutions, the life insurance and superannuation sector, and the growth of financial conglomerates.

Overview of main trends

The financial system in the 1950s and 1960s

  1. 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. The discussion that follows makes use of a basic distinction between the credit institutions (or financial intermediaries) sector, comprising those institutions whose core functions involve borrowing and lending,[1] and the managed funds sector, comprising mainly life insurance and superannuation funds along with other investment vehicles like unit trusts. Emerging areas of competition and ‘functional overlap’ between the two areas are discussed further below.
  2. Table A1 illustrates long-run trends in the structure of the credit institutions 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 A2) 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 almost 90 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 Statutory Reserve Deposits (SRDs) with the RBA, 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.
  3. 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 a later section.[2]
  4. From this sketch can be identified the three elements of what might be called the traditional bank business mix; namely, lending, deposit-taking and the provision of transactions services.[3] An important issue 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 securitisers, was not possible.

Development of financial institutions

  1. Overall growth of the financial system and its institutional subsectors is illustrated in Figure A1. System assets more than doubled as a ratio to GDP between the 1960s and 1990s, with most 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.
  2. 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. 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 responded by creating 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 intermediaries (NBFIs) not affiliated with 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.
  3. 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 since 1992, saw the foreign bank presence increase, in part at the expense of the merchant bank sector.
  4. A critical factor shaping the recent history of the financial system 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 effect (in a qualitative sense) 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.
  5. The shifting market share of banks vis-a-vis other credit institutions is illustrated more starkly in Figure A2, which shows banks' assets as a share of the total credit institutions sector. This declined steeply to a low point of 57 per cent in 1981 before recovering equally dramatically to almost 80 per cent by 1993, its highest share for thirty years.
  6. The pattern of decline and recovery is exaggerated somewhat by the growth and subsequent reabsorption of non-bank 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 discussed in greater detail below.

The non-financial sectors

  1. 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.

Government

  1. Developments in government finance have exerted a powerful influence on the financial sector throughout the post-war period. The federal government entered the post-war 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.

Corporate sector

  1. 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 are slightly lower than in the US, Canada and the UK, and significantly below those in European countries and Japan which have very different banking systems and methods of corporate governance (Table A3).[4]
  2. The Australian historical experience seems broadly consistent with the pattern of increasing corporate debt observed in other low-leverage systems, particularly in the US 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 A3). The spike in leverage in the late 1980s is in fact understated by the data in Figure A3 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.[5] 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.
  3. An unusual 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 credit institutions – 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.[6] In this respect the pattern of corporate financing in Australia differs from those in the larger English-speaking countries, particularly the US and the UK, where debt security issuance has historically represented a sizeable proportion of overall corporate sector funding.[7] 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.
  4. The fact that direct forms of financing have not been more important to date, however, provides little guide to the future and conditions seem likely to favour 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.
  5. Trends here will have an important bearing on the long-term role of banks. One view [8] is that technological improvement is continually reducing the information costs associated with direct financing even for relatively small companies. An alternative view[9] is that banks (or credit institutions 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 these views. 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 major role would 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.

Households

  1. The data in Figure A4 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.[10] 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.[11]
  2. 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.

Financial intermediation and securities markets

  1. Within the credit institutions (intermediaries) sector, two main trends have been important in shaping the competitive environment. The first, already outlined in the preceding section, 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 A1, 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.
  2. The second trend, elaborated 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 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 their traditional business base.

The bank product mix

  1. As 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 accounted for by fees as opposed to net interest earnings. Nonetheless, net interest income continues to provide the bulk of the aggregate profits of Australian banks.[12]
  2. An important issue in relation to the basic economics of the banks' product mix concerns the extent to which the joint products within the mix are 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? Historically, there has always been 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 A5), 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.
  3. 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-like’ and lending services by separate institutions. Three examples illustrate the process.
  4. 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.
  5. 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 A5). 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. Merchant banks engage 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 taking deposits from households. 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. Nonetheless, they 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.
  6. The third and most 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 one per cent only a few years ago (Figure A6). Mortgage managers arrange housing loans funded ultimately 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 certain forms 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.
  7. 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 US, 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 US and there is no reason to believe that the process will not go further in Australia.

Competition and margins

  1. 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 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.
  2. 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.[13] 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.
  3. 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 A7). 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 deposit base. 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, particularly cash management trusts. 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.
  4. 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.
  5. 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 (see 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.[14] 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.
  6. The data in Figure A8 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 A8 and for the main indicator lending rates. Similar behaviour has been observed in a number of other OECD countries that deregulated their financial systems.[15]
  7. 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.
  8. 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, 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.
  9. Banks have also sought to reduce costs through measures to increase operating efficiency, particularly through reductions in branch and staff numbers, and they have accelerated their move toward more efficient modes of product distribution – mobile banking, telephone, Internet and so on. 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 A9), and these and other card-based payment systems now account for more than half the volume of remote payment transactions.[16] A by-product 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.[17]
  10. 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, and they have gained market share ( Table A4).
  11. 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.

Financial markets

  1. Growth of financial market activity has been a major feature of financial sector development since the 1970s. Important early developments were the freeing of certificates of deposit (CD) rates in 1973, subsequent growth of the CD and commercial bill markets, and the introduction of a bill futures market in 1979.[18] Additional impetus came from the introduction of market tenders for treasury notes (1979) and government bonds (1982), 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.
  2. 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 A5.
  3. 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.[19] Figure A10 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.
  4. 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 A11, 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).
  5. 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. The scope for continued product innovation, however, is hard to predict. Equity and commodity-related derivatives are gaining in interest among 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 embryonic even in the US. 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.

Profits, productivity and efficiency

  1. 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 tend to have enhanced it. Available data suggest that profitability of banking in Australia, in fact, grew steadily over the 1960s and 1970s, probably reaching a peak by the early 1980s (Figure A12). At that point, profitability in banking appeared to be well above the average of other Australian industrial sectors (Table A6).
  2. Following deregulation 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, this expansion was halted and reversed in the early 1990s. 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.
  3. 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.[20]
  4. 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.

Funds management

  1. As explained in the body of the Submission, a basic distinction in principle can be made between credit institutions, which offer deposit and loan services on a capital-backed basis, and funds managers, which manage but do not bear investment risk on behalf of their investors. This distinction is reflected in the differing balance sheet structures of the two types of institutions. Credit institutions require capital in order to shield depositors and other debt holders from investment risks whereas funds managers have a structure in which investment risk is borne by the members; in effect, members' funds are a form of equity. To a large extent the two sets of institutions have developed separately in Australia, and their structure and growth need to be explained in terms of rather different forces. It was also argued earlier that households have tended to view deposits and funds under management as quite distinct products and not closely substitutable; at any rate, the broad historical experience seems consistent with that interpretation. Nonetheless, a number of areas of growing competitive interaction between credit institutions and funds managers can be identified, including the increasing involvement by banks in funds management activities already discussed. The discussion that follows focuses mainly on the life insurance and superannuation sector, which comprises the bulk of the funds management sector,[21] considering first the historical sources of growth of these institutions and then competition between funds managers and intermediaries.

Life insurance and superannuation: sources of growth

  1. Historically the life insurance and superannuation sector has represented around 20 to 25 per cent of the total assets of the Australian financial system. It is currently a little above that range, having grown rapidly in recent years. The structure of the industry has been influenced by a number of major policy developments during the past 10–15 years. Three have been particularly important.
  2. The first was a shift in the tax treatment of superannuation. Prior to 1983 superannuation was taxed at extremely low effective rates, with contributions fully deductible, earnings untaxed, and only a small tax on final benefits. Subsequent tax changes (the most important of which were made in 1983 and 1988) reduced this concessional treatment substantially by introducing or raising taxes at all three of these levels; the treatment remains concessional relative to other financial savings, but much less so than previously.
  3. The second main policy development was the introduction of award superannuation beginning in 1986, when the Industrial Relations Commission endorsed a claim for a general employer-provided superannuation benefit, set initially at three per cent of income. This benefit was gradually incorporated into employment awards as they came up for renegotiation over the next several years. Payments were directed either into existing funds or into union-created industry funds which in other respects were the same as those already in existence (ie managed by private funds management firms); these funds now represent the fastest-growing part of the superannuation industry, although their asset base remains small. A consequence of this history is that many of the structural features of superannuation coverage for the newly-covered employees (for example, the choice of fund, and the nature of benefits provided) are written into awards which continue to govern those basic conditions under the newer government-mandated scheme.
  4. The third main development was the introduction of the Superannuation Guarantee Charge in 1991. This gave the mandatory system its current basic shape by legislating a timetable for further increases in contributions and setting tax penalties for non-compliance. The target level of employer contributions, to be phased in over a number of years, was set at 9 per cent. Further policies announced in 1995 specified a timetable for supplementary contributions by employees of three per cent, with a matching contribution from the federal government, to bring the total contributions rate to 15 per cent by 2002.
  5. The higher contributions rates resulting from these policies can clearly be expected to have a major impact on the industry, and indeed on the financial system as a whole, in future decades.[22] Already the proportion of employees covered has increased dramatically from around one-third of private-sector employees in the early 1980s to around 90 per cent at present. But this increase has yet to have a significant impact on the sector's overall asset growth, which is explained largely by other factors outlined below.
  6. Trends in the superannuation sector's overall size and its sources of funds are summarised in Figures A13 and A14.[23] Broadly, the historical growth of the superannuation sector can be divided into three phases. The first, which ended in the early 1970s, was one of moderate and fairly steady growth. In the second phase, which comprised most of the 1970s, superannuation assets shrank relative to nominal GDP, largely reflecting poor earnings performance and high inflation. The third phase, from the early 1980s onward, has been one of rapid expansion in which total assets more than doubled as a ratio to GDP, although this may have slowed down in the latest few years. The data presented in Figure A14 divide the sources of superannuation asset growth between net new contributions and a residual representing earnings on existing assets and capital gains. Although net contributions have fluctuated significantly in some periods, it is apparent that most of the variation in overall growth performance is attributable to variation in the earnings and capital gain component, rather than in contributions.[24] The three growth phases outlined above correspond broadly to periods of moderate, negative, and high real rates of return on financial assets, as summarised in Table A7.
  7. Aggregate net contributions to superannuation funds do not yet show the upward trend expected to result from the compulsory plan.[25] A number of reasons can be given for this. First, there is a strong cyclical influence on net contributions, likely to have been important in the recession periods of the early 1980s and early 1990s. Secondly, many employers were already satisfying, at least partly, the requirements of the compulsory plan under pre-existing voluntary arrangements. This has allowed some scope for absorption of the compulsory scheme into existing arrangements, and has meant that the aggregate effect of the new compulsory schedule has been relatively small so far; but it can be expected to increase as the mandatory contributions rate increases significantly above levels currently prevailing. Thirdly, an important factor in the second half of the 1980s was the phenomenon of overfunding of existing defined-benefit schemes. High rates of return meant that surpluses were accumulated in many of these schemes, enabling the employers who sponsored them either to withdraw funds, or to finance their superannuation liabilities with reduced contributions.
  8. To summarise these trends, it is apparent that almost all of the variation in the growth of superannuation funds' assets in recent decades is attributable to changes in the funds' earnings rates, combined with the fact that the long-term nature of superannuation accounts tends to mean that earnings are locked in and automatically reinvested. Although a sustained lift in net superannuation contributions is projected for the future under current policies, it has not yet occurred. This observation is relevant to debate as to the potential for compulsory superannuation to divert household funds that would otherwise have gone to financial intermediaries.[26] On the basis of the trends outlined above, claims that this has already occurred to a significant degree would not be substantiated. Nonetheless, competition for new savings between banks and superannuation funds is likely to be an important issue in the future.

Competition with credit institutions

  1. This raises the more general question of whether funds managers and credit institutions are coming more directly into competition, through overlap in their functions or increasing similarity of product lines.
  2. A good general case can be made that the two sets of institutions have operated in fairly distinct markets. On the assets side of the respective balance sheets, the banks' core business of direct lending can be contrasted with the life and superannuation sector's main investments in debt securities, equities and property. However, one area of overlap historically was that life offices were significant mortgage lenders for a period of time up until around the early 1970s. Their involvement in mortgage business reflected a number of conditions prevailing at the time, including the banks' inability to meet fully the underlying demand, and the relatively early stage of development of alternative mortgage lenders. The life offices were also able to link their loans with the provision of whole-of-life policies which benefited from generous tax treatment. Life-office mortgages were generally on fixed-interest terms, which meant that their profitability declined substantially as the general level of interest rates rose in the 1960s and 1970s. Total direct lending by life offices has declined steadily in relation to their balance sheet, dropping from around 40 per cent of assets in the late 1950s to around 7 per cent at present. Similarly, superannuation funds at present have only a small involvement in direct lending (Table A8).
  3. In terms of liabilities, the basic differences in financial structures of credit institutions and funds managers have already been noted. Superannuation fund liabilities are the long-term savings of their members, whereas bank liabilities are a combination of transaction balances, short-term savings and marketable debt instruments. The banking system in Australia has not traditionally been an important vehicle for longer-term saving,[27] so the competition with the long-term savings institutions for household sector funds has not been particularly strong. This short-term/long-term distinction reinforces the conceptual distinction between capital-guaranteed deposits with intermediaries, and funds under management which are subject to investment risk. On the basis of these two sets of distinctions, intermediaries and funds managers have historically been competing for household funds in quite different areas of the market.
  4. In a number of respects, this neat division is becoming less clear cut. Specialist funds management institutions, such as unit trusts, are able to offer a range of short-term investment services, some of which closely resemble deposits, and these institutions have grown substantially in recent years. Increasingly, banks are offering the same services, but not on the balance sheet of the bank itself. Also important is that the superannuation sector has become a major holder of essentially mobile or short-term savings of retirees. This trend has been boosted by increasing rates of early retirement, the wide availability of lump-sum retirement benefits and the advent of rollover funds, which retain the status of tax-favoured superannuation vehicles but offer some of the characteristics of shorter-term savings.[28] This has provided a category of relatively high-wealth individuals with a highly attractive alternative to standard deposits for holding what are fairly liquid balances. Another important consequence of these developments is that the funds management sector has itself become an important provider of funds to credit institutions. For example, around $40 billion or 15 per cent of superannuation assets are currently held as bank securities or deposits with financial institutions, a significant proportion of these institutions' liability base. Growth of these ‘wholesale’ sources of funds to the banks represents a potential source of upward pressure on their average cost of funds.
  5. The banks clearly believe there are advantages to be gained from combining their intermediation role with funds management activities, and have pushed for allowance of more direct involvement in retirement saving products, as well as having introduced a range of over-the-counter investment products in recent years. These developments, and the changing nature of the funds management sector itself, point to increasing areas of overlap between the products offered by banks and funds managers. Although the legal distinction between capital-backed and other products is preserved, the system seems to be moving towards a spectrum of more closely substitutable products in place of the clear traditional dividing line between deposits and funds management services.

Financial conglomerates

  1. As noted above, one of the responses of banks to the growing demand for superannuation and other funds management products has been to purchase or establish such operations in subsidiary companies. At the same time, some insurance companies have established intermediary subsidiaries or formed associations with banks to take advantage of their extensive distribution networks. Consequently, financial conglomerate structures have become more common and now dominate the financial system, with the top 25 holding 70 per cent of aggregate financial assets, and conglomerates in total accounting for around 80 per cent.
  2. Financial conglomerates in Australia are not extensively diversified in the sense that most are dominated by either a bank or an insurance company. Very few have significant involvement in non-financial activities. Of the 25 largest conglomerates, 9 include a bank which accounts for more than 75 per cent of the group's total Australian assets, 3 include a life office with at least 75 per cent of group assets and 4 have a funds management arm of similar size. Table A9 shows that conglomerates headed by banks account for almost 60 per cent of financial system assets, a little higher than in 1980.
  3. The growth of conglomerates and the common practice of selling products of the component companies from common distribution points has contributed to perceptions of blurring in distinctions between banks, insurance companies and other financial institutions.

Footnotes

The main groups are banks, merchant banks, finance companies, building societies, credit unions and pastoral financiers. [1]

More recently, life offices have again become active in the mortgage market. [2]

A fourth element, the passive holding of government securities, is best thought of as something separate and only incidentally important in the early postwar 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. [3]

Some caution is needed in comparing balance sheet ratios across countries because of differences in accounting practices. [4]

See Mills, Morling and Tease (1993). [5]

This figure excludes bank bill finance. [6]

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. [7]

Bisignano (1991). [8]

Goodhart (1988). [9]

This view is consistent with more detailed evidence presented by Dilnot (1990). [10]

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). [11]

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. [12]

The Prices Surveillance Authority report (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. [13]

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. [14]

See Edey and Hviding (1995). [15]

See Mackrell (1996). [16]

Prices Surveillance Authority report (1995, p. 179). [17]

This was the first interest-rate contract offered on an exchange outside the United States. [18]

For a review, see Reserve Bank of Australia (1996). [19]

Similar experiences occurred in a range of different countries over a comparable period (the United States, Japan, parts of Europe, Scandanavia). 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 (see Macfarlane (1989), Borio (1990) and BIS (1993)). [20]

Many of the products supplied by life offices are capital backed – and, in that sense, like deposits – but the ultimate return to investors/policyholders depends also on investment performance. Cash management trusts and other unit trusts are also, strictly speaking, funds managers. [21]

Projections by Knox (1995) suggest that the superannuation sector could roughly double as a ratio to GDP, from its current level of 40 per cent, over the next 25 years, eventually reaching something like four times GDP when the system reaches its peak asset holdings. [22]

For statistical purposes this discussion treats life insurance and superannuation funds as a single aggregate because their activities are similar and much of the historical data does not distinguish between the two. [23]

Capital gains are likely, however, to be understated in the 1960s and 1970s, and overstated in the early 1980s, as a consequence of the widespread use of historical-cost valuations prior to the 1980s. [24]

A point of caution is that the available data in this area have in the past been subject to substantial revision. [25]

This issue was discussed by the Martin Committee Report, House of Representatives (1991). [26]

This view is documented by Edey, Foster and Macfarlane (1991). [27]

Following rule changes in 1992, rollover-fund operations can now be carried out within ordinary superannuation funds. [28]