Submission to the Financial System Inquiry 1. Background: Financial System Trends

Introduction

1. This Chapter highlights the main trends in the Australian financial system which are important in thinking about the scope and structure of financial regulation. It is, of course, somewhat artificial to itemise these factors because they interact with one another. For instance, expansion of the funds management sector, with its appetite for investment assets, has made loan securitisation more viable and opened the way for mortgage originators, using innovative distribution techniques, to compete successfully with the traditional providers of housing finance.
2. An understanding of the main trends is obviously relevant to an assessment of the effectiveness of official regulation. Changes in the financial system – in the legal structures of financial institutions, the technology they employ and the nature of risks they incur – call for a review of regulations to ensure that they remain appropriately targeted and are achieving, as efficiently as possible, the Government's objectives. Meanwhile, regulations are themselves one of the many factors which help to shape the financial system.
3. A more detailed account of developments over the past forty years and of the forces which are shaping the future of the financial system is provided in Appendix A. Similar forces are evident in other advanced economies.

Changing market shares

4. Measured by assets, the aggregate market share of financial intermediaries – institutions which issue mainly deposit-type liabilities and make loans – is declining. This share is currently 62 per cent, compared with 74 per cent in 1980. The share of banks within this group has, however, increased since their operations were largely deregulated in the 1980s and entry policy was liberalised. This growth has been largely at the expense of non-bank financial intermediaries – building societies, credit unions, finance companies and money market corporations (merchant banks) – which had expanded to serve markets denied the banks by regulation. As a result, the banks remain dominant in the financial system with just under half of total assets, excluding their subsidiary operations.
5. The funds management and insurance sector has been the fastest growing sector over the past 15 years. It currently accounts for 38 per cent of assets, compared with 26 per cent in 1980. Its expansion has, however, been underpinned more by the reinvestment of earnings than by significant growth in new investments/contributions.
6. Assets are not the only indicator of institutional importance. While intermediaries have lost market share on that measure, they have led the way in the trading of financial instruments, particularly public sector securities, foreign exchange and derivatives. Banks are responsible for almost 90 per cent of foreign exchange dealing and around 80 per cent of over-the-counter (OTC) derivatives ( Table 1).

Product ‘mobility’

7. This refers to the offering by financial firms of products which had previously been associated mainly with other institutional groups. Conventional wisdom is that this phenomenon is increasing rapidly, and examples usually cited include:
   • housing loans offered by life insurance companies and mortgage originators;
   • liquid investment accounts offered by funds managers (eg cash management trusts) which are functionally similar to bank deposits. Some of these incorporate transaction facilities through links with a parent bank; and
   • savings products from life companies which have similarities to term deposits (eg insurance bonds and certain term annuities).
8. This sort of overlap is not a new phenomenon. For instance, life offices were much more significant lenders for housing in the 1960s than they are now, and cash management trusts were introduced 15 years ago. It is also easy to overstate the extent and growth of these overlaps. Cash management trusts hold funds equivalent to about 7 per cent of call deposits at banks, a little less than they represented five years ago. Only around 5 per cent of deposit-type investments are held with institutions other than intermediaries such as banks and building societies, a proportion which has held steady over recent years.

Product diversity

9. Another dimension of change in financial markets is increasing product diversity. Virtually all financial firms now offer a much wider range of products and services than a decade ago, with multiple options as to rate of return, liquidity, risk characteristics, and so on. These features are combined in different ways and may be linked with other services previously regarded as separate (eg mortgage offset accounts, housing equity loans). At the same time, services previously offered in a package (eg housing loans and savings accounts) are being unbundled. As a result, the consumer of any basic financial service – such as a savings account – is confronted with a spectrum of choices, with only fine gradations of difference between them. In professional markets there has been a sharp expansion in the use of derivatives products for managing risk; some of these have been used to make retail products such as fixed-rate or ‘capped-rate’ loans more readily available.
10. This growing diversity is driven by the relative freedom of financial groups to tailor products to the changing needs of their customers, the application of new technology to product design and delivery and an apparent increase in consumers' willingness to shop around. These and other innovations have been some of the benefits of financial deregulation.

Conglomerates

11. Financial conglomerates – the linking by ownership of institutions such as banks, insurance companies and unit trusts – have become a more important feature of the landscape. Among the causes are:
    • aspirations of banks to participate in the more rapidly growing funds management sector, particularly with the prospect of increased compulsory saving in superannuation;
    • the ambition of some insurance companies to be able to offer their customers payments and banking services; and
    • the desire of insurance companies to make use of the banks' more extensive distribution networks, and the banks' interest in improving the earning capacity of these relatively expensive branches.
12. Conglomerates currently account for around 80 per cent of financial system assets, with the 25 largest holding almost 70 per cent of total assets. Conglomerates headed by banks have about 56 per cent of financial system assets while groups headed by insurance companies have a little over 15 per cent. Bank/insurance groups are particularly significant. Currently, seven banks own life insurance companies and one life insurance company owns a bank; collectively, these groups account for more than 38 per cent of financial system assets. The importance of conglomerates, which leads to a wide range of financial products being available in the one place, has no doubt contributed to perceptions of ‘blurring’ in traditional institutional boundaries and is probably a more significant factor than the phenomenon of product mobility (Table 2).

Mergers and acquisitions

13. The high capital costs of competing systems and communications infrastructure have spurred rationalisation of the financial system through mergers and acquisitions, in pursuit of efficiencies and opportunities to streamline branch networks. This has been particularly evident among smaller institutions such as credit unions and building societies. Changes in the population of the different groups of intermediaries are shown in Table 3. Rationalisation has also seen an increase in the number of banks, due mainly to conversions from building society status and the entry of foreign banks, many of which already had a presence in Australia as a money market corporation. While driven by competitive pressures, the trend toward consolidation itself can raise concerns about potential diminution of competition. These are discussed in Chapter 9.

Securitisation

14. The growth of securities markets in Australia has been influential in a number of financial innovations (eg cash management trusts in the 1980s). Traditionally, securities markets have consisted mainly of government and semi-government paper, short-term private debt securities and longer-term debt of a small number of top-ranking corporates. The market for long-term private sector debt has been and remains thin, despite recent growth in the securitisation market.
15. Increasing demand for asset-backed securities from the growing funds management sector, and the advent of more sophisticated means of tailoring such securities to investor demands, will see securitisation become more widespread in the future. It has been an important feature of US markets for many years.^[1] This form of funding has been exploited by the mortgage securitisers in the past year or so, and could be extended soon to credit card and other relatively standardised receivables. Over time, developments in securitisation may see interest extend to the ‘middle level’ corporate market, as is now occurring in the US. The 1995 modification of the RBA's prudential guidelines also made it easier for banks to arrange loan securitisation without compromising capital adequacy.

Challenges to cross-subsidisation

16. When the financial system was heavily regulated and new entry relatively difficult, cross-subsidisation in pricing was common. The most prominent example has been the cross-subsidisation by banks of their payments services (cheque-clearing in particular) from the margin between interest received on loans and paid on deposits. This margin also funded the banks' extensive branch networks and large staff numbers.
17. More recently, entry into certain markets dominated by banks has become easier because of:
    • new delivery methods, which have reduced the strategic importance of full-service branches in establishing contact with customers. Such channels include ‘virtual bank’ kiosks, travelling salesmen (mobile banking), telephone and the Internet;
    • other changes, such as the growth in securities markets, which have given new players access to funding without having to raise deposits; and
    • a greater willingness of consumers to shop around for the best price and other features.
18. Banks and other established institutions (such as building societies and credit unions) would have been vulnerable to new competitors anyway, because of their high cost infrastructures and inability to adapt quickly to more advanced technology, but the cross-subsidies in their price structures have made them more susceptible to ‘cherry-picking’ by entrants in niche markets. Again, mortgage originators are the clearest example.

Technological change

19. Technological change, in its various guises, is having such a diverse and widespread impact as to be almost meaningless as a single category for discussion. There are, nevertheless, some useful distinctions. One is the use of electronic data transmission in financial services, rather than physical contact and paper flows. The clearest examples are in the payments system where, inter alia, EFTPOS and direct debiting are providing substitutes for cheques and credit cards.
20. A second impact is the application of computing power and advanced mathematics to the construction and pricing of complex financial products (both wholesale and retail), and to managing market and credit risks in financial firms. Such changes are clearly relevant to prudential supervision, posing questions about the management of market and operational risk. A third broad impact of technological change is new delivery channels for financial services. Some of this technology – such as the use of telephone for banking transactions – is not new. More modern technology includes the use of laptop computers by mobile lenders and of the Internet for inquiries and instructions about bank accounts.

New players

21. New delivery technologies are not only altering the competitive balance among established players, but along with cross-subsidies in existing price structures, are also creating opportunities for new entrants in the financial system. Examples include the mortgage originators (which have effectively linked home buyers with the wholesale capital markets or are acting as agents of traditional lenders), innovators in the field of stored value cards, and the providers of specialised telecommunications and computer equipment which are increasingly providing the linkages between financial firms and their customers. These players are bringing new skills and enhanced competition to Australia's financial system. To date, non-financial firms have not sought to become large-scale suppliers of financial services in their own right in Australia.

Payments System

22. The payments system is undergoing significant change. In very broad terms, this consists primarily of the gradual replacement of paper-based messages (cheques, money orders, etc) with electronic transmission. Stored value cards, using computer chip technology, are another prospective change in retail payments. These developments are making payments cheaper and faster, although initial infrastructure costs can be very high; they are also creating business opportunities for new specialist entrants, as noted above. A major development in wholesale payments is the move to the settlement of interbank payments on a real-time gross basis, which will cut down interbank settlement risk and substantially reduce one potential source of system instability.

Footnote

However, the importance of mortgage securitisation in the US, where nearly two-thirds of mortgage loans are securitised, owes much to ‘sponsorship’ of private securitisation schemes involving access to lines of credit from the US Government. Indeed, only 14 per cent of securitised mortgages go into ‘private label’ schemes. A high proportion of credit card receivables have also been securitised. [1]