Submission to the Financial System Inquiry 6. Competition, Efficiency and Innovation in Banking

This Chapter discusses developments in competition, efficiency and innovation in the Australian banking system. Competitive pressures for different banking products are considered, alongside a brief discussion of the interplays between competition and stability, as well as regulation and competitive neutrality. Seven key points stand out from the Australian experience:

• Competition in banking is procyclical. In times of optimism, competition is often more pronounced on the lending side, whereas competition for funding often intensifies following a financial crisis.
• The competitive landscape was transformed by the deregulation of the banking sector in the 1980s and the opening up of the system to greater competitive forces. Since then, while the regulatory framework continues to affect competition, cyclical dynamics in risk-taking among market participants have been at least as important.
• New entrants, or the threat of new entrants, shape the markets for banking services in important ways. In Australia, the arrival of mortgage originators led to a marked decline in spreads to the cash rate on mortgages. And the entry of foreign banks in the online deposit market saw deposit rates increase relative to the cash rate.
• Competitive forces contributed to a substantial decline in banks' net interest margins – the broadest measure of average intermediation costs – over the two decades prior to the global financial crisis. Despite the many changes in the prices of loans and debt instruments since then, Australian banks' net interest margins are still around their historic lows.
• The market for small business loans has more structural impediments to competition than most other lending markets, because the information asymmetries tend to be more significant. Technological advances and financial innovation can help to reduce these information asymmetries. In addition, measures to improve the supporting infrastructure for capital market funding can help to provide companies with substitute sources of funding to bank loans.
• Competition beyond a certain threshold may have implications for financial stability. But Australia's experience over the past two decades demonstrates that competition in the banking sector, and new entry in particular, can occur without compromising financial system stability.
• The perceived safety of banks, including the belief by many that some are ‘too big to fail’, could also alter competition, for example by lowering the funding costs of such banks.

6.1 Theory and Practice

As in other industries, the degree of competition in banking affects the efficiency of the provision of financial services, the quality of financial products and the innovativeness of the sector (Claessens 2009). Ultimately a healthy level of competition in the banking sector provides important benefits to households and businesses, including improved access to finance, increased scope for choice and lower prices.

The benefits of competition for allocative efficiency are well established in the literature on industrial organisation (Tirole 1988, p 6). However, there are a number of reasons why the textbook view of competitive markets needs to be nuanced for the banking sector. As discussed in Chapter 1, financial intermediaries are inherently fragile because of the maturity transformation that they provide. In addition, asymmetric information and moral hazard can lead to excessive risk-taking. And, in the event of a bank failure, the highly leveraged and interconnected nature of the industry can result in large social costs and instability, often of a systemic nature (Vives 2001). While competition is not responsible for the fragile nature of banking, excessive competition can exacerbate some of the risks. Prudential regulation is partly motivated by the need to channel competitive pressures to productive needs and maintain financial stability (Section 6.5).

The trade-offs between competition, efficiency, financial stability and, ultimately, economic growth are complex; Claessens (2009) provides a comprehensive discussion on these issues, and a summary of the literature on the effects, determinants and measurement of competition in the financial sector.

6.2 Evaluating Competition

Competition in any industry is difficult to define and assess (Porter 1979), and this is particularly so in the banking sector. For one, prices of banking products contain information about risk and liquidity as well as the degree of competition (Beck 2007). Moreover, the lines between some product markets are not clear-cut, so that competitive forces interact in complex ways.

Even so, one conclusion emerges clearly from the literature: the degree of contestability is particularly important for competition. Countries with fewer entry and activity restrictions tend to have greater competition in their banking systems (OECD 2011). It need not be actual entry that matters. The threat of entry can limit the ability of incumbents to exercise market power. In addition to regulatory barriers to entry, there are other frictions in the banking sector that impede contestability and competition. Examples include information asymmetries and switching costs.

It is widely agreed that indicators of market structure, such as market concentration, do not measure competition among financial institutions accurately (Davis 2007; OECD 2010). A market can be concentrated but highly competitive if it is open and contestable, resources are allocated efficiently, and pricing power of incumbents remains limited. However, these structural measures are often used in empirical work, given their relative ease of construction.

In addition to measures of contestability and concentration, some papers measure the intensity of competition directly by estimating the responsiveness of prices to changes in costs (the H-statistic is one such example; Claessens and Laeven 2004).^[1] These measures have a stronger theoretical foundation than structural measures, but they are limited by the difficulty in determining when changes in price reflect competitive pressures versus changes in risk or liquidity premia.

6.3 Competitive Forces in Banking

Competition can be reflected in both the price of services and in their characteristics:

• Price competition can include the interest rate attached to a product, as well as fees and charges.
• Non-price competition may include loyalty programs and special access to certain events. It may also extend to the amount of finance offered to borrowers and the terms attached to a loan. In this way, competition can interact with lending standards and shape systemic risk (Chapter 4).

Because the literature finds concentration to be an inaccurate measure of competition, the focus below is on the forces that have shaped the contestability of the markets – including with respect to switching costs, pricing power and barriers to entry.^[2]

There is not space here to examine the full range of banking services, so some selected markets are considered. Although each market is discussed separately, competitive dynamics across the various segments interact in important ways. Banking products are often bundled together: for example, some mortgages are provided with an offset facility that is akin to a deposit account. In addition, some banking products can be substituted for others: credit card debt may be substituted for a secured loan, for instance.

Moreover, because banks intermediate between borrowers and lenders, competitive dynamics in markets in which banks source funds can affect the way they compete for loans. Indeed, although the speed and scope of structural change has differed across markets, there is a common thread to most banking services: competitive forces since the Wallis Inquiry have been shaped to a significant extent by financial market conditions. Changes in risk appetite among market participants during the past decade have often been at least as important to competitive dynamics as regulatory reform or other structural change (discussed below). That does not deny, though, that the regulatory and supervisory structure has influenced competition (see ‘Box 6A: Regulation and Competitive Neutrality’).

The interaction of the competitive forces in funding and lending markets means that the spread to the cash rate for individual products is problematic in gauging competition. This has been especially true since the onset of the crisis, as a reappraisal of risks has increased banks' funding costs relative to the cash rate (Graph 6.1; Berkelmans and Duong 2014). A more comprehensive measure of bank margins, though still an imperfect one, is the net interest margin – which is closely linked to the difference in banks' average lending and borrowing rates.^[3] Greater competitive pressures contributed to a halving in the major banks' net interest margins between the late 1980s and the mid 2000s (Graph 6.2). Australian banks' net interest margins have remained around their historic lows, despite the many changes in the prices of loans and debt instruments since the crisis. The net interest margins of the regional banks continue to be lower than those of the major banks, in part because of higher debt funding costs and larger shares of lower-margin housing lending.

Some developments in bank fees are considered; further details will be available in the next report on the Reserve Bank's annual bank fee survey that is due for publication in mid 2014. The operation and effects of the ‘four pillars’ policy that ensures the separation of each of the four major banks is not addressed here – it has been discussed in Chapter 4 and at length elsewhere (Davis 2007).

6.3.1 Deposits

Competition for deposits has intensified since the Wallis Inquiry. Providers of deposits still face barriers to entry, such as the costs associated with obtaining a licence from APRA and establishing brand recognition. However, developments in information technology have lowered entry costs – by removing the need for foreign entrants to establish physical branches, for instance. Greater access to the internet has enabled more customers to ‘look around for a better deal’, which has aided price competition; this may have partly contributed to the decline in dispersion of deposit rates in recent years (Graph 6.3). Even so, the market for deposits is concentrated: the major banks account for roughly three-quarters of total deposits in Australia.

Although the structural features of the deposit market have been important, financial market conditions have strongly influenced competition for deposits in Australia. The decade following the Wallis Inquiry was characterised by readily available wholesale funding for financial institutions at low cost, which reduced the incentive to compete for deposits. Banks offered interest rates on savings and term deposits that were well below the yields on market instruments of equivalent maturities (Graph 6.4).

Since the financial crisis, however, banks, investors, rating agencies and regulators globally have reassessed the risks of various funding instruments. Banks' demand for deposit funding has increased, and competition has intensified. Interest rates on term and saving deposits have consistently exceeded the interest rates on market instruments of equivalent maturities.

Some of the intensification of competition reflects regulatory reforms such as the Basel III liquidity standard (Chapter 3). At the same time, the reassessment of funding risk by banks, investors and ratings agencies has also played a role; there are many forces pushing in the same direction. The introduction of a deposit guarantee via the FCS may also have bolstered competition to the extent that this reduced perceptions that deposits at some institutions were safer than others.

Competition for deposits over recent decades has fostered product innovations. For example, foreign banks introduced online saver accounts as a way of competing for deposits without having a large physical presence. Regulatory changes have also led to innovation; for instance, the forthcoming tightening of liquidity rules has induced higher rates for notice-of-withdrawal (NOW) accounts where the funds cannot be accessed for at least 30 days.

6.3.2 The mortgage market

The competitive dynamics in the mortgage market have changed considerably in recent decades. New participants, known as mortgage originators, entered the market and gained considerable market share throughout the late 1990s and early-to-mid 2000s. They took advantage of innovations in the packaging and pricing of risk by funding themselves primarily in securitisation markets. They employed mobile lenders to circumvent the need for the costly branch networks employed by the banks. And the banks' funding advantage that arose from access to low-cost deposits was eroded as nominal interest rates declined (Ryan and Thompson 2007). This enabled mortgage originators to undercut the banks' mortgage rates. The banks responded, and spreads on mortgages declined markedly (Davis 2011).

Lenders also competed for new business through product innovations, including:

• Home-equity loans, which provide a line of credit against residential property;
• Low-doc loans, which enable self-employed borrowers, or those with irregular incomes, to access housing finance;
• 100 per cent offset accounts, which allow borrowers flexibility in paying down their loan ahead of schedule while having access to costless (or low cost) withdrawals.

Beyond the expanded product range, competition also contributed to a gradual easing in credit standards (albeit not to the extent that occurred in some other countries). There was a relaxation of permissible debt-servicing caps and genuine savings requirements, an increase in maximum loan-to-valuation ratios and the introduction of less onerous property valuation techniques. Recently there has been some tightening in standards, though this has only partially retraced the easing in standards that occurred over the past couple of decades since the sector was deregulated.

Following the onset of the US sub-prime crisis, there was a reappraisal of the risks associated with investing in securitised products. The Australian RMBS market suffered through association even though Australian RMBS had (and have) continued to perform very well. The funding costs of mortgage originators rose markedly and their lending was curtailed, prompting Government support via direct purchases of RMBS in the primary market through the Australian Office of Financial Management (Chapter 5). The major banks continued to expand their mortgage lending and thus gained market share (Graph 6.5; Commonwealth Bank's acquisition of Bankwest in 2008 also contributed to the rise in concentration).

In recent years, the household sector has adopted a more prudent approach to their finances and credit growth has slowed. In response, banks have competed more aggressively for the existing loans of their rivals. Lenders have offered fee waivers and cash back offers, lowering switching costs. These dynamics were influenced to some extent by the prohibition of early termination fees from July 2011 (on new loans).

Despite the increase in market concentration, a number of the structural changes to the mortgage market that arose out of the entry of mortgage originators in the 1990s have endured. For instance, brokers continue to reduce the search costs for many mortgage customers in comparing the available products. These services, combined with greater access to the internet, have supported price competition (and non-price competition).

International comparisons of interest margins on housing loans are difficult, partly because the typical mortgage product differs across countries and the size of discounts to posted rates is often unobserved. Moreover, the features offered on mortgages can differ significantly across countries; for example, loans with redraw facilities and flexible repayment structures are common in Australia but are relatively scarce in most European countries. Despite these difficulties, the available evidence suggests that the average spread to the policy rate on variable-rate mortgages in Australia is within the range of those in other advanced economies (Graph 6.6; Heath, Robertson and Stewart 2013).

Since 2007, there have been nine parliamentary inquiries into the Australian financial sector, a number of which have focused on the mortgage market. The main conclusion from these was that, while some indicators of competition have decreased since the financial crisis, the supply of credit to households in Australia remained adequate. Several inquiries focused directly on competition: Senate Economics References Committee (2008, 2011). They found that a reassessment of risk increased the cost of funds for lenders that rely on securitisation, which, together with a tightening in lending standards, reduced the number of lenders and products available in the market. There were a number of recommendations to increase competition, including initiatives to encourage activity by smaller participants. Several of these, including the removal of early termination fees on mortgages, were adopted in the Federal Government's Competitive and Sustainable Banking System package that was announced in December 2010 (Commonwealth of Australia 2010).

6.3.3 Personal lending

As with the mortgage market, the adjustment to financial deregulation and the ensuing competitive pressures have increased Australians' access to personal finance. Search costs for potential borrowers fell due to gains in technology, aiding price competition. And foreign banks increased their presence as the cost of distribution declined. At the same time, borrowers have substituted towards cheaper financing – shifting the composition of their borrowing towards mortgage finance. Recent efforts to improve lenders' access to borrower information will reduce information asymmetries and hence may facilitate a more efficient pricing of risk.

The reassessment of credit risk following the onset of the crisis was particularly pronounced in the personal lending space: spreads to the cash rate on all forms of personal loans rose considerably (Graph 6.7). This partly reflects the increase in funding costs relative to the cash rate. But, as with the other lending markets, it is difficult to determine the extent to which the higher spreads reflect lesser competition or simply more prudent pricing of risk.

Interest rates on credit cards have continued to increase relative to the cash rate in recent years. Competition in the credit card market is influenced by specific factors such as the effect of interchange fees that apply in four-party card schemes (Chapter 8).^[4] Competition focuses on influencing cardholders' behaviours via reward points and loyalty schemes. These are typically funded by increasing interchange fees, the costs of which are often passed on to merchants through higher service fees. The service fees were subsequently being passed on to users of credit cards and other payment instruments through higher merchant prices. In 2003, the Reserve Bank placed a cap on interchange fee arrangements in the major card schemes to address this – initially counterintuitive – result of competition driving prices up.

At the same time, the Reserve Bank also took measures to promote greater efficiency and competition in the payments system, including through the removal of certain restrictive practices in card scheme rules – such as ‘no-surcharge’ rules (Bullock 2010; Chan, Chong and Mitchell 2012; Chapter 8). This has resulted in the increased availability of credit cards, including low-rate and low-fee cards, alongside rewards-based products.

6.3.4 Large business lending

Large businesses tend to have access to a range of financing options, which may aid price competition for loans. Large businesses can overcome, to some extent, many of the informational barriers that necessitate borrowing via traditional bank credit. For example, larger institutions often have greater reporting requirements and are more closely scrutinised by investors.

The level and the distribution of large business lending spreads narrowed over the decade preceding the financial crisis (Graph 6.8). The extent to which these trends reflected an underpricing of risk (and an undesirable level of competition) is unclear. Since the crisis, both the level and the variation of these spreads have increased, which has at least partly reflected a reassessment of the risks by lenders. Even so, the average spread on large business loans is around its level of a decade ago.

Many large businesses are able to access loans that are provided jointly by two or more lenders – a process known as syndicated lending. Both Australian-owned and foreign-owned banks participate in the Australian syndicated loan market. The competitive pressures in the market, including developments in loan volumes and pricing, can therefore be influenced by international developments. Since 2007, Asian institutions have increased their involvement in the syndicated lending market – especially in resource-related sectors – as European lenders have retreated (Graph 6.9). Moreover, Australian large businesses have increasingly issued corporate debt in offshore markets (see ‘Box 5A: Australia's Corporate Bond Market’).

6.3.5 Commercial property

Competition in the market for commercial property lending has a strongly procyclical element, in part reflecting the lengthy construction lags (Owens 1994). Prior to the financial crisis, the provision of finance to the commercial property sector grew strongly, with foreign-owned and regional Australian banks expanding their market shares. Since the crisis, however, a re-evaluation of funding risks and expected losses saw the smaller banks reduce their exposures to commercial property (Graph 6.10). Although competition for commercial property lending appears to have eased somewhat from its pre-crisis levels, there is little evidence to suggest that this has unduly constrained activity.

The commercial property market is a notable example of how competition and lending standards are linked. Most commercial property lending is for specific projects, where loans are frequently syndicated, making it easier for new entrants to expand more quickly than other types of lending. Moreover, new entrants often end up with the more marginal, riskier, borrowers. The consequences of these forces are borne out in Australia through the difference in non-performance rates on commercial property loans across bank types. For example, a number of foreign banks expanded their commercial property lending briskly prior to the crisis and have since incurred high impairment rates (Ellis and Naughtin 2010).

6.3.6 Small business lending

Small businesses tend to have access to fewer sources of financing than large companies because the information asymmetries make it more difficult and costly for small businesses to directly access capital markets. As noted in Chapter 5, there may be some scope for small businesses to substitute trade credit – essentially loans from suppliers – for traditional bank credit (Fitzpatrick and Lien 2013). And recent innovations, such as peer-to-peer lending, may be another option for small business financing. However, overall, the available range of funding sources tends to be more restricted than for large companies.

Small businesses may also lack the expertise and resources to identify financing to meet their needs at the lowest cost (East & Partners 2011). The increased presence of brokers over recent decades has lowered search costs for some small businesses and supported price competition. Survey responses suggest that the use of brokers is particularly attractive when sourcing equipment financing, though it has declined somewhat since the financial crisis. The decline may reflect banks' tightening of lending practices, as credit risk can be more difficult to assess through the broker channel.

The market for small business lending in Australia is more concentrated than that of large business lending (Graph 6.11); this may be due to greater economies of scale in monitoring and assessing potential borrowers. The major banks' share of outstanding loans rose following the financial crisis as they continued to lend while other financial institutions scaled back. Commonwealth Bank's acquisition of Bankwest also contributed to the rise in concentration.

The average spread on small business loans narrowed markedly in the decade following the Wallis Inquiry, and price dispersion declined (Graph 6.12). These trends were reversed, however, following the onset of the financial crisis. The average spread to the cash rate widened as banks' funding costs rose. And price dispersion increased as loan pricing became more sensitive to the perceived risks of individual borrowers. This is one illustration of the procyclical nature of competition for small business lending. Arguably, the risk inherent in some of these loans was underpriced as competition intensified prior to the crisis.

Overall, the available data and liaison by the Reserve Bank, including through its Small Business Panel, suggest that small businesses in most industries had tighter but still reasonable access to funds throughout the financial crisis, albeit at higher cost. This is broadly consistent with the findings of a number of Inquiries that have addressed small business finance in recent years (Senate Economics References Committee 2011, 2012). Both Inquiries found that a reassessment of risk partly explained the tightening in financial conditions faced by some small businesses since the crisis. The Inquiries also concluded that there had been some reduction in competition since the crisis.

6.4 Bank Profitability

The Australian banking system has remained profitable since the mid 1990s despite a temporary fall in profits during the financial crisis. Since 1997, the profits of the major banks have grown at an average annual rate of around 10 per cent, the return on equity has averaged around 16 per cent and the return on assets has averaged around 0.9 per cent (Graph 6.13). These returns are similar to those for banks in other countries prior to the financial crisis (Graph 6.14), and to those of other major companies in Australia.

Profitability during the decade prior to the crisis was supported by strong growth in net interest income, which was driven by a rise in interest-earning assets (Graph 6.15). The rapid increase in assets was partly offset by a sustained contraction in net interest margins (Graph 6.2).

Following the onset of the financial crisis, the profitability of Australian banks declined because of higher bad and doubtful debt charges, albeit by less than was experienced in many other countries (Graph 6.16). Since 2010, bad and doubtful debt charges of Australian banks have declined, supporting profits. The lower bad debt expenses of Australian banks partly explain why their return on equity has remained higher than rates achieved by overseas banks since the crisis.

Gains in operational efficiency have also supported the profitability of Australian banks. The major banks' cost-to-income ratio – a common measure of efficiency – has trended downwards over the past couple of decades, falling by around 20 percentage points since the mid 1990s (Graph 6.17). The adoption of new technologies enabled banks to provide more streamlined banking services to customers and improve back-office processes. And a focus on reducing high-cost, low-value operations resulted in the closure of a large number of branches during the 1990s.

At around 40–45 per cent, the major banks' cost-to-income ratios are currently at the bottom end of the range of their peers internationally (Graph 6.18). Cross-country differences in cost-to-income ratios may reflect differences in banks' business models. Banks with a greater focus on traditional lending activity (as proxied by the share of earnings derived from net interest income) tend to have lower ratios than those with a greater focus on other activities, such as investment banking or wealth management. The Australian major banks' cost-to-income ratio may also be relatively low because their loan books are more weighted towards mortgages; as mortgages are more homogenous than business loans, the cost of distributing them is likely to have benefited more from technological advances.

6.5 Banking Competition and Financial Stability

There is an extensive body of literature on the relationship between competition for banking services and financial stability (Beck 2008; Freixas and Ma 2013). The links are complex, and there is no consensus in the literature as to whether competition reduces or increases financial stability. However, it is likely that causality will depend on the level of competition: for example, it would be reasonable to assume that once a certain threshold is reached, an increase in competition would have a negative effect on financial stability (OECD 2011).

Two key theoretical papers put forward contrasting views as to the effects of competition on financial stability: the ‘charter value’ view based on Keeley (1990), and the ‘risk-shifting’ view proposed by Boyd and De Nicolò (2005). The ‘charter value’ view focuses on the potential for competition to be destabilising: greater competition results in a decline in banks' market power, which reduces their franchise or charter value; this encourages banks to take on more risk to generate higher returns. Proponents of this view also argue that larger banks tend to be more diversified and have more sophisticated risk management systems (Chan, Greenbaum and Thakor 1986; Keeley 1990). They also argue that a smaller number of larger banks may be easier for regulatory authorities to monitor and regulate (Allen and Gale 2004).

In contrast, the ‘risk-shifting’ view focuses on the potential for competition to add to financial stability. According to this view, an increase in competition results in a decline in lending rates and therefore allows borrowers to earn higher returns on their investment, which in turn lowers their risk of default. Proponents of this view also point out that large banks may take excessive risk because of an implicit guarantee of support in times of crisis, and that large banks can be more complex and more difficult to monitor by regulators.

Although the literature is mixed, Australia's experience over the past two decades demonstrates that competition in the banking sector, and new entry in particular, can occur without compromising financial system stability. Over the past two decades, the Australian banking system has been subject to increasing levels of competition and market contestability; examples include new entrants using securitisation funding to enter the mortgage market and foreign banks using online distribution to enter the deposit market. The increase in competition aided market efficiency and provided important benefits to consumers, both in terms of increased choice through innovation and through lower prices for financial services. This positive outcome owed partly to the framework of strong prudential supervision and its application to the bulk of the financial system. The problems related to commercial property lending in the late 1980s, however, demonstrates the potential for intense competition to undermine financial stability (Macfarlane 1990, p 33–35).

Footnotes

Claessens and Laeven (2004) calculate a H-statistic of 0.80 for Australia – the seventh highest value among the 50 countries studied. (A higher value corresponds with greater competition.) [1]

This is consistent with the framework set out by Porter (1979) for examining industry structure in terms of five key competitive forces: the rivalry among existing competitors; the threat of new entrants; the bargaining power of suppliers; the bargaining power of buyers; and the threat of substitute products or services. [2]

Banks' net interest margins are affected by a number of factors in addition to movements in lending rates and funding costs, including the extent to which banks fund themselves with equity, their holdings of liquid assets, and gains or losses on derivatives (RBA 2010, pp 20–21). [3]

Competition in card payment systems is also observed in measures undertaken by card schemes to be the primary or only ‘brand’ on the card, which may involve incentive payments to the card issuers. [4]

Box Footnotes

More generally, institutions providing financial products (whether they be licenced banks or not) are also subject to ASIC's financial services licencing regime. [1]

This is consistent with the Basel Committee on Banking Supervision's Core Principle Number 8 for Effective Banking Supervision. [2]

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