Submission to the Financial System Inquiry 2. Key Financial Developments Since the Wallis Inquiry

This Chapter provides an overview of some important developments in the Australian financial system since the Wallis Inquiry was completed in 1997. It focuses on trends in the size, growth and performance of the system and the impact of the global financial crisis on these trends.

2.1 Introduction

The Australian financial system has grown rapidly since the Wallis Inquiry and, in certain respects, as is typical of finance, in ways that were not anticipated. New technologies have changed the way that services are delivered and risks are managed. The scope of choice for end users has increased, and with it the complexity of the system.

Underpinning these developments has been the protracted adjustment of the financial sector to a system where credit availability is essentially market determined, and to an environment of low and stable inflation. These forces have interacted with a range of other factors – including favourable macroeconomic conditions, increased globalisation of finance and changing demographics – to produce a number of important results. For example:

• household finance has become more widely available, which has been associated with a rise in household indebtedness and dwelling values
• the value of financial assets has risen markedly, increasing household wealth. Superannuation holdings have risen particularly strongly, which has increased households' exposure to market risk.

Although these shifts were underway around the time of the Wallis Inquiry, the extent of the adjustments turned out to be larger and more protracted than many had anticipated.

While the provision of financial services has also changed considerably, the traditional model of intermediation via the banking system has remained dominant in Australia. In the mid 1990s, there was a growing sense that financial markets would displace banks in providing the core functions of the financial system (Financial System Inquiry 1997, p 172). In the event, some new technologies and products, such as complex securities, were misused and their risk mitigation properties overestimated – particularly overseas. Domestically, the capacity for banks to expand and acquire other businesses (wealth management firms, for instance) was perhaps underestimated.

The remainder of this Chapter considers these and other key developments in the Australian financial system. As the title of this Chapter suggests, the primary point of reference is the completion of the Wallis Inquiry in 1997. However, in some cases it will be important to delve further back into history to provide the context in which the system has evolved. In addition, the period since the Wallis Inquiry had two distinct phases: the decade or so leading up to the global financial crisis, during which many risks were underpriced; and the period since, which has seen a renewed focus on systemic risk.

2.2 Growth in the Financial System and Some Key Influences

The most striking development in the Australian financial system in recent decades is its growth. A few summary measures illustrate the extent of the expansion that took place from the early 1980s until the onset of the financial crisis:

• Total credit rose from around 50 per cent to 160 per cent of GDP.
• Total assets of financial institutions increased from around 100 per cent to 370 per cent of GDP (Graph 2.1).
• Measures of financial market turnover increased even more dramatically. To give just one example, turnover in Australian equities increased more than 70-fold from the mid 1980s to 2007 (compared with a sixfold increase in the size of the nominal economy).^[1]

As it turns out, then, the Wallis Inquiry of 1997 occurred in the midst of a profound period of growth in the Australian financial system. What caused this spectacular growth? And why has it slowed in recent years?

Simply itemising causal factors ignores the complex ways that the various elements of a financial system interact. Nonetheless, one starting point is the observation that rapid growth in the financial system since the early 1980s is not unique to Australia. Most developed economies experienced similarly large, or even larger, expansions. And, in most countries, that period of rapid growth has ceased. This suggests the importance of some common, once-off factors, including:

• the deregulation of the financial sector
• the move to a low-inflation environment.^[2]

2.2.1 Deregulation

Financial deregulation in Australia began in the early 1970s and culminated in many important changes to the financial landscape in the 1980s, including:

• the floating of the Australian dollar and the removal of many of the restrictions on foreign borrowing and lending
• the removal of most restrictions on banks' interest rates and liability structures
• the removal of constraints on foreign bank entry (which were further eased in 1992).

There is not space to chronicle these processes here; they have been extensively covered elsewhere (Macfarlane (1991) and Davis (2007), for example). But, fundamentally, the result was a shift from a situation where credit was price-controlled and quantity-rationed, to one where credit availability is market determined. The behaviour of credit providers changed accordingly as they adapted to a more competitive environment. Taken together, the easing of regulatory constraints had the predictable effect, at least in a qualitative sense, of allowing a once-off expansion of the financial sector relative to its historical trend.

2.2.2 Low-inflation environment

Alongside the adjustment to deregulation, Australia's shift from being a high-inflation country to a low-inflation country had profound implications for the domestic financial system. Prior to the 1990s, Australia had one of the highest inflation rates among developed economies. However, the spare capacity in the economy from the early 1990s recession saw inflation decline, and the introduction of inflation targeting helped to entrench that reduction. Nominal interest rates eventually fell in line with the lower inflation compensation required.

These dynamics were already in place prior to the Wallis Inquiry, but it was in the years around and subsequent to that Inquiry that the effects were most apparent. Nominal interest rates on housing loans did not fall as quickly as inflation in the early part of the 1990s. However, competition from new entrants to the mortgage market during the late 1990s helped to bring mortgage interest rates down in line with the structural decline in inflation.

These developments had important consequences for household balance sheets. Because a borrower's ability to repay is uncertain, lenders impose various constraints on the amount that they will lend to particular borrowers. One reasonable approximation of these constraints is that the debt repayment must be no more than a certain percentage of the borrower's income. As nominal interest rates fall, borrowers can service a larger loan with the same repayment.^[3] This is a permanent shift in serviceable debt loads (provided the reduction in inflation is permanent). A corollary of this is a permanent increase in the size of the financial system relative to the real economy.

2.2.3 Long-run forces

The adjustment of the financial system to these once-off factors has been shaped by a number of long-run forces that reflect trends in incomes, technology, demographics, and so on. For instance, one phenomenon that has been observed is a tendency for financial systems to grow, relative to GDP, as real income levels increase (Goldsmith 1985).

It is difficult to disentangle the effect of higher incomes from the once-off adjustments to deregulation and lower inflation that were considered above. But it does seem plausible that as household income increases, a larger share of it can be spent on asset purchases and debt servicing, as proportionately less needs to be spent on necessities. Associated with this, the relative value of scarce assets (including well-located housing) might be expected to rise over time.^[4] If sustained, this would imply that growth in the financial sector could outpace the real economy for extended periods (though not indefinitely) without necessarily reflecting an undue build-up of risk.

2.2.3.1 Technological change

Alongside income growth, technological change has exerted substantial influence on the Australian financial system in recent decades. Finance is an information-intensive industry. Its key outputs depend on the capacity to store, analyse and transmit information securely. Given this, the advances in information technology in recent decades are likely to have generated growth in finance industry productivity relative to that in less information-intensive sectors. For instance, the use of computer databases in place of paper-based filing systems has improved the efficiency of storing and retrieving customer information.

Measuring the real value of financial outputs is difficult because of the complexity of the financial system and the special characteristics of the financial intermediation process (Burgess 2011). The result is that measurement of productivity in the financial sector is imprecise, partly because distinguishing between genuine improvements in productivity and changes in the price of risk is difficult.^[5] Bearing these caveats in mind, the available estimates suggest that labour productivity growth in the financial sector outpaced that of the broader economy over the past couple of decades. The share of gross value added – the value of goods and services produced – attributed to financial services nearly doubled over the quarter-century to 2013, whereas the financial sector's share of employment was little changed.

The rise in the share of value added by the financial sector in Australia is towards the upper end of the range of international experience since the Wallis Inquiry (Graph 2.2). This may reflect the larger role for traditional intermediation within the Australian financial sector, as well as the size and structure of Australia's superannuation industry. It also reflects the resilience of the Australian economy and financial system in recent years. Credit continued to expand in Australia over this period, unlike the experiences in the United States and a number of European countries.

2.2.3.2 Internationalisation

Associated with the advances in technology has been a lowering of the cost of transacting across borders. This aided the proliferation of cross-border investment and credit, which was facilitated by the progressive removal of restrictions on foreign capital by many developed economies during the 1980s. In Australia, this afforded households and companies greater access to finance from abroad (either directly or via the banking system), and hedging markets developed to help manage the risks. As Chapter 5 explains, a key reason that Australians have benefited from financial globalisation is the willingness of foreign investors to take on the risk of lending to us in Australian dollars.

Capital flows across borders rose rapidly from the early 2000s in an environment of low interest rates and solid economic growth globally (Graph 2.3). During the financial crisis, a number of these flows reversed, as lenders repatriated their foreign holdings and home bias reasserted itself, especially in Europe. These dynamics were less pronounced in Australia, reflecting the comparatively favourable conditions in the banking system and the broader economy.

2.2.3.3 Demographics

The demographic transition that is occurring throughout the world has important implications for the financial system, including through its influence on labour supply, saving behaviour, capital accumulation, international capital flows and the relative demand for different assets (IMF 2004; Kent, Park and Rees 2006). Populations are ageing at the same time as fertility rates are declining, although the extent and speed of these changes differs significantly across countries.

In Australia's case, a striking development since the Wallis Inquiry is the marked growth in superannuation assets. Since 1997, superannuation assets as a per cent to GDP have more than doubled to be over 100 per cent. The increase in superannuation has had important structural implications. For instance, many banks acquired wealth management businesses, which have helped to support their profitability. And households have increased their exposure to market-linked investments. Chapter 7 explores developments in superannuation.

2.2.4 Cyclical dynamics

A further category of forces that have shaped the growth in the financial system are those associated with the cyclical dynamics of credit and asset prices (Borio and Lowe 2002; Bean 2003). The financial sector has a well-documented capacity to engage in bouts of overexpansion, driven by self-reinforcing expectations, followed by periods of readjustment and consolidation (Kindleberger and Aliber 2005); this is sometimes called procylicality. Business cycles can be unpredictable in duration, and the associated credit cycles can vary in amplitude.

Cyclical dynamics help to explain the spectacular growth in the financial sector in a number of countries during the 2000s, amid an environment of low interest rates globally, and the subsequent reversals. In Australia, the macroeconomic environment from the early 1990s was particularly conducive to expansion in the financial system. There was a marked reduction in the level and volatility of the unemployment rate, for instance (Table 2.1). And Australians experienced virtually uninterrupted economic growth for a long period, which is likely to have influenced the extent to which households and businesses took risks.

The robust economic growth was to some extent self-reinforcing, as strong employment growth and rising wages drove income growth, which contributed to rapid housing price growth. This, in turn, further spurred spending, putting more upward pressure on housing prices. The strong growth in housing prices abated in late 2003, owing in part to policy initiatives (Kearns and Lowe 2011). From the mid 2000s, the household saving ratio increased – in part, because of a return to more prudent saving behaviour by the household sector.

2.2.5 Implications of growth in the financial system

The expansion of the financial system that followed deregulation and disinflation was more protracted than many had expected. Nonetheless, this was by its nature a once-off adjustment, and one that seems to have run its course. Regulatory developments in recent years have continued to shape the financial system, but not to the same extent as the paradigm shift that occurred over the 1970s and 1980s.

That still leaves the long-run forces. The financial sector could keep growing as long as those trends continue, with implications for the broader economy.

There is considerable debate about the relationship between the size of a country's financial system (relative to its GDP) and its economic prosperity. The linkages are complex and hence very difficult to measure, so it is not surprising that scholars have come up with different findings (Law and Singh 2014). Most early studies find a positive link between the size of the financial sector and economic outcomes (King and Levine 1993). However, more recent work has suggested that there is a threshold beyond which further expansion in financial activity no longer benefits the broader economy (Santomero and Seater 2000; Levine 2005; Cecchetti and Kharroubi 2012; Greenwood and Scharfstein 2012).

Clearly, the financial system expanded to the detriment of the economy in a number of countries – Cyprus and Ireland, to name a couple (Graph 2.4). But crucial to those episodes was the manner in which they expanded. Essentially, there was a build-up of poorly chosen investments alongside an accumulation of risk by those not well placed to bear it. In many cases, banks rapidly expanded abroad without incorporating the different institutional and cultural environments into their risk management practices.

Rather than size, per se, the focus ought to be on whether the financial system is efficient in performing its core functions with a desired level of safety (Cochrane 2013). That assessment should incorporate its size to the extent that it influences the potential for bouts of optimism to result in a misallocation of resources and a build-up of vulnerabilities (Greenwood and Scharfstein 2012). But size should not be the only consideration.

In assessing the expansion of the Australian financial system, it is useful to examine the evolution of the system around the four core functions that were outlined in Chapter 1:

• Value exchange: a way of making payments.
• Intermediation: a way of transferring resources between savers and borrowers.
• Risk transfer: a means for pricing and allocating certain risks.
• Liquidity: a means of converting assets into cash without undue loss of value.

The first of these functions – value exchange – is considered in Chapter 8. The others are considered below. An assessment of how changes in the financial system have shaped systemic risk is provided in Chapter 4.

2.3 Intermediation

The Wallis Inquiry took place in an atmosphere of expectation for change regarding the intermediation process. New technologies had enabled a number of new entrants to compete with banks for individual product lines. And great store was placed in the ability of product innovations to efficiently allocate risk.

As it turns out, the traditional model of bank intermediation has remained dominant. While some have been surprised by the constancy of the providers of intermediation, credit has become more widely available and at lower cost, as was widely expected.

2.3.1 Servicing households

The extent of intermediation services provided to households has increased markedly over the past two decades. Household balance sheets were transformed, of which two aspects stand out in the context of intermediation. The first is the substantial increase in household indebtedness. The second is the increasing tendency for household savings to be channelled through superannuation funds.

2.3.1.1 Households' borrowing

The pace of borrowing by Australian households was especially rapid from the early 1990s until the mid 2000s (Graph 2.5). The reasons for this have been discussed elsewhere and were outlined earlier in this chapter (Ellis 2006; Productivity Commission 2004). Briefly, on the demand side, the most important structural factor was the shift to a low inflation, low interest rate environment. The increase in borrowing capacity was accommodated by the removal of controls on banks' provision of credit (RBA and APRA 2007). New product innovations also increased borrower flexibility and access to finance. Moreover, the demand for credit by investors increased over this period, supported by longstanding aspects of the tax treatment of residential property investments (including negative gearing, capital gains tax concessions and depreciation allowances).

Integral to these developments was greater competition for mortgage lending from the mid 1990s (Chapter 6). New participants, known as mortgage originators, entered the market and gained considerable market share throughout the late 1990s and early to mid 2000s. These mortgage originators relied on the securitisation market to fund their lending.^[6] Banks also began to use securitisation as a source of funding, given its relatively low cost and potentially broader investor base. As a result, by mid 2007, securitisation accounted for over 20 per cent of housing loans outstanding (Graph 2.6). This marked a significant shift in the provision of intermediation services, towards greater use of capital markets and away from the full-service banking model.

The trend towards securitisation was reversed, however, following the onset of the US subprime crisis. Despite the continued strong credit performance and transparency of Australian residential mortgage-backed securities (RMBS), demand for these securities was affected by the brand damage to securitisation globally. Conditions in the RMBS market have since improved, with a number of issuers returning to the market after a hiatus of several years (Aylmer 2013). So although a return to pre-crisis levels of activity is unlikely in the near future, the RMBS market will continue to play an important role in the provision of housing credit in Australia.

Viewed in aggregate, the most visible change in the mortgage market since the financial crisis has been the increase in the major banks' market share (Graph 2.7). However, in terms of the outcomes for end users, many of the changes that were initiated by the arrival of mortgage originators have endured:

• The variety of mortgage products available to customers remains much greater than it was in the mid 1990s.
• The average size of discounts relative to the major banks' standard variable rates – and the share of borrowers receiving them – are around their historical highs.
• Fees paid by borrowers have declined in recent years, in absolute terms as well as relative to the value of outstanding loans (Pratten 2013).^[7]
• The supply of housing credit has remained adequate. Although credit standards were tightened following the financial crisis, this only partially retraced the easing that occurred over the previous couple of decades.

2.3.1.2 Managing household wealth

Households' assets rose alongside the increase in their indebtedness. Within households' financial assets, one important development since the Wallis Inquiry is the increased extent to which household savings have been channelled through superannuation funds (Graph 2.8).

The increase in assets held with superannuation funds reflects a number of government initiatives to boost retirement incomes and increase the private provision of superannuation in Australia. Among these initiatives were the introduction of compulsory employer superannuation contributions and various tax incentives to encourage voluntary retirement savings (Chapter 7).

For the purposes of this Chapter, it is sufficient to note that the greater prominence of superannuation funds has increased their importance to the intermediation process. The growth in superannuation assets has also changed the structure of intermediation among institutions. For example, banking groups have played an increasing role in wealth management following a number of acquisitions over the past decade. Life insurers also began to source more of their income from fund management and less from traditional life insurance products.

2.3.2 Corporate finance

In contrast to the household sector, the business sector did not – in aggregate – significantly increase its gearing in response to lower interest rates and the stable macroeconomic environment from the early 1990s. This initially reflected the need to repair balance sheets after the early 1990s recession. Since the early 2000s, corporate gearing has generally remained low compared with some other countries, although it did rise in the lead-up to the financial crisis and directly afterwards. One contributing factor to relatively lower corporate gearing is Australia's dividend imputation tax system, which has the effect of lowering the cost of equity relative to debt.

Australian companies have traditionally borrowed from financial intermediaries such as banks and finance companies. In the period since the Wallis Inquiry, large companies have increasingly borrowed via market instruments (Graph 2.9). However, Australian companies still make relatively little use of bond funding compared with some other developed economies. The stock of bonds on issue by Australian companies grew rapidly from the late 1990s until the financial crisis. The pace of issuance has quickened again in recent years as resource companies have increased their investment in the Australian economy. Resource companies tend to borrow directly from capital markets for their external financing needs (Arsov, Shanahan and Williams 2013).^[8]

An increasing number of Australian companies have accessed offshore funding markets. Over the past two decades, around three-quarters of corporate bond issuance has been conducted offshore. Most of the offshore issuance has been denominated in US dollars, reflecting the size and depth of the US bond market. For a number of Australian companies, US dollar issuance also provides an opportunity to match the currency of their revenues with that of their interest payments. Offshore markets have also allowed some firms to access long-term financing on more favourable terms than have been available domestically, and to diversify their funding sources.

A corollary of Australian companies' ready access to offshore funding markets, and low level of aggregate gearing, is that the size of the domestic corporate bond market (relative to GDP) is smaller than in some other advanced economies, particularly the United States. However, in many respects the United States is the exception – reflecting the relatively fragmented nature of its banking system, and a degree of self-fulfilling momentum from having the most liquid debt markets in the world.

Overall, what is most important is that businesses have access to a range of funding sources, at reasonable cost, to facilitate investment in the Australian economy (along with access to hedging instruments to manage the risks). For many companies that earn revenues in US dollars – resources companies, for instance – the most efficient source of funds may well be the US debt market. Moreover, access to equity funding can be just as important as access to debt funding.

Banks and other credit institutions have continued to play an important role in funding Australian companies. This was evident during the financial crisis, when stress in wholesale debt markets led companies to use more intermediated credit, alongside sizeable equity raisings. An important longer-run development has been an increase in syndicated lending, whereby two or more lenders jointly provide credit to the same borrower. This growth has contributed to an increase in large Australian companies' access to offshore finance.

Even with the recent trend towards more market-based funding, some banks still play an integral role in helping to bring firms to capital markets. Others have shifted their lending portfolios towards housing and small business finance.

Most small businesses continue to use loans from banks and other financial institutions for most of their debt funding because it is often difficult and costly for them to raise funds directly from capital markets. Briefly, the available data and liaison by the Reserve Bank, including through its Small Business Panel and Roundtable (RBA 2012a), suggest that access to small business finance increased over the decade preceding the financial crisis. Since then most industries have had tighter but still reasonable access to funds, albeit at higher cost during the crisis. Chapter 5 considers small business finance in more detail.

2.3.3 Intermediation in the post-crisis environment

The price of risk has increased since the crisis, and with it the cost of intermediation. One consequence of this is that banks' lending rates have risen relative to the cash rate, across all loan types (Graph 2.10). This has predominantly reflected an increase in funding costs, although higher risk premia for the various kinds of borrowers have also contributed. For instance, the rise in mortgage rates has been, on average, less than the corresponding increase for loans to small businesses. The difference partly reflects the fact that the increase in perceived risk in small business loans has been greater.

Over the same period, the interest rates earned by savers on deposits have increased relative to the cash rate. Prior to the crisis, interest rates on term deposits and saving deposits were consistently below the cash rate, whereas now they are consistently higher. This marks a fundamental change in the intermediation process. For much of the pre-crisis period, competition among financial intermediaries was focused mainly on the lending side of the business. In effect, intermediaries could assume that funding would be available and compete for market share in lending out the available funds. The focus has changed since the financial crisis, with competition for deposits and other funding intensifying.

Lending rates in Australia nonetheless remain well anchored to changes in the cash rate. The Reserve Bank Board takes developments in banks' funding costs into account when determining the appropriate setting of the cash rate (Lowe 2012). This ensures that the structure of interest rates faced by households and businesses reflects the desired stance of monetary policy.

The same repricing of risk that has raised the level of borrowing and lending rates, relative to the cash rate, has also contributed to a shift in the market shares of different types of intermediaries. In particular, banks now account for a greater share of the total assets of Australian intermediaries than at any time in the past half-century (Graph 2.11).

The largest increase in banks' market share occurred during the 1980s and early 1990s, following the removal of interest rate controls that had previously placed banks at a competitive disadvantage to other intermediaries. Banks have further increased their market share since the Wallis Inquiry. And concentration within the banking system has also increased, in part due to a number of acquisitions by the major banks in the years surrounding the crisis.

Despite greater concentration among providers, the competitive forces that were introduced in the 1990s seem to have endured, lowering the cost of intermediation for banks' customers. In the late 1980s the average net interest margin of the major banks was above 5 percentage points. By the mid 2000s, it had fallen to less than half that level and, broadly speaking, remains there today (Graph 2.12). The net result is that, despite the adjustments to the post-crisis environment, intermediation has become both cheaper and more widely available.

2.4 Pricing and Allocating Risk

Developments in recent years have reaffirmed the importance of properly pricing and allocating risk. The Wallis Inquiry took place amid growing confidence that financial innovation would help to efficiently distribute risk (Financial System Inquiry 1997, p 4). The optimism continued for another decade or so but, ultimately, the vulnerabilities of the global financial system were laid bare. For financial historians this was an all too familiar narrative: a fundamental shift in technology led to real and sustainable changes, but also engendered a wave of optimism that ultimately went too far (Kindleberger and Aliber 2005).

One reason for the excessive build-up of risk was a focus on the merits of each innovation in isolation without proper consideration for the system as a whole. Chapter 4 examines the concept of systemic risk, alongside a broader discussion of the various financial risks.

2.4.1 The pre-crisis euphoria and the post-crisis rethink

Prior to the financial crisis, financial market volatility was low and stable. Credit spreads were narrow and leverage was readily available. It was the so-called ‘Great Moderation’. Favourable macroeconomic conditions globally were shaped by – and reinforced – a belief that new technologies had allocated risk to those most capable of holding it (IMF 2006, p 36). Many business models were based on the assumption that the benign conditions in global financial markets would persist indefinitely, and many financial products were priced accordingly.

For a while, everything looked to be working out quite well (at least to some); financial institutions were highly profitable and global growth was strong. But in reality, risks were underpriced, there was too much leverage and little was being done to address the building vulnerabilities. Financial institutions and markets had become highly interconnected and large maturity mismatches were common.^[9]

The financial crisis brought these latent risks to the fore. Compensation for risk spiked because financial institutions suddenly became unwilling to assume as much of it (BIS 2009, pp 16–36). The result was a swift tightening in financial conditions, at great cost to the global economy. Trust in the financial system was eroded. Extraordinary intervention by regulators, central banks and governments was needed to avoid further debilitating economic effects (IMF 2009, pp 39–51).

The episode was a reminder of the need to consider risk allocations from the perspective of the system, rather than viewing single exposures in isolation. In recent years, policymakers have focused on reforming the global regulatory framework to address the tendency for financial companies to overlook the systemic implications of their actions (particularly during the boom times; Chapter 3).

2.4.1.1 The Australian experience

Australia was not immune to these events: risks were mispriced and misallocated. But, broadly speaking, the Australian financial system adapted quite well throughout a period of acute stress (Davis 2011). Some public support was required, but not to the extent or for the duration that was needed elsewhere.

A number of factors contributed to the resilience of the Australian system. For one, lending standards were not eased to the same extent as in some other countries during the decade prior to the financial crisis. For another, Australian institutions took on relatively little exposure to the complex structured products that caused large losses at banks in Europe and the United States. The sound prudential framework in Australia was also a source of resilience. In part, the lessons learned from the failure of HIH Insurance in 2001 served to bolster industry and supervisory practices (see ‘Box 2A: The Collapse of HIH Insurance’).

2.4.2 Some longer-run trends

Stepping back from the crisis, there were a number of important longer-run trends in the pricing and allocation of risk during the period since the Wallis Inquiry. First, innovations enabled the pricing of increasingly granular risks. Second, financial institutions reformed their approaches to risk management and devoted more resources to the enterprise. Third, Australian households took on greater financial risk.

2.4.2.1 Innovations in pricing and allocating risk

Financial and technological innovations in recent decades enabled the unbundling – and the re-bundling – of financial risks on a greater scale. Market participants have increasingly used instruments, including derivatives and structured finance products, to deconstruct risk events into their constituent elements and repackage them in a variety of ways; this process is perhaps best described as the ‘atomisation’ of risk (Knight 2007). While a source of problems in recent times, these innovations do hold the promise of tangible benefits regarding the allocation of risk.

The result has been a marked increase in the range of instruments that are traded in financial markets (Borio 2007). The new products and markets have increased the scope for households and companies to tailor their risk exposures. For instance, many Australian companies use derivatives to manage the risk on their offshore borrowings or to insulate their balance sheet positions from changes in interest rates (Gyntelberg and Upper 2013).

At the same time, the financial system has become more complex. And the interlinkages between markets and institutions have grown. Banks have increasingly used financial markets to source income and to hedge their operations. Markets, in turn, have remained dependent on banks for liquidity. Moreover, the globalisation of finance has increased the potential for financial shocks to be propagated across borders and markets. Each of these changes was evident during the years surrounding the crisis. For instance, the rapid growth in over-the-counter (OTC) derivative markets led to large bilateral, cross-border exposures. It also increased the interconnectedness and counterparty risk in the financial system, which helped to amplify the global liquidity shock of 2008.

2.4.2.2 Risk management among financial institutions

The growth in the size and complexity of the financial system has led to an increase in the resources devoted to allocating and managing risk. In Australia, the financial sector and its supervisors have taken a number of measures to improve risk practices over recent decades, including:

• Greater resources for risk management (Laker 2007). This reflected, in part, a response to the large losses recorded by Australian financial companies in the early 1990s (Sykes 1994).
• Some enhancements to risk identification. For example, credit risk management systems provided further information on the characteristics of loan portfolios. And advances in information technology have enabled banks to view the exposures of their various business segments and subsidiaries, in contrast to some of the systems that were in place prior to the Wallis Inquiry (Carew 1997).
• Greater use of risk modelling and quantitative approaches to the allocation of capital. The implementation of the Basel II Capital Framework was an important catalyst for a more granular allocation of capital according to risk (see ‘Box 2B: The Basel II Capital Accord’).

These improvements contributed to the resilience of the Australian financial system in recent years. But they do not imply an absence of vulnerabilities. First, the operational risks remain acute, as demonstrated by the large losses of a major bank in 2004 due to ‘rogue’ trading losses, and similar transgressions at a number of foreign banks in recent years. Second, many risks to the financial system remain largely untested. One consequence of more than two decades of virtually uninterrupted economic growth is that the Australian financial system has not had to adapt to a period of prolonged weakness in the domestic economy. It is important that households, businesses, and financial institutions remain alert to the risks.

2.4.2.3 Risk allocations among households

There is not space here to detail the many changes in risk allocations since the Wallis Inquiry. A regular timely assessment of risks to financial stability is provided in the Reserve Bank's semiannual Financial Stability Review. Briefly, though, it is worth outlining two key changes to the allocation of risks among households since the Wallis Inquiry:

• the rise in indebtedness
• the increase in direct exposure to market risk.

Greater household indebtedness

Similar to many countries, Australia's household debt-to-income ratio roughly trebled between the 1980s and the mid 2000s (although it has since stabilised; Graph 2.13). Greater access to finance has benefited Australian households in a number of ways, including by expanding their scope to smooth consumption over their lives (Modigliani 1986). Even so, the rise in indebtedness has made some households more vulnerable to sudden changes in macroeconomic conditions (Borio and Lowe 2002).

Most of the increase in household debt in Australia accrued to higher-income households, which tend to have lower debt-serviceability ratios and debt-to-income ratios than other borrowers (Finlay 2012). And lending standards generally remained prudent, despite some easing in the early 2000s and in the lead-up to the crisis. Some pockets of stress emerged, including in western Sydney during the mid 2000s (Urban Research Centre 2010), followed by some regions in Queensland and coastal New South Wales, and in Western Australia (RBA 2012b, p 41). But, viewed in aggregate, relatively prudent lending standards, alongside favourable economic conditions, have contributed to the strong performance of Australian mortgages in recent decades (Graph 2.14).

Greater direct exposure to market risk

The rise in superannuation holdings since the Wallis Inquiry has increased the exposure of Australian households to market risk – the risk of losses due to fluctuations in the market price of assets (see ‘Box 4A: Types of Financial Risk’). In particular, the share of household assets held in equities has increased to 40 per cent, compared with less than 30 per cent in the late 1990s.

Over a long investment horizon, equities have generated higher returns than less risky investments such as deposits. For instance, on a pre-tax basis, $100 invested in the ASX 200 when the Wallis Inquiry was published would have nearly trebled by the end 2013, whereas the corresponding investment in a savings deposit would have not quite doubled.

Even so, the financial crisis demonstrated the risks to Australian households' wealth. Australian equity prices halved, reducing household wealth, including the retirement funds of many Australians. While equity prices rebounded swiftly, not all households could wait for the recovery before selling assets to generate cash. Subsequently, households have adopted more conservative asset allocations – shifting funds away from equities and into deposits.

From a system perspective, the increase in households' exposures to equities had little impact on financial stability. One reason for this is that few equities were directly purchased using debt, which reduced the scope for a cycle of margin calls and sell-offs. Moreover, the increased direct exposure to market risk among households has reduced the concentration of these risks in institutions.

2.5 Liquidity

The financial crisis brought into sharp relief the importance of liquidity provision, not only for financial institutions but also for the broader economy (see ‘Box 2C: The Global Financial Crisis’). The dearth of liquidity in late 2008, and the abrupt tightening in financial conditions, led firms to cut back on investment and production. The result was the most synchronised collapse in global trade since at least World War II.^[10]

Whereas most scholars had focused on managing the liquidity risks associated with banks' retail deposits, the predominant channel through which the global liquidity shock of 2008 came about was the closure of interbank lending markets (Bech and Keister 2013). There were some deposit runs in Europe – most notably on UK lender Northern Rock (Shin 2009). But the key source of the liquidity shortage was the sudden unwillingness of banks to lend to each other. This is best exemplified by the spread between a short-term rate in the interbank market and the expected policy rate (Graph 2.15). In Australia, the spread did not rise as much as it did in other countries, reflecting fewer counterparty concerns and the associated smoother functioning of the interbank market.

2.5.1 Central bank support

In the face of an unprecedented global shock, central banks took extraordinary measures to inject liquidity into the financial system. These efforts were initially concentrated on improving the functioning of short-term money markets. Policy rates were reduced to multi-decade lows. And central banks expanded the scale of their money market operations by widening the scope of eligible collateral and lengthening the term of repurchase agreements.

One summary way to gauge the actions of the Reserve Bank with those of other central banks during the crisis is to compare the evolution of their balance sheets. Graph 2.16 shows that the Reserve Bank provided liquidity support during late 2008 that was subsequently unwound.^[11] In contrast, the balance sheets of central banks in Europe and the United States expanded significantly more and remain elevated.

The methods of support also differed. The US Federal Reserve and the Bank of England, for instance, directly purchased securities as part of their quantitative easing policies. For the Reserve Bank of Australia, the balance sheet expansion was achieved predominantly through its regular market operations.^[12] The Reserve Bank was able to respond to market pressures promptly and with few changes to the operating framework, partly because of the flexible framework for open market operations (Debelle 2008). The fact that the Bank had dealt daily with a range of counterparties over an extended period also aided the Bank's response.

Several other factors enabled the Reserve Bank to promptly address the liquidity shortage in Australia. Two deserve special mention.

First, the foreign-currency denominated funding of the Australian banking system was hedged into Australian dollars – as it continues to be today. This meant that most of the liquidity demand was in Australian dollars rather than in foreign currency. This compares to the situation of a number of European banks that funded US dollar assets with US dollar liabilities which had been swapped out of their local currency. When liquidity issues arose for those European banks, the European Central Bank was constrained in its ability to provide the US dollar liquidity needed to address those stresses.

Second, the asset quality of the Australian banking system remained in good shape. An important role of the central bank in a crisis is to lend to illiquid yet solvent institutions (Thornton 1802; Bagehot 1873). And the solvency of a bank is first and foremost a function of the quality and value of its assets.

2.5.2 The post-crisis environment

The crisis has not changed the desire among many households and businesses to borrow at long maturities while having access to their savings at short notice. It has, however, resulted in a reappraisal of the associated risks.

Prior to the crisis, the importance of liquidity in markets and to institutions had perhaps not been emphasised as much as it should have been in international regulation, where the focus had been on capital adequacy. The crisis demonstrated that, under conditions of uncertainty, liquidity pressures could emerge in markets that have seldom been affected in the past. It was a reminder that the same speculators that add liquidity to markets in good times may withdraw liquidity in bad times (Lowenstein 2000). Relatedly, the liquidity characteristics of some financial instruments had been overestimated.

In response to the difficulties encountered, predominantly in the North Atlantic countries, reforms to address bank liquidity have been developed; these form part of the broader Basel III package of bank reforms. The liquidity reforms and their implementation in Australia are discussed in Chapter 3. One key element is a requirement that banks hold sufficient liquid assets to withstand a 30-day stress period, including by taking into account the liquidity risk inherent in their various liabilities.

Alongside the regulatory response, there was a fundamental reassessment of liquidity risk by investors, ratings agencies and banks globally. The change in mindset is evident in the repricing of banks' liabilities and adjustments to the composition of their funding. Australian banks have competed strongly for deposits, reflecting a view that deposits pose less liquidity risk than short-term wholesale funding. The competitive pricing, alongside more prudent household behaviour, has contributed to an increase in the deposit funding of the Australian banking system.

Banks have also adjusted the composition of their assets to address liquidity risk, including through greater holdings of liquid assets (such as government debt). Australian banks have begun to place more weight on liquidity considerations in the pricing of some of their lending products.

It is worth reiterating that the changes in the cost and provision of liquidity services are not purely the result of regulatory changes. There are a number of interacting forces at work. Some of these changes are self-imposed, as financial institutions look at the lessons learned over recent years and seek to increase their resilience to future developments. Some are being imposed by the market in terms of the price and quantity of the available funding. Others reflect pressure from ratings agencies. In general, financial institutions have a better appreciation of liquidity risk than they did before the crisis. And efforts have been made to advance liquidity risk management and stress testing techniques. Taken in conjunction with the reforms to capital requirements and other risk management measures, these developments should help to make banks more resilient to future stress events. Moreover, the regulations will serve as a backstop in the event that some of the other forces dissipate in the future.

Footnotes

Part of the increase in turnover is due to the privatisation of previously public entities and the demutualisation of some member-owned organisations. [1]

The timing of these changes differed across countries. For instance, the decline in inflation in Australia occurred later than in many other countries. [2]

As a simple illustrative calculation, assuming a debt-servicing ratio of 30 per cent on a 25-year mortgage, a household's borrowing capacity would have risen from around two times annual income in the late 1980s to roughly four times by the mid 2000s. [3]

CGFS (2006) and Kent, Ossolinski and Willard (2007) discuss some of the institutional differences across countries that may influence these adjustments in the context of housing. [4]

Part of the revenue earned by financial intermediaries is derived from implicit fees, embodied in the spread between their lending rates and funding costs. For national accounts purposes, estimates of these implicit fees are obtained via a construct known as FISIM – financial intermediation services indirectly measured (United Nations et al 2008). Simply put, FISIM combines observed lending and deposit rates with the stock of outstanding loans and deposits to provide a measure of output. As a consequence, it is difficult to discern between changes in prices due to productivity improvements and shifts in the price of risk. For example, if a bank increases its lending rates due to a perceived higher risk of default, the FISIM concept will record an increase in financial sector output. [5]

Simply put, securitisation involves consolidating a pool of debt, such as residential or commercial real estate loans, and issuing securities that provide cash flows to the purchasers. The cash flows at various points in time are typically tied to the performance of the underlying pool. [6]

An update will be provided in the Reserve Bank's next survey of bank fees, which will be published in the June 2014 issue of the RBA Bulletin. [7]

Both Australian and foreign listed resource companies primarily fund themselves with internal funds. From 2003 to 2012, internal funding was 86 per cent and 150 per cent of total net funding flows for Australian and foreign listed resource companies, respectively. The share of internal funding is higher than in non-resources sectors. For example, other non-financial Australian listed companies have typically sourced around two-thirds of their net funding internally. [8]

The fact that risk was underpriced was apparent to many observers, including the Australian authorities (APRA 2005, p 9; BIS 2006, pp 140–144; Laker 2006, p 8; RBA 2006, p 1). [9]

The specific topic of trade finance is considered in CGFS (2014). [10]

The Reserve Bank's balance sheet expanded in November 2013 as a result of the move to same-day settlement of direct entry payments. This increase was related to changes in the payments system and does not reflect crisis measures. [11]

Some of the increase reflected the foreign exchange swap facility with the Federal Reserve, which was primarily initiated to assist the Federal Reserve's actions to ease global US dollar pressures. [12]

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