Submission to the Inquiry into the Australian Banking Industry B. Evolution of the Banking System

3. Banks comprise the largest group of financial institutions in Australia. They provide the bulk of the credit extended to households and businesses and they are the major repositories for household savings. Banks employ about 167,000 people (about 2 per cent of the workforce) across a national network of some 6,600 branches. Their significance in public policy terms is that they:
   • are a major channel for monetary policy;
   • provide the low-risk end of the spectrum for household savings, given the ‘depositor protection’ provisions of the Banking Act; and
   • are at the centre of the payments system for the economy.
4. Government policy towards the banking industry, therefore, has been an important part of general economic policy. For most of the post-war period, policy towards the banking industry relied on widespread use of direct controls. In large measure, this approach can be traced to the recommendations in the Report of the Royal Commission on the Monetary and Banking Systems of Australia of 1937, as encapsulated in the Banking Act 1945. Many of these controls were designed for monetary policy purposes – that is, to help the Government, through the Reserve Bank, to influence the growth of money and credit in order to pursue its goals for inflation, economic growth and employment. They provided scope also to direct credit into particular sectors, and to assist with other objectives, such as reducing the cost of financing the budget deficit.
5. Prudential supervision was not mentioned specifically in the post-war legislation but it was implicit in the ‘Protection of Depositors’ Division of the Banking Act. In any event, the Bank was able to keep itself well informed of banks' operations and the body of regulations was sufficiently restrictive that there was little incentive, or room, for banks to engage in excessively risky behaviour. It was not until 1989 that specific responsibility for prudential supervision was included in the Act, by which time the Reserve Bank had developed – and was applying – a range of prudential guidelines.
6. The main controls applied to banks during most of the post-war period were:
   • interest rate ceilings on deposits and loans (including zero interest on normal cheque accounts);
   • the Statutory Reserve Deposit (SRD) system, whereby a percentage of trading bank deposits was held at the Reserve Bank at below market interest rates;
   • the Liquid Assets and Government Securities (LGS) Convention, under which a percentage of trading bank deposits was invested in cash or Commonwealth Government securities;
   • asset restrictions on savings banks, which were required to invest a relatively high proportion of their deposits in prescribed assets mainly government securities issued by the Commonwealth and State Governments, with the remainder in housing loans; and
   • quantitative lending guidelines, which required banks to limit growth in their lending and, at times, qualitative controls which required banks to prefer lending for certain purposes.
7. Over time, these controls were relaxed or removed. This occurred gradually during the 1970s, but accelerated sharply in the early 1980s, stimulated largely by the public discussion surrounding the Committee of Inquiry into the Australian Financial System (the Campbell Committee), which reported in September 1981, and the subsequent Report of the Review Group (the Martin Report) in December 1983.
8. The major deregulatory measures directly affecting banks were:
   • in the early 1970s, the interest rate ceiling on one category of deposits – certificates of deposit – was removed, as was the ceiling on large overdrafts (the major category of non-housing lending);
   • in 1971 banks were permitted to trade as principals in foreign exchange – previously they had traded as agents of the Reserve Bank;
   • in several steps during the middle and late 1970s, the prescribed asset ratio of savings banks was reduced from 65 per cent to 40 per cent;
   • in 1980, interest rate ceilings on all trading and savings bank deposits were removed;
   • in 1982, quantitative lending guidance was discontinued;
   • in 1985, sixteen foreign banks were invited to accept banking authorities;
   • in 1988, the SRD arrangement was replaced with the much less-onerous system of non-callable deposits (NCDs). The successor to the LGS ratio – renamed the Prime Assets Ratio (PAR) – was also substantially reduced; and
   • during this period, there were a number of other important changes which moved the financial sector in a more market-oriented direction. The most important were the introduction, in two stages in 1979 and 1982, of a tender system for issuing government securities, and the floating of the Australian dollar and ending of exchange controls in 1983.

A comprehensive listing of deregulatory measures is at Appendix 1.

Pressures Leading to Deregulation

9. The gradual reduction of direct controls reflected several factors, including moves towards financial deregulation overseas. More important was the growing disenchantment, within Australia, with the accumulating consequences of three decades of regulation. These consequences, which the Bank believes are pertinent to understanding and assessing the deregulation process, are elaborated in the following sections.

(a) The erosion of the regulated sector

10. Controls on banks reduced their capacity to adjust to changing conditions and imposed a cost disadvantage on them – through, for example, having to hold a large proportion of their portfolio in assets which earned below-market rates of interest. While it also gave them some measure of protection – for instance, a monopoly of foreign exchange transactions and protection from foreign bank entry – it cost them considerable market share as financial intermediaries not subject to the same controls grew at the banks' expense. In 1953, banks accounted for 67 per cent of the assets of all financial institutions but by 1981 this had fallen to about 42 per cent (Graph 1). One result of this was that the monetary authorities, by relying on direct controls, were exerting influence over a shrinking proportion of the financial system.
11. The major beneficiaries of the restrictions on banks were finance companies, which increased their market share from 2 per cent in 1953 to 9 per cent by 1960, and permanent building societies, which grew from 2 per cent in 1968 to 7 per cent by 1978. In the late 1970s and early 1980s, merchant banks also increased their share quite sharply, as did cash management trusts although their absolute size was a lot smaller. The growth of non-bank financial intermediaries is detailed in Table 1 (see page 3).
12. In addition to the incursions of domestically owned non-banks, the increasing integration of Australia into world financial markets brought further incursions from overseas offices of foreign banks, their domestic representative offices, and from their partly-owned domestic merchant banks. Non-banks, not being constrained by the same controls, had more scope to be innovative than the banks (in, for example, currency hedging and cash management trusts, which helped attract customers away from banks).
13. The shrinkage of the controlled sector weakened the capacity of monetary policy to affect the economy (see next section). It also meant that many borrowers had to go outside the banking system to obtain credit even though this usually entailed higher rates of interest than banks were able to charge. Depositors too gradually moved more of their savings outside the banks in pursuit of higher interest rates, not always appreciating the loss of the depositor protection provisions of the Banking Act in the process. Other forms of investment – such as building society deposits, credit union deposits, bank-owned finance company debentures and cash management trust investments – were increasingly perceived by the public as offering virtually the same security as bank deposits, storing up problems for the future.
14. One possible reaction to the relative decline in the regulated sector would have been to apply the controls more widely. This possibility was debated in the 1950s and 1960s but was not adopted, in part because of uncertainty about the Commonwealth's power to legislate in this area. In the mid 1970s, a widening of the regulatory net in the form of the Financial Corporations Act of 1974 was contemplated, but in the end the Act was not used for that purpose. Once again it was recognised that as each new set of financial institutions was brought within the regulatory net, another set could be expected to emerge outside that net. As we had seen, the growth of finance companies was followed by building societies, which in turn were followed by merchant banks. Less formal forms of financial intermediation were waiting in the wings, including the inter-company market, the solicitors' funds market and, of course, the commercial bill market. Many of these were decentralised, ‘telephone’ markets with a diverse set of participants which would be difficult, even in principle, to regulate.

(b) Problems with the implementation of monetary policy

15. With the original controls intended primarily to assist the implementation of monetary policy, it is not surprising that problems in effecting this purpose encouraged a re-assessment of the regulated system. It became increasingly apparent, particularly in the 1970s, that the regulated system was not delivering the expected results on monetary policy. The main weaknesses were:
    1. Over time, the erosion of the controlled sector limited the capacity of monetary authorities to control the growth of money and credit. Even when some success was achieved in slowing the activities of banks, non-bank financial intermediaries often continued to grow very strongly. In the 10 years to 1974, for example, banks' assets grew at an annual rate of 11 per cent, while non-banks grew by 21 per cent. As a result, total credit over this period expanded faster than the authorities wished.
    2. Even when bank interest rate ceilings were lifted, serious difficulties remained in restraining the growth in money and credit. One reason for this was the failure to fully fund the budget deficit in the market i.e. part of the funding was provided by the central bank, which pushed cash into the banking system. Another factor was the ability of financial markets to obtain liquidity from the rest of the world through the fixed (or quasi-fixed) exchange rate mechanism. These technical aspects of monetary policy do not need to be pursued here, but they lay behind the decisions to move to a tender system for issuing government securities and to float the exchange rate.^[1]
    3. Over short periods of time, the authorities could implement changes in monetary policy, with immediate effects on financial markets. The concern here was more with the abruptness and dislocation associated with such changes in monetary policy, rather than their ineffectiveness. With interest rate ceilings on banks, a tightening of their liquidity position caused by a change in monetary policy meant that they could not cushion the squeeze by bidding for funds. Instead, their only response was to call in loans which could result in severe ‘credit squeeze’ conditions, as occurred in 1961 and 1974. It is worth remembering also that during the period of regulation – but when some bank interest rates were free to vary – these conditions were often associated with sharp rises in interest rates. Rates on Certificates of Deposit and bank bills, for example, reached 25 per cent in June 1974 and 23 per cent in April 1982 – higher than comparable rates in the period since full deregulation.

(c) Inefficiencies in the allocation of credit

16. ‘Allocative efficiency’ is jargon for the capacity of the banking system to direct credit to areas of greatest productivity and long-term benefit to the country. Under the regulated system, with interest rates on loans controlled, banks had little opportunity to innovate or incentive to lend for new or more risky activities. There was widespread acceptance in the community that bank credit was difficult to come by, for all but the safest borrowers.
17. With all banks offering similar interest rates, it was difficult for one bank to gain market share at the expense of others. Even if a bank were keen to expand its lending into what it believed was a new and profitable area, it could not be confident of being able to raise the deposits to finance that expansion. This tended to reduce competition among banks, except in less-productive ways such as the expansion of branch networks.
18. It is the essence of banking that if loans are to be made which involve higher risk, the bank should be compensated with a higher rate of return. If, however, all loans have to be made at the same interest rate, logic dictates that the bank allocate its funds to the lowest-risk borrowers. These are likely to be concentrated in established firms in traditional industries. Other prospective borrowers, such as small firms and those seeking to expand into newer and less-familiar industries, do not get much of a look-in under such conditions. Moreover, with interest rate ceilings on both the deposit and the lending sides, it was not essential for banks to develop expertise in pricing their products for risk – another shortcoming of the regulated era which has become apparent in recent years.
19. One response to the inherently conservative lending policies of banks and the inability of newer and/or riskier borrowers to obtain credit was for governments to establish new lending facilities in an attempt to fill the gap. The main examples were the establishment of the Commonwealth Development Bank in 1959, the Term Loan Fund in 1962, the Farm Development Loan Fund in 1966, the Australian Resources Development Bank in 1968 (owned by the private banks) and the Australian Industries Development Corporation in 1971.
20. The regulated system also involved allocative inefficiencies in the form of cross-subsidization. The role of the Reserve Bank in clearing the foreign exchange market daily at fixed exchange rates, and the provision of set margins to banks in respect of foreign currency transactions gave banks assured and substantial profits. This, and the interest margins applying with official approval at the time, relieved banks of the need to look too closely at the profitability of particular types of savings bank and trading bank accounts. Transaction fees were not generally charged. One consequence was that some groups of customers – for example, those with many transactions but low balances – benefited at the expense of others – for example, longer-term savers with few transactions.

Footnote

For a detailed explanation of this point, see Australian Financial System Inquiry: Final Report, September 1981: Money Formation and Interest Rates in Australia, T.J. Valentine, Australian Professional Publications, 1984; and Methods of Monetary Control in Australia, l.J. Macfarlane, in Economics and Management of Financial Institutions, eds Valentine and Juttner, Longman Cheshire, 1987. [1]