Submission to the Inquiry into Competition in the Banking and Non-Banking Sectors 5. Factors Influencing Competition

As discussed above, changes in the cost of funding for different lenders have been an important factor shaping the competitive dynamics in retail banking. In addition, two other factors play a key role in influencing the degree of competition in the system. The first is the entry of new players and advances in financial technology. And the second is the ability of customers to compare prices and switch institutions. Both of these factors are discussed below.

5.1 New players and innovation

In most markets, including retail financial services, the ability of new players to enter the market is an important source of competitive discipline on the existing players. In retail banking, one reason for this is that new entrants need only be concerned about attracting new customers when setting their prices, and not the impact of their pricing decisions on the profitability of their existing customer relationships. New entrants are also sometimes more easily able to take advantages of improvements in technology, as they do not have to deal with ‘legacy’ issues.

Not surprisingly, over the past decade a major source of competitive pressure in retail banking in Australia has been the entry of new players using new technology and taking advantage of financial innovations. Examples include:

• the entry of specialist non-bank lenders to the mortgage market in the early to mid-1990s. As noted above, in the early 1990s the spread between the standard variable mortgage rate and the cash rate was around 450 basis points. At this spread, new housing loans were very profitable. Reflecting this, banks competed strongly for new business by offering ‘honeymoon’ rates, but maintained the high interest margins on existing loans. In contrast, the specialist non-bank lenders had no existing customers and were able to offer lower rates to all borrowers. They were able to do so because of their ability to issue residential mortgage-backed securities at relatively low spreads.^[8] The banks eventually responded to this new source of competition by lowering their standard variable interest rates, with the margin to the cash rate falling to around 180 basis points by the mid 1990s.
• the entry of foreign-owned banks in the retail deposit market. Again, the new entrants – in this case the foreign-owned banks – did not have to take into account the impact of their pricing decisions on the profitability of their existing deposits. Their entry, without establishing costly branch networks, was made possible by improvements in technology and, in particular, the development and widespread take-up of the internet.
• the entry of new players into stock broking offering non-advisory discount broking services. Competition in this market was increased by the entry of one of the largest banks and the development of technology that allowed trades to be placed over the internet. Over time, each of the five largest banks has developed on-line stock broking services. This competition has seen the commissions on small parcels of ASX-listed equities fall from around 2 per cent in the early 1990s to about 1 per cent for full-service brokers and about 0.1 per cent for online transaction-only brokers. The range of services offered by these platforms has also expanded. Reflecting these developments, 53 per cent of respondents to the ASX's 2006 Australian Share Ownership Study who had purchased or sold shares in the preceding two years had done so using a discount broker, up from 13 per cent in the two years to November 1999.
• the entry of foreign-owned banks in the credit card market. A foreign-owned bank was the first to offer a credit card with a loyalty scheme in the mid 1990s, and more recently, foreign-owned banks, along with some other smaller players, have been at the forefront of introducing no-frills credit cards.

These experiences illustrate the importance of ensuring that the regulatory regime is conducive to new entrants. If the profitability of a particular financial service is very high due to a lack of competition, then over time new entrants would be expected to enter the market to push down prices. Ensuring that barriers to entry are minimised is therefore a very important element in promoting a competitive market place.

In general, advances in technology have lowered entry barriers, as has the increased willingness of customers to use new technologies to access a variety of financial services. Furthermore, the regulatory regime in Australia is for the most part, access friendly, and does not impose significant impediments to the establishment of new entrants.

One area that the Reserve Bank has been closely involved in is the credit and debit card markets. Through its various reforms it has sought to increase the competitive pressure on the hidden interchange fees that banks pay one another. It has also established access regimes for the MasterCard and Visa credit card schemes as well as the EFTPOS system. These reforms have liberalised access and reduced the cost of new entrants in joining these systems. The Reserve Bank has also worked with the Australian Payments Clearing Association to improve access to the other electronic payment systems. While some improvements have been made in these areas, the Reserve Bank's Payments System Board (PSB) has continued to draw attention to the difficulties that arise from the fact that a number of Australia's payments systems are built around bilateral links between financial institutions. These bilateral links mean that new entrants are required to reach agreement with existing participants – who are likely to be competitors – before they can enter the system. The PSB has asked the industry to consider, as a matter of priority, how access arrangements to these payment systems could be further improved.

5.2 Information and switching costs

A second factor influencing competition is the ability of consumers to access information with which to compare financial products, and the ease of switching to products or institutions that offer a lower price or better service.

Over the past decade, access to information has been improved by two main developments, which have both helped to reduce search costs and improve competition. They are:

• the availability of information on financial products and services on the internet. In Australia, there are a number of websites that allow comparisons of the costs and features of retail financial products. Some of these focus on particular products (for example mortgages), while others are more comprehensive in their coverage of different types of housing, credit card and other personal loans, as well as retail deposit/savings accounts. These websites are typically run by private-sector organisations, although there are a number of government-operated financial literacy sites.
• the emergence of brokers, offering a range of products from different lenders. Brokers allow borrowers to compare more easily the costs and features of different loans, and have allowed lenders to compete in geographical locations without the need to set up extensive branch networks. In aggregate, it is estimated that broker-originated loans currently account for around 30 per cent of new housing loans, though this figure varies considerably across lenders. It is worth noting, however, that brokers are paid by commission, which as the US experience illustrates, can sometimes lead to loans being made that are not in the best interest of the borrower.

A related issue that has recently attracted attention is the costs that a borrower incurs when switching to a different financial institution, with most lenders in the mortgage market charging a fee if the loan is repaid within a few years of it being taken out. Earlier this year, the Government requested that ASIC conduct a review into mortgage fees, with the review finding that early-exit fees are often in the range of around $1,000 for authorised deposit-taking institutions (ADIs), and $2,000 for non-ADIs. While these fees are often seen as an impediment to switching accounts, they sometimes substitute for loan establishment fees, being used by lenders to recoup the costs that they incur when loans are established. In comparison with a number of other countries, loan establishment fees in Australia are relatively low.

In other areas of retail banking, the recent focus has been on the difficulty that customers face in switching institutions when there are direct debit and credits linked to an account. For many customers the inconvenience associated with switching institutions may have increased over recent times, particularly given that many loan accounts are now ‘bundled’ with transaction accounts. While this bundling may have benefits in terms of convenience, the difficulty of switching accounts effectively increases the market power of the existing institutions. In February this year, the Treasurer announced a package of measures designed to make it easier for customers to switch their accounts between banks. A key element of this package is a listing and switching service whereby ADIs will provide customers wishing to switch institutions a list of all direct credits and debits made to the old account over the previous 13 months. The introduction of these new arrangements – which will be in place by 1 November this year – is being overseen by the Reserve Bank.

More generally, many consumers appear reluctant to switch accounts either because of a lack of information or an assessment that the benefits of doing so are not sufficient to outweigh the ‘hassle’ factor, the costs of switching, or the convenience of having a number of services ‘bundled’ with the one institution. This reluctance to switch, even where competing institutions offer superior products, tends to dull competition in the system and confers benefits to the existing institutions. It is likely to best be addressed by a combination of further efforts to improve financial education, more widespread use of comparison services, and efforts, along the lines of those discussed above, to reduce switching costs.

Footnote

For further details see Gizycki and Lowe (2000). [8]