The Essay Modified Significantly In Order To Incorporate An Economic Overview Of Australian Financial Sector.

Discuss about the Modified Significantly In Order To Incorporate.

The economic principles and theoretical frameworks in the global framework have developed considerably and modified significantly in order to incorporate newer ideas and explain the happenings and phenomena occurring in the different sectors of the economics across the world (Bös 2014). The economic ideas of market, market structures and their dynamics, concentration of power, production and consumption activities, costs and benefits of the producers and consumers, externalities and many other concepts are found to be considerably relevant when it comes to explanation of different phenomena occurring in the increasingly integrated and inclusive global economy.

Keeping these economic concepts into consideration and taking into account the debates present in the aspects of working of different socio-economic systems, the concerned report tries to shed light on the current dynamics and issues arising in the financial sector of one of the predominant economies in the global scenario, Australia (Joshi et al. 2013). The issues which the concerned sector of the country has been experiencing indicates towards the question of individual and overall economic welfare and trade-offs regarding the decision-making processes of especially the supply side players as well as the roles played by the government and regulatory institutions and the implications of their actions.

The Australian financial sector, especially the banking and the insurance sector have been among the dominant and most dynamic sectors of the country, contributing significantly in the development of the industrial, real estate and commercial aspects of the countries, thereby contributing immensely to the economic growth of the country and also getting facilitated by the economic growth itself, in terms of increased economic and financial activities by the residents of the country (Cavusgil et al. 2014). However, several issues of concern have been cropping up in the concerned sector since the last few decades, which the report tries to analyse and interpret in the light of the economic conceptual frameworks.

To study the same, qualitative and descriptive research methods have been taken where several articles and other literary sources are considered. To highlight the issues of concern in the financial sector of the country, the concerned report takes reference of the article named, “Falling bank returns don't indicate competitiveness: Productivity Commission”, published in the Financial Review on 5^th March, 2018 (Afr.com 2018). Apart from the same, economic theories and conceptual frameworks have been studied and the same have been related to the issues taken into consideration in the concerned report.

Findings

The article taken into consideration in the concerned report highlights the views of the chairman of Productivity Commission of the country, according to whom the current increased levels of the regulatory capitals has led to a decrease in the returns to equity of the banks of the country and also assert that the same does not indicate towards the presence of high competition in the market. according to the article, in spite of the withering market power of the big four banks in the economy of the country, the same have the potential to overcome the increase in the costs by increasing the level of prices, thereby keeping the profitability as well as shares of clienteles same (Pc.gov.au 2018).

The article highlights a debate ongoing among the participants in this industry regarding the level of competition and its dynamics in the current period. While one view (especially of the banking and financial officers of big four banks) propose that the decrease in the returns to equity of these banks indicate towards an increase in the level of competition in the industry, the other view points towards the fact that given the profitability of the big four banks, the competition is still weak in the sector of the country.

In this context, the article also attributes the main underlying reason behind the increase in the regulatory capital of the banks to be the financial crisis which occurred in the banking and financial sector of the country due to lesser restrictions and more lending and borrowing activities in the banking sector of the country, which in turn led to the creation of an investment bubble, especially in the housing sector, the burst of which led to the creation of immense credit crunch and recession like situation in the country (Erkens, Hung and Matos 2012).

Thus, the present decrease in the returns on equity faced by the banks, especially the big four banks of the country can be primarily attributed to the regulatory actions and not due to increase in competition in the market, according to one side of the views. In fact, this view has been backed by several relevant individuals, as shown by the article, who shows that the ROE of the small banks, especially after the crisis period, has been nearly half of the same witnessed by the big banks (Davies and Green 2013). According to them the competition in the sector has been compromised even more by the imposition of investment caps on the investors and has actually benefited the large investors.

Australian Financial Sector: An Economic Overview

Given the needs for the macroprudential policies and imposition of regulatory operations for safety purposes of the economy as a whole and the negative implications of the same in terms of less competition, less efficiency and higher cost, these become critical issues of economic trade off for the regulators as well as the banks themselves. The report takes these issues into consideration and tries to explain and interpret the same in the light of the theoretical and conceptual framework of economics and its applications.

To understand the dynamics and problems cropping up in the financial sector of the economy, it is of utmost importance to have an overview of the sector and the type of market structure under which it operates as the same have considerable implications on their operational activities and profit generation.

In this context, the banking and financial sector of the concerned country can be termed as an industry showing considerable oligopolistic traits. This is primarily because in spite of the presence of many small banks in the industry, a significant share of market power of the industry is seen to be consolidated in the hands of big four banks, namely the Commonwealth Bank, the Westpac Banking Corporation, the Australia and New Zealand Banking Group and the National Australia Bank, each of which has enjoyed considerable share of profit, clientele and decisive power over the years (Nava 2015).

Figure 1: Market share of banks of Australia

(Source: Jdfp.com.au 2018)

As is evident from the above figure, the big four banks have been enjoying considerable market share in the country, compared to all the other banks operating in the economic domain of the country, taken together. These four banks not only have attracted a significant share of domestic clientele over the years but also played active roles in attracting foreign investments in the country substantially.

The sector-wise share of these four dominant banks in the country can be seen from the following figure:

Figure 2: Combined share of the big four banks of Australia

(Source: Asianbankingandfinance.net 2018)

From the above figures it is evident that the Australian financial sector strictly shows oligopolistic trends.

In economic, the oligopolistic market structure refers to a situation where there are many buyers and a few sellers (not more than 20), which in turn gives each of the seller considerable market share as well as market power. Each of the sellers have decision making power regarding their pricing and output decisions although their decisions are interdependent on one another as the actions of one of the supply side players have considerable impacts on the decisions and outcomes experienced by the other sellers (Baumol and Blinder 2015).

In these types of situations in general the firms either indulge in a price competition or form a cartel like situation where the supply side players operate together and collectively earn profits and prosper together. In case of price competition, each of the oligopolistic suppliers experience a kinked demand curve which can be shown as follows:

Figure 3: Kinked Demand Curve in Price War situation in Oligopolistic Market

(Source: As created by the author)

As can be seen from the above figure, in the presence of a price competition situation, in an oligopolistic market, a reduction in prices of goods or services by one of the supplier is followed by reduction in the prices by all the rival suppliers but an increase in price is followed by increase in prices by all the rivals.

As discussed above, keeping the threat of profit reduction in the face of price war like situation, the four dominant banks of the country operate in more or less a cartel like situation, which in turn posits a credible threat of increasing their combined market power and dominance even more and giving a collective monopolistic trend in their coordinated operations, if the threat of operational amalgamation actually occurs.

If the banking industry starts showing monopolistic trends, with the four big banks operating together to increase their profits, then the cost and price gap is expected to increase even more (Pindyck and Rubinfeld 2014). This is primarily because in terms of economics, a monopoly market refers to that type of market structure where there is one seller and many buyers, which in turn gives the single seller the entire market power thereby making it capable enough to be a price maker, with the price decided by him being abided by all the consumers.

Figure 4: Wider price-cost gap leading to higher profit in Monopoly

(Source: As created by the author)

The presence of monopoly as well as oligopoly can be beneficial for the bigger banks in the country. However, their benefits may come at the cost of the welfare of the customers as well as the small-scale suppliers (Askar 2013). To prevent this and to increase the level of competition in the industry, it is important to help the small banks, by supporting them and giving them financial aids and protecting them from the harsh competitions they face from the collective operations of the four big banks.

In presence of a competitive market, the market power is evenly distributed among the different buyers and sellers and none of them no longer enjoys the sole decision-making power. There also remains equal distribution of knowledge and the presence of competition among the supply side providers of the market induces them to be more innovative and cost efficient, which in turn helps in increasing the efficiency of the industry itself (Rios, McConnell and Brue 2013). The presence of competition tends to reduce the profits of the bigger players to some extent and tends to form a more equally distributive environment.

The recent trends of the returns on shareholder’s equity and the profitability of the banks of Australia can be seen from the following figure:

Figure 5: Profitability of the banks on the basis of ROE in Australia

(Source: Rba.gov.au 2018)

From the above figure it is evident that the profitability of the four major banks of the country, which used to be considerably higher in the 2000s has been decreasing visibly in the recent times, especially within the period of 2012-2016, with the same experiencing a stark decline in 2016. This has been viewed by many as the outcome of increased competition in the banking industry of the country. This notion comes from the above discussed concept of competition in the market, which, if prevails, decreases the disparity of distribution of profit and revenue among the different supply side players.

However, had the competition in the banking industry actually increased, then with the fall in the ROE of the big four banks, the gap between the big banks and the smaller and mainly regional banks in terms of returns on equity was expected to reduce with time. However, this is not the case observed in the banking sector of the economy of Australia in the contemporary period (Brailsford, Handley and Maheswaran 2012). As is evident from the above figure, there still exists a significant gap between the returns to shareholders equity enjoyed by the major banks of the country and the smaller ones, which can be seen from the gap in their profitability. This can also be seen to be supported by the following figure, showing the dynamics in the concentration in the banking industry of the concerned country over the years.

The term market concentration in economics shows the degree of competition in the market. An industry with low market concentration indicates towards the presence of higher competition in the industry and vice versa. In this context, it can be seen that the degree of competition in the insurance sector of the country has fluctuated over the years and does not show any particular pattern as such. However, the same is not true for the banking industry of the financial sector of the country, as the level of market concentration has actually increased within the industry with each year, which actually indicates towards the lack of competition in the banking sector of the country.

Given the scenario of existing high market concentration in the financial sector of the country, the fall in the returns on equity experienced by the banks of the country cannot be attributed to any increase in the level of competition. A comparatively plausible explanation of the decrease in the ROE which can the banks have been experiencing in the current period may be the imposition of stricter regulations by the governing authorities of the country on the financial sector and its activities, especially in the form of higher regulatory capital (Zhang et al. 2013).

The regulatory capital is the amount of capital which the banks and the financial organizations in the country have to hold according to the requirements determined by the monetary authority of the country. This is usually determined as a percentage of the risk-weighted assets which has to be help by the banks (Barth et al. 2017). Higher percentages of regulatory capital in a country indicates towards lesser lending capabilities of the financial institutions which leads to a fall in the profitability of the same, which is the situation in the financial sector of Australia in the contemporary period.

The need for imposition of stricter regulations and more state intervention was felt in the financial sector of Australia after the Financial Crisis of 2008, which primarily occurred due to the bursting of the investment bubble in the residential sector of the country. This bubble was however created due to the high demand and high price situations in the housing sector of the country prior the crisis. The banks played the role of facilitator of easy and risky loans during this period with the intension of own profit maximization, thereby forming the investment bubble (Schularick and Taylor 2012). The burst of the bubble led to immense negative externality in the economy as not only those who participated in the same suffered but the crisis was percolated to each and every section of the society and the whole economy went to an acute recession.

Apart from regulatory capital, bindings have also been imposed in the form of investment caps and similar forms with the objective to reduce the negative externality in the economy. However, the same is also seen to have negative implications in terms of loss of overall efficiency in the economy and the large investors are actually benefited while the small ones are suffering, which in turn indicates towards the further distortions created in the financial sector as competition is actually not increased and the large banks still have scopes of regaining back their profitability without losing their clientele and market share (Balassa 2013).

The above situation can be explained in the light of the Socialist Calculation Debate. This debate is mainly about how the economic calculations will be done in a socialistic economy with higher controls of state and with lack of private ownership of resources, value for money and pricing mechanisms. This in turn poses an important question regarding whether socialist construct can actually be a better option than capitalist form an economy, in terms of efficiency (Pennington 2012). In the current context, this seems to be relevant as the increased intervention and regulation of the state in the financial sector of Australia, done with the intension to increase the overall welfare of the economy, is actually seen to distort the sector and distribution of power and benefits in the same even more in some aspects, thereby affecting the efficiency as well as equitability in the financial sector of Australia.  

Conclusion 

From the above discussion it can be asserted that the banking and financial sector of Australia has been subjected to considerable fluctuations and dynamics over the years. The banking sector, being mainly oligopolistic, has contributed considerably in the financial crisis of 2008, which in turn has led to stricter regulations on part of the governing authority, in terms of higher regulatory capital and investment caps. The former has resulted in decrease in the ROE of the banks, which is thus, not the result of high competition. In fact, the concentration in the banking sector has been observed to increase in the country with years. The investment caps have not helped that much as the large investors have been actually benefited, which in turn questions the role of excessive intervention of the state in this aspect. Thus a mixture of both private freedom and state intervention is required with a perfect balance maintained in the same in order to combat the issue of market distortions occurring in the concerned scenario.

References 

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