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Understanding the Australian Banking System

In its draft report on competition in the financial system, the PC said last month the four major banks "have the ability to pass on cost increases and set prices that maintain high levels of profitability without losing market share" and "prudential regulation substantially limits the scope for traditional price competition".
Discuss.

The Australian Productivity Commission recently, reviewed the competition in Australian financial system and found that competition in Australian Banking system is concentrated as compared to its international peers. A part of the review also, took a look at the impact of regulation on the smaller entities. The Productivity Commission suggested that the regulations should not affect the Big Four since they were capable of passing the costs to the consumer (The Productivity Commission, Australia, 2018). However, it is alleged that stringent regulations that have followed the Global Financial Crisis. The traditional price competition is eroded due to the higher regulations as the current regulations place caps on investments based on their risk profiles, thus taking away the chance to gain higher profits. In cases where there is a limit on the opportunities for risks, the profitability of firms will be decided based on scale. (Eyers, 2018)
According to David Carter, the CEO of Suncorp, the prudential regulation is hurting the smaller banks in Australia and there is no level playing field in the Australian Banking system for the smaller banks, new entrants and the larger banks. (Eyers, 2018) The returns on equity can be limited due regulations. As the returns on equity fall, banks are unable to pay a higher rate of interest to independent capital such as personal deposits. Thus, banks have a limited ability to compete for capital by offering depositors and investors higher returns on money. The latest figures of Australian banking industry have confirmed the claims of lower returns on interest based products. (KPMG Inc., 2018)
This paper seeks to understand the structure of the banking industry in the current scenario, the past experience with regulations and deregulation of the financial system in Australia and the links between the Global Financial Crisis and the current regulatory environment. The current macro-economic environment (the monetary policy) is also discussed, in order to understand whether greater regulation , which increases the costs of functioning of banks, is really necessary.

Australia has over 53 banks out of which only 14 are owned pre-dominantly by Australian share holders. This makes the banking industry highly fragmented. Almost all Australian-owned banks are publically listed and traded on the Australian Stock Exchange, with one exception Financial. All of these banks are owned privately and there is no bank in Australia that is owned by the Government, which regulates the banking system through the Australian Prudential Regulation Authority (APRA) formed in 1997( Reserve Bank of Australia, 2006)

Even though the Australian banking system is fragmented, the Big Four or the four largest banks in Australia are the ones that have a disproportionately larger share of the market.(The Productivity Commission, Australia, 2018)

The Pre Financial Crisis Period

In the 1970s, a wave of banking deregulation took over countries like UK and USA . This was aided, partly by the rise of Non Banking Financial Institutions. During this area, financial and Non-Financial companies argued that regulations were making it difficult to provide loans to credit worthy people. Following this trend, financial deregulation took root in Australia in the 1980s and kept growing until 1996. The reforms included a broad base of issues such as privatization of government owned corporations, factor market reforms, floating of the Australian Dollar, etc.(Li, 2014)
Following a period of economic boom, asset prices starting increasing in Australia During the late 1980s and early 1990s. The continued growth of GDP of Australia that lasted for a period of nearly a decade, beginning in the early 1990s, is often cited as an economic miracle.  The liberal reforms that changed the nature of banks, were seen as the reason for the boom (along with the removal of barriers in trade. Banks became less of intermediaries that transferred small deposits from households to firms that need them. Instead, banks became complex entities that negotiated deals with investors, institutional borrowers and provided securitized assets. In simple terms, the primary, traditional function of banks came to decline. As a result, risk taking behavior of banks increased. (Li, 2014)(Docherty, Bird, Henckel, & Menzies, 2016)

In 1997, the Wallis Inquiry Report was put forward and sought to improve the efficiency and competitiveness of the financial system in Australia.  As a result the Australia Prudential Regulatory Agency was formed in 1998. Banks responded to the new prudential norms by charging fees over transactions (which were previously charged with subsidized rates) and by reducing the number of bank branches. Thus, banks started to perform the traditional loans on a lower scale than earlier. A number of banks reduced their staff. Banks started offering more products to a wider market. As a result, a large chunk of public started having access to credit and banking products that they did not have earlier. Additionally, non-banking financial firms started offering services that were traditionally offered by banks only. This could increase systemic risks(Docherty, Bird, Henckel, & Menzies, 2016)

In the period prior to the Global financial crisis, Australian banks had reportedly become very profitable and recorded an average of 21% of return on equity in 2005.( Reserve Bank of Australia, 2006)

The Global Financial Crisis caused the Aggregate demand within the Australian economy to fall. The Reserve Bank of Australia decreased the cash rate as soon as crisis struck with the hope that this would fuel the economic demand domestic demand. This was the right policy at the time since Central Banks worldwide had to lower interest rates as a response to the crisis in order to fuel demand. Some Central Banks, such as the Federal Reserve Bank of the USA were not averse to zero percent interest rates. (Blanchard, Dell'Arricia, & Mauro, 2010) (McDonald & Morling, 2011)  The monetary policy of Australia, since then, has pushed for low interest rates and low inflation targets.

 

                                                                  Figure 1 Real Lending Rates of Reserve Bank
                                      Data Source: (Organization For Economic Co-operation and Development, 2018) . Prepared by Author.

The Australian economy has responded wonderfully to this, as the economy has picked up well and the demand for credit has increased. (Organization for Economic Co-operation and Development, 2017)

Reforms post the Global Financial Crisis

The Global Financial Crisis of 2008 shook the financial world and presented a case for a more prudential and regulated banking system. Since the Global Financial Crisis, governments all over the world , and particularly in Australia have been looking for ways to regulate the financial world. Prudential stability has been the direction of most reforms in Australian financial system since the crisis. The Global Financial Crisis led Australia to adopt the, Basel III which required the banks to adopt more prudential reforms. The sub-prime mortgage crisis demonstrated to the world that excessive deregulation could be harmful too. There are several other examples that point towards the fallacies of being complacent during periods of economic expansion. These example have been repeated, time and again all over the world. During periods of economic expansion, the need for credit is greater as households and firms demand more. Hence, banks and other financial institutions tend to take more risks, performing a greater role as financial brokers in the structured finance and capital market. The crisis playing out in the banking industry in India currently is a case in point. As banks expect greater returns , in an increasing market, they tend to lend more and more, without necessarily ensuring due diligence in the decision making process of handing out credit to large institutional buyer or in making decisions relating to fund management. (Chakravarty, 2018)
 According to Docherty, Bird, Henckel, & Menzies, (2016) the liquidity to income ratios decreases due to excessive bank lending. This is the risk that banks should seek to moderate. The psychological confidence itself that the bank can provide for its liabilities can help prevent the sparking of a financial contagion. The sequence of loss of consumer confidence- pulling out of deposits can be avoided just by ensuring that there are prudential norms.
Some have pointed out that the competitive excesses that existed in the USA in the pre crisis period were primarily responsible for the falling standards of credit in USA, which in turn, could be held responsible for the Global Financial Crisis. Intuitively then, it can be said that the Australian banking industry should have traditional price competition but the competition should not be greater.(Docherty, Bird, Henckel, & Menzies, 2016)
 


              Figure 2 Household Interest Payment Ratios to Income in Australia and Household Savings to Income Ratio since 1981
                                                      Data Source: (Reserve Bank of Australia, 2018) . Prepared by Author

As seen in the graph, the interest payments from households to banks have remained stable since 1980s, since the deregulation. The interest payments lowered only during the aftermath of the Global Financial crisis but increased significantly, in response to the low interest rate and have remained considerably high. Household debt in Australia, currently, stands at an average of 200% of the average household income. In the meanwhile, savings ratio has been on the decline continually since the 1980s and is now at less than 4%.

The Case For and Against Greater Regulation


A look at the household savings and the Real GDP charts shows that household savings ratio in Australia were the lowest when the economy was growing fasts. This suggests that Australians have a greater appetite for credit than for savings Hence, intuitively one can say that Australian banks could run the risk of over lending if another period of economic expansion strikes. This could be a suggestion a case for greater regulation.  


Critics against regulation suggest that, the returns on equity in the Australian banking system currently are far away from the average returns on equity is had in the pre-financial crisis period.(Eyers, 2018)

Additionally, critics point out that the caps on the lending categories have led to the erosion of the profits that banks may gain from the wealth management of funds. These caps have increased the inequality among banks as banks that have the higher scale profit from the scale, leaving smaller banks in a lurch. This makes a case for the removal of caps to allow the banks to pursue the investment strategies of their choice.(Eyers, 2018)
These criticisms take a very narrow view of Australian economy. Australian banks have some of the highest rates of returns in equity in the world. Moreover. there is no proof that links excessive regulation to the erosion of profitability. Profitability of Australian banks could have been eroded for a number of reasons. The share of non-performing assets and housing loans increased between 2016 and 2017. This calls for greater regulation, not a decrease in regulation. As a matter of fact, Australian banks continue to decrease their exposure in risky overseas assets due to the risk profile and continued to increase their investment in the less risky Australian and New Zealand markets.(Reserve Bank of Australia, 2017)


The Australian economy is structurally changing as the average age of Australian population grows older. This implies, that the increase in savings is lower and demand for pay-outs such as pensions, gratuities, insurance pay outs is greater. Additionally, it seems that Australian productivity has peaked and real wages were not growing until 2017, According to a report by (PricewaterhouseCoopers (Australia) Pty. Ltd., (2016) . The report suggests that all these factors directly affect the productivity of the banks, along with tighter financial regulations within Australia. However, it is important to understand the increase in the value of the shares of banks since the Global Financial Crisis has been almost entirely led by the increase in investment in the housing sector of the country. However, the demand for housing sector investments is about to slow down, the Reserve Bank as warned. This implies that the profitability of the Australian banking sector may be even lower.(PricewaterhouseCoopers (Australia) Pty. Ltd., 2016)


According to Organization for Economic Co-operation and Development, (2017) the worker productivity in Australia may have peaked and, in order for the economy to grow, real wages must grow. However, the scenario does not look bleak and forecasts suggest that Australia will experience a growth rate of 3% in 2018, (Organization for Economic Co-operation and Development, 2017)(Reserve Bank of Australia, 2017)  If the growth rate of economy picks up, then there is a chance that the profitability of the banking sector may increase.


Docherty, Bird, Henckel, & Menzies, (2016) demonstrated that there are there are several theoretical reasons that back the idea of banks taking on greater non-traditional role. However, on the other side of the balance is the question of how banks affect in a negative way. An adverse shock to one bank can start a contagion. “Adverse shocks combined with asymmetric information thus have the potential to generate bank runs and contagion of runs from bank to bank.” (Docherty, Bird, Henckel, & Menzies, 2016). Consumers do not necessarily have all the information regarding a bank’s functioning i.e. different stakeholders of banks have asymmetric information regarding the functioning of the banks specifically, and the financial system in general. In such a case, higher regulations ensure that the banks have internal checks and balances that prevent them from taking excessive risks and increase consumer confidence.

The Big Four banks of Australia had some of the highest profit margins in the world.(The Productivity Commission, Australia, 2018)  It is the smaller banks that need policy support, in order to ensure that the competition within Australian banking system isn’t skewed unfairly towards the larger player. Given the profit margins of the big four banks, the big four banks can certainly pass on the costs of increased regulation to their consumer or they can absorb these costs themselves.
The current regulations which follow the Basel III norms require higher liquidity ratios.(Docherty, Bird, Henckel, & Menzies, 2016) Higher liquidity ratios do not present entry barriers for smaller banks to entry. There is also, evidence to suggest that regulation is stifling the ability of banks to grow higher. As a matter of fact, some research suggests that Australian banks must pursue the strategy of small scale and simpler products.  Currently, there is a great diversity in the products offered by Australian banks which might be preventing efficiency.

References

Reserve Bank of Australia. (2006, March ). Financial Stability Review – March 2006 The Structure of the Australian Financial System. Retrieved April 7, 2018, from Reserve Bank of Australia: https://www.rba.gov.au/publications/fsr/2006/mar/struct-aus-fin-sys.html


Blanchard, O., Dell'Arricia, G., & Mauro, P. (2010). Rethinking Macroeconomic Policy. Journal of Money, Credit and Banking, 199-215.


Chakravarty, M. (2018, February 28). The roots of the current banking crisis. Retrieved April 13, 2018, from Live Mint ePaper: https://www.livemint.com/Opinion/2hLkRxtfw4JWumOLHPScYN/The-roots-of-the-current-banking-crisis.html


Docherty, P., Bird, R., Henckel, T., & Menzies, G. (2016). Australian Prudential Regulation Before and After the Global Financial Crisis. Melbourne: Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.


Eyers, J. (2018, March 28). Regional banks plead for level playing field. Retrieved April 13, 2018, from The Australian Financial Review: https://www.afr.com/business/banking-and-finance/financial-services/regional-banks-plead-for-level-playing-field-20180328-h0y2ae


KPMG Inc. (2018). Major Australian Banks: Full Year 2017 Results Analysis. Retrieved April 13, 2018, from KPMG : https://home.kpmg.com/content/dam/kpmg/au/pdf/2017/major-australian-banks-full-year-2017-results-analysis.pdf


Li, S. (2014). Emerging Trends in Smart Banking: Risk Management Under Basel II and III . Australia: Business Science Reference (IGI Global).


McDonald, T., & Morling, S. (2011). The Australian Economy and the Global Downturn Part 1: Reasons for Resilience. Economic Round-up, 1-31.


Organization for Economic Co-operation and Development. (2017). 2017 Economic Survey of Australia. Paris: Organization for Economic Co-operation and Development.


Organization For Economic Co-operation and Development. (2018). Monthly Monetary and Financial Statistics (MEI). Retrieved April 13, 2018, from OECD.stat: https://stats.oecd.org/Index.aspx?DatasetCode=MEI_FIN#


PricewaterhouseCoopers (Australia) Pty. Ltd. (2016, September 21). Australian banks must evolve to escape the ‘commodity trap’. Retrieved April 13, 2018, from PwC Australia: https://www.pwc.com.au/press-room/2016/commodity-trap-sep16.html


Reserve Bank of Australia. (2017, April). FINANCIAL STABILITY REVIEW. Retrieved April 13, 2018, from Reserve Bank of Australia: https://www.rba.gov.au/publications/fsr/2017/apr/pdf/aus-fin-sys.pdf


Reserve Bank of Australia. (2017). Statement on Monetary Policy, February 2017. Melbourne: Reserve Bank of Australia.


Reserve Bank of Australia. (2018, March 30). Statistical Tables. Retrieved April 13, 2018, from Reserve Bank of Australia: https://www.rba.gov.au/statistics/tables/
The Productivity Commission, Australia. (2018, Januaury). Competition in the Australian Financial System, Draft Report. Retrieved April 13, 2018, from Australian Givernment: Productivity Commission: https://www.pc.gov.au/inquiries/current/financial-system/draft/financial-system-draft.pd

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