Competition working in banking

Competition has worked well in the banking industry in Australia and it is a mistake to view the financial sector as "too big", Rodney Maddock, adjunct professor in economics at Monash University, argued in a paper prepared for the Australian Centre for Financial Studies.

Maddock set out to provide a local perspective on research by the Bank of International Settlements, which, he said, "purports to show that financial sector growth correlates with economic growth up to a certain level but has a negative impact above that."

"Overall it is difficult to conclude that any increase in the size of the financial sector as a result of the rapid growth in household borrowing was the result of financial sector distortions," he wrote in his paper.

"Individuals made their own decisions to live with higher levels of debt and bid up asset prices."

"Normally when the demand curve for a service shifts outwards, as has apparently happened in these three markets, we would not see supplier margins fall. In fact, they would normally rise at least for a period until entry chiseled away the excess profits.

"Surprisingly then, bank margins have fallen quite consistently, with net interest margins roughly halving since the 1990s and bank fees per asset funded also falling.

"However since most countries have had a downward trend in net interest margins, technology and globalisation were probably the drivers rather than local factors (such as the rise of mortgage brokers).

"And while Australian bank margins have fallen sharply over twenty years, the Bank of International Settlements suggests they are still (at 183 basis points) only in the middle globally."

Maddock says "what does stand out is the efficiency of the banking system."

"The Productivity Commission has found the sector to have sustained levels of total factor productivity improvement well above industry averages.

"The global data reveals a similar picture, with operating costs (including personnel costs) as a share of assets running at 117 bps in Australia."

"This and the data cited above suggests that local banks have driven productivity faster than most of their international peers and have been able to retain more of the benefits for shareholders without excessive (but still substantial) margins.

"It is not surprising that they are amongst the most profitable banks globally. This provides part of the explanation for the large size of Australia's financial sector."

However, Maddock says "the economy is distorted in support of the financial sector mainly as a result of government policies favouring compulsory superannuation and housing investment. It is too big in that sense."

Household behaviour has also changed, with households being "more comfortable with higher levels of debt, and more accustomed to financially volatile assets, than was the case historically."

Maddock wrote that "this may be a matter of their being richer and hence desirous of diversifying their portfolios, or may simply be a matter of gradually learning how to operate in a more open capital market."

"Margins have tended to fall, and there has been significant entry. Given the large expansion in demand for financial services, such margin compression reflects well on the institutional design."

"The broad impression, however, is that competition has worked better in banking than in superannuation."

Maddock delivered his paper at the Melbourne Money and Finance Conference.