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180
Marianne Gizycki and Philip Lowe
The Australian Financial System in the
1990s
Marianne Gizycki and Philip Lowe
1
1.
Introduction
This paper examines the major developments in the Australian
financial system
over the 1990s and discusses how these developments might
affect the nature and
transmission of financial disturbances.
2
The paper focuses on the following five issues:
• the losses by financial institutions in the early 1990s
and the general resilience of
public confidence in the financial system despite these
losses;
• the transformation of the household sector’s balance
sheet, and the consequences
for the balance sheets of financial institutions and the
composition of Australia’s
foreign debt;
• the high level of profitability in the financial services
sector in the face of
increased competition within particular markets, and
consolidation across the
industry;
• the shift away from traditional intermediation through
balance sheets of financial
institutions towards intermediation through markets; and
• the strengthening of prudential supervision and the
overhauling of arrangements
for the regulation of the financial system.
These issues are discussed in Sections 2 through 6 of the
paper.
Two recurring themes arise from this discussion. The first
is that financial
liberalisation looks to have been much more successful than
appeared to be the case
a decade ago. In 1991, the Reserve Bank devoted its entire
Annual Conference to a
stocktake of the benefits and costs of financial
deregulation (see Macfarlane (1991)).
While the various papers were able to point to some
benefits, including more
effective instruments of macroeconomic policy, wider access
to credit and greater
financial innovation, they also observed that interest
margins remained relatively
high, record losses were being recorded by financial
institutions, and the framework
for prudential supervision and regulation had not kept pace
with changes in the
financial system. At the time, there was a sense that
liberalisation had promised
much, but delivered relatively little, other than a
speculative property boom and a lot
of wasted investment.
1. The views expressed in this paper are our own and not
necessarily those of the Reserve Bank of
Australia. We would like to thank the following for comments
and assistance in preparing this paper:
Les Austin, Patrick D'Arcy, Guy Debelle, Chay Fisher, Bryan
Fitz-Gibbon, David Gruen, Chris
Kent, John Laker, Adrian McMachon, Ali Razzaghipour and
Peter Stebbing.
2. For reviews of developments in the Australian financial
system over recent decades see Edey and
Gray (1996), Financial System Inquiry (1997), and Grenville
(1991).
181
The Australian Financial System in the 1990s
Nearly ten years on, the scorecard is much more positive.
Competition has
increased (largely through pressure from new entrants),
lending margins have fallen
and the range of financial services has increased further.
Financial institutions are
stronger, risk is better managed, and the regulatory and
supervisory frameworks
have been overhauled. Financial markets have grown strongly,
new forms of debt
finance have emerged, and the range of risk-management
products has increased.
Notwithstanding this more favourable picture, public
criticism of banks remains
high, in large part due to increases in fees, the closure of
branch networks, and
continuing high levels of profitability.
The second recurring theme is that in contrast to the 1980s,
it has been changes
in the balance sheet of the household sector, rather than
the corporate sector, that
have altered the shape of the financial system. The increase
in households’ holdings
of market-linked investments, and the declining share of
wealth held in deposits, has
prompted banks to focus their growth strategies on funds
management. In turn, this
is leading to a further blurring of the distinction between
different types of financial
institutions, and pressure for consolidation focused around
the major banking
groups. The increase in financial assets has also led to the
development of markets
in a wider range of debt securities, a proliferation of
investment products, and a more
important role for institutional investors. It has also
helped prompt changes in the
nature of financial regulation, with an increased focus on
the arrangements for the
protection of consumers of financial services, and a shift
to a regulatory framework
based on functions, rather than types of institutions.
Among other things, the changes in the roles of financial
institutions and markets,
and in the balance sheets of the various sectors of the
economy, have important
implications for the nature and transmission of financial
shocks. This issue is
discussed in Section 7 of the paper. We argue that
developments over the past decade
have reduced the probability of serious financial headwinds
being generated by
problems in financial institutions, while at the same time,
the probability of
headwinds being created by developments in financial markets
has increased. On
balance though, we speculate that despite continued
increases in the ratio of financial
assets to GDP, the health of the macroeconomy is at less
risk from developments in
the financial sector than was the case a decade or so ago.
The paper concludes by raising some public policy issues
that are likely to remain
alive over the coming decade.
2.
Losses Early in the Decade
The 1990s began with the banking industry experiencing its
worst losses in almost
a century. The sum of the individual losses (before tax) in
1990, 1991 and 1992
exceeded A$9 billion – equivalent to over 2
1
/
4
per cent of GDP in 1990, or over
one-third of the aggregate level of shareholders’ funds in
the banking system in 1989
(see Figure 1 and Table 1).
182
Marianne Gizycki and Philip Lowe
Figure 1: Bank Profitability
Return on shareholders’ funds
Note:
Profit figures are adjusted to exclude the government
assistance provided to the State Bank
Victoria (SBV) and State Bank South Australia (SBSA).
Adjusted after-tax figures for 1990 and
1991 are unavailable due to the large transfers between SBV,
SBSA and their state government
owners.
Source: Banks’ financial statements
-5
0
5
10
15
20
25
-5
0
5
10
15
20
25
-5
0
5
10
15
20
25
-5
0
5
10
15
20
25
1985
%
%
1988
1991
1994
1997
2000
Before tax
After tax
Table 1: Total of Individual Bank Losses Incurred in 1990,
1991 and 1992
Type of bank
Total of individual
Total of individual
losses
losses
A$ billion
% of shareholders’
funds in 1989
State government owned
5.0
187
Foreign subsidiary
1.5
64
Private domestically owned
2.7
16
Total for banking system
9.2
36
Note:
The loss figures are before tax and exclude banks that
reported profits. The figures for
shareholders’ funds include all banks in the relevant
category. Figures for SBV and SBSA have
been adjusted to exclude government assistance.
Sources: Banks’ financial statements
183
The Australian Financial System in the 1990s
The largest losses were recorded by the State Bank of
Victoria (SBV) and the
State Bank of South Australia (SBSA). Both banks were owned
by state governments
and experienced pre-tax losses exceeding three times the
1989 level of shareholders’
funds. Large losses were also recorded by Westpac and ANZ
(two of the four major
banks
3
) in 1992, following comprehensive market-based revaluations
of their
property assets; in Westpac’s case this process led to a
reduction of almost 40 per cent
in the value of its property assets and collateral. While
the losses by these two banks
were large, they were easily absorbed by the banks’ capital.
In contrast, like SBV and
SBSA, a number of the foreign banks recorded losses in the
late 1980s and early
1990s that exceeded their shareholders’ funds.
The main reasons for the difficulties of the early 1990s are
well understood.
Deregulation in the mid 1980s intensified competition and
the desire by institutions
to grow their balance sheets rapidly. This took place in an
environment in which asset
prices, particularly commercial property prices, were
increasing quickly, and credit
assessment procedures in many financial institutions had not
adjusted to the new
liberalised environment. The result was extremely strong
credit growth secured
against increasingly overvalued commercial property. In
1989, the combination of
high interest rates and a softening of the commercial
property market exposed the
poor credit quality of some of the most risky loans. Then,
as the economy went into
recession and the decline in property prices accelerated,
more broadly based credit
quality problems became evident; by mid 1992, the ratio of
non-performing loans to
total loans had increased to 6 per cent.
The concentration of losses in banks owned by state
governments and foreign
banks occurred mainly because these institutions were the
most aggressive in
chasing market share. Without strong customer bases, they
relied on relatively risky
borrowers for rapid balance-sheet growth. Additional factors
in the cases of SBV and
SBSA included a rapid shift in the nature of the banks’
businesses and limited
external scrutiny (arising from the fact that the banks were
not listed on the stock
exchange, and that the boards were appointed by state
governments intent on
fostering rapid regional growth). Supervision of these
institutions was also complicated
by the fact that the Reserve Bank of Australia did not have
formal legal powers
regarding licensing, even though the institutions had given
voluntary undertakings
to meet the Reserve Bank’s prudential standards.
In the face of the large losses, public confidence did
become more fragile in 1990
and 1991, although this did not lead to widespread concerns
about the stability of the
financial system as a whole. There were, however, a number
of runs on relatively
small institutions, including a couple of banks that were
formerly building societies.
In general, these runs were stopped by public sector
intervention.
The most significant run on a deposit-taking institution was
on the Pyramid
Building Society. After runs in February–March 1990, and
again in June 1990,
Pyramid’s operations were suspended by the Victorian State
Government and all
3. The other two major banks are the National Australia Bank
and the Commonwealth Bank of
Australia.
184
Marianne Gizycki and Philip Lowe
accounts were frozen.
4
Pyramid’s problems caused some contagion, particularly for
non-bank financial institutions in Victoria, with the
highest profile case being the
OST Friendly Society. Like Pyramid, OST was heavily exposed
to the property
market, and its problems were eventually resolved by a
merger with IOOF (the
largest friendly society). Pyramid’s difficulties also
contributed to runs on the
Bank of Melbourne and Metway Bank (both previously building
societies), with
both banks experiencing a drop in deposits of more than 15
per cent over a couple
of weeks. The runs stopped shortly after the Reserve Bank
issued press releases
stating that the banks continued to meet prudential
standards and were soundly
managed. The Reserve Bank did not provide emergency
liquidity support in any of
these cases.
Runs also occurred on a number of public trusts investing in
either commercial
property or commercial property mortgages.
5
The first of these, in
March–April 1990, was on a mortgage trust, Estate Mortgage.
This run came to an
end when, in the face of mounting liquidity problems, the
National Companies and
Securities Commission froze redemptions. There were also
runs on unlisted property
trusts in the second half of 1990, as investors attempted to
withdraw their funds
before the fall in property prices was reflected in unit
prices. In response, a number
of trusts (not operated by banks) suspended withdrawals and
extended redemption
periods. In 1991, runs also spread to the bank-owned trusts.
This raised the
possibility of a broader loss of confidence in the financial
system, particularly if
banks also suspended redemptions, or undertook a fire sale
of their property assets.
In response, the Commonwealth Government announced a
12-month freeze on all
property trust redemptions.
Weakened public confidence also affected life insurance
companies, particularly
National Mutual (the second largest life company). During
the late 1980s, National
Mutual competed aggressively for retirement savings by
offering capital-guaranteed
investment products, underwritten by its substantial
reserves. In the early 1990s,
however, falls in property and equity prices led to a sharp
drop in National Mutual’s
capital reserves, creating doubts about its solvency. As a
result, the insurer experienced
heavy policy redemptions and a large decline in funds under
management in 1991
and 1992, with public concerns reaching a peak in February
1993 after extensive
media coverage of the problems. In response, the Insurance
and Superannuation
Commission issued a public statement indicating that
National Mutual’s capital and
reserves exceeded minimum regulatory requirements and that
it had sufficient liquid
assets. While outflows of managed funds continued, changes
in the company’s
management and a return to profitability in 1993 saw
confidence gradually restored.
4. For comprehensive accounts of the Pyramid episode see
Kane and Kaufman (1992) and Sykes (1994).
Eastway (1993) provides a brief summary of the problems in
non-bank financial institutions in the
early 1990s.
5. There were also runs on a small number of financial
institutions in the late 1980s, particularly
following the share market crash in 1987. The highest
profile cases were the runs in October 1987
on Rothwells and Spedley Securities (both merchant banks).
Both institutions were eventually
placed in liquidation.
185
The Australian Financial System in the 1990s
In retrospect, given the various problems in 1990, 1991 and
1992, Australia was
probably fortunate that it did not experience a more
pronounced episode of financial
instability. The various public sector actions were probably
important in this regard.
Also helpful was the fact that the institutions that
experienced the largest losses (as
a share of capital) were either owned by state governments
(which
guaranteed
the
repayment of deposits) or by foreign banks (which were
prepared to recapitalise their
Australian subsidiaries). Similarly, the domestic banks were
not prepared to allow
their loss-making non-bank subsidiaries to fail, for fear of
reputational damage to
themselves. Nor was the Government of Victoria prepared to
allow the depositors
in Pyramid to lose their deposits, ultimately guaranteeing
the repayment of the
nominal value of principal over a period of up to five
years, although in present-value
terms depositors did bear some loss.
At no time were there serious concerns about the safety of
depositors’ funds in the
four large banks. Despite some large losses, the capital
ratios of the major banks
remained above regulatory minima, with the capital ratio for
the system exceeding
9 per cent through the early 1990s (see Figure 2). A number
of banks (most notably
Westpac) did, however, make a concerted effort to increase
their capital ratios
immediately after the announcement of losses, so that by
1995, the system-wide ratio
had increased to above 12 per cent. In part, this reflected
new capital raisings, but at
least 1 percentage point of the increase can be attributed
to a change in the
composition of banks’ assets towards lower risk-weighted
assets (i.e. housing
loans).
Figure 2: Regulatory Capital Ratio for Banking System
Source: Reserve Bank of Australia
Bulletin
(Table B.6)
8
9
10
11
12
8
9
10
11
12
8
9
10
11
12
8
9
10
11
12
1985
%
%
1988
1991
1994
1997
2000
186
Marianne Gizycki and Philip Lowe
While the problems of the early 1990s did not undermine
public confidence in the
financial system, they did create strong ‘financial
headwinds’ that retarded the
economy’s recovery from recession. While balance-sheet
restructuring by the
corporate sector was an important source of these headwinds,
credit supply constraints
arising from the difficulties experienced by financial
institutions also played a role,
although it is difficult to disentangle the various effects.
6
Many financial institutions
significantly reduced their appetite for risk, with some
announcing goals of large
reductions in business loans. Consistent with a supply-side
effect, the
share
of
finance for the construction and purchase of commercial
property provided by
banks
fell to historically low levels between 1991 and 1993. The
financial headwinds were
also evident in a substantial rise in interest-rate margins
as banks attempted to restore
strong profitability.
After the troubled years of the early 1990s, the Australian
banking industry
returned to strong profitability relatively quickly, largely
thanks to the willingness
of the household sector to significantly increase its
borrowing, and by the banks’
ability to charge large interest-rate margins (see Sections
3 and 4). By 1995, the
after-tax rate of return on shareholders’ funds had
recovered to more than 15 per cent,
and it remained around this level for the rest of the
decade.
The only other sector of the financial system to experience
serious difficulties
over the decade was the reinsurance industry. In 1998 and
1999, losses by GIO,
New Cap Re and Reinsurance Australia Corporation exceeded
A$1
3
/
4
billion. In
part, these losses reflected a large number of natural
catastrophes and significant
downward pressure on operating margins. While the losses
caused problems for the
owners of these firms, they had no discernible effect on the
public’s confidence in
the insurance industry, or on the stability of the financial
system more generally.
3.
A Transformation of Balance Sheets
Arguably the most notable financial development of the 1990s
was a deepening
of the household sector’s financial balance sheet. In line
with developments in many
industrialised countries, Australian household indebtedness
increased strongly over
the decade, as did the household sector’s holdings of
financial assets, particularly
market-linked investments. A by-product of this financial
deepening has been a
marked change in the structure of the balance sheets of
financial institutions, and, in
turn, in the structure of Australia’s foreign debt.
From 1992 onwards, household debt increased by at least 10
per cent every year,
with growth peaking at 17 per cent in 1994. As a result, the
ratio of household debt
to household disposable income almost doubled over the
decade, rising from
54 per cent in 1990 to almost 100 per cent at the end of
1999 (see Figure 3). Most
of the additional debt was used to purchase residential real
estate (Stevens 1997).
6. See Kent and Lowe (1998) and Lowe and Rohling (1993) for
econometric evidence of these
‘headwinds’.
187
The Australian Financial System in the 1990s
The rise in indebtedness was, in part, made possible by the
fall in nominal interest
rates in the early 1990s. In the 1980s, high interest rates
meant that loan servicing
burdens were heavily skewed to the early years of the loan,
restricting the size of
borrowings and preventing some low-income households from
obtaining a mortgage
at all. Lower interest rates in the 1990s eased this
constraint, and access to debt was
also increased by a proliferation of new lending products.
Particularly popular over
the second half of the decade have been ‘home equity’ loans,
which allow households
to borrow against existing equity in their home, primarily
by drawing against
previous loan repayments. Household borrowing has also been
supported by
increases in the value of collateral arising from strong
increases in house prices,
particularly over the second half of the decade; for
example, in both Sydney and
Melbourne median residential property prices increased at an
average annual rate of
over 10 per cent over the years 1996 to 1999.
Relatively low nominal interest rates meant that
interest-servicing burdens were
low for much of the decade. However, recent rises in
interest rates and the steady
increase in indebtedness have brought the ratio of interest
payments to household
disposable income close to 8 per cent, which is only just
below the peak recorded in
1990, and more than 1 percentage point above the average
ratio during the 1980s.
On the other side of the household sector’s balance sheet,
holdings of market-linked
financial assets also increased rapidly. At the end of 1999,
the household sector’s
total holdings of financial assets were the equivalent of
245 per cent of household
Figure 3: Financial Liabilities and Assets of the Household
Sector
Per cent of household disposable income
Sources: ABS Cat Nos 5206.0 and 5232.0; Reserve Bank
calculations
0
20
40
60
80
100
120
0
20
40
60
80
100
120
0
20
40
60
80
100
120
Household debt
Household financial assets
%
%
Life and
superannuation funds
Deposits and currency
Other managed funds
Equities
1985
1988
1991
1994
1997
2000
1988
1991
1994
1997
2000
188
Marianne Gizycki and Philip Lowe
disposable income, up from 160 per cent in early 1990. Of
these assets, the share held
in life offices and pension (or superannuation) funds rose
from 39 per cent to
47 per cent, while the share held in cash and deposits fell
from 39 per cent to
25 per cent. The household sector also increased its direct
holdings of equities,
particularly over the second half of the 1990s. According to
the Australian Stock
Exchange, 41 per cent of Australian adults directly owned
equities in 1999, up from
20 per cent in 1997, and 10 per cent in 1991.
Most of the increase in aggregate holdings of financial
assets has been due to
valuation effects, rather than to higher savings. In
contrast, the change in the
composition of financial assets reflects two important
structural factors. The first is
the privatisation of government-owned assets and the
demutualisation of financial
institutions; at the end of 1999, these privatised and
demutualised companies
accounted for around 18 per cent of the stock market
capitalisation. The second, and
ultimately more important factor, is the introduction in
1991 of compulsory
retirement savings in the form of legally mandated minimum
employer contribution
rates to pension funds (Edey and Gower, this volume; Edey
and Simon 1996;
Johnson 1999). The contribution rate was initially set at 3
per cent, but will increase
to 9 per cent by 2002. This scheme has helped fundamentally
change the way people
save for retirement and the type of financial assets they
hold. Little more than a
decade ago, the household sector’s major financial assets
were direct claims on
institutions, either in the form of bank deposits, or
defined benefit pension schemes.
Households held considerable institutional risk, but little
market risk. Today, market
risk is much larger, with the return on the bulk of
households’ financial assets directly
determined by the performance of financial markets, rather
than by the performance
of financial institutions.
The net effect of the changes in the structure of the
household sector’s assets and
liabilities has been a modest increase in leverage over the
decade, although since
1995 there has been little change. Over recent years, the
solid increases in the price
of residential property (which accounts for around 60 per
cent of households’
conventionally measured assets) and the strong gains in the
equity market have kept
pace with the increase in indebtedness. At the end of 1999,
the ratio of household debt
to household wealth stood at around 13 per cent, compared
with 10 per cent in 1990.
In contrast to the household sector, the corporate sector
spent the first half of the
decade unwinding the borrowing excesses of the 1980s.
Between 1991 and 1995, the
ratio of business debt to GDP fell 15 percentage points to
around 45 per cent (see
Figure 4). Over the second half of the decade, business debt
increased at a faster pace
than nominal GDP, although the ratio of business debt to GDP
still remains well
below the peak reached in the late 1980s. Interest-servicing
burdens over the second
half of the decade have been low by historical standards,
reflecting the decline in
leverage and low nominal interest rates.
These patterns in business and household borrowing are
clearly reflected in the
balance sheets of financial institutions. In 1990, 1991 and
1992, the ratio of
aggregate credit to GDP declined as the corporate sector
repaid debt, but then
increased at a solid pace over the remainder of the decade
due to the strong growth
189
The Australian Financial System in the 1990s
in household borrowing. This strong growth has also meant
that the share of
mortgage loans in the total assets of the banking system
reached a record high of
nearly one-third in 1995, and despite some securitisation of
housing loans by banks
subsequently, this share has remained at historically high
levels.
The combination of strong credit growth and subdued growth
in domestic
deposits has led financial institutions to rely increasingly
on wholesale markets for
funding, largely through issuing debt securities. Given the
relative lack of domestic
savings, many of these securities have been issued to
non-residents. This has led to
a rise in the share of the banking system’s total
liabilities owed to non-residents from
less than 10 per cent in 1990 to over 20 per cent at
present. At the same time, the
corporate and public sectors have reduced their demand for
foreign borrowing, so
that now well over half of Australia’s net foreign debt is
now intermediated through
financial institutions (see Figure 5).
While around 70 per cent of foreign borrowing by financial
institutions is
denominated in foreign currency, these institutions do not
have large foreign
currency risks, with the currency risk typically hedged
through the swaps market.
One indicator that the banks’ foreign exchange risk is small
is that the aggregate
regulatory capital charge for the Australian banks’ market
risk (which includes
foreign exchange risk) accounts for just 1 per cent of the
total capital requirement,
compared to over 5 per cent for the large Canadian and
German banks, and over
10 per cent for the large Swiss banks.
Figure 4: Corporate Debt
Sources: ABS Cat Nos 5204.0 and 5232.0; Reserve Bank
calculations
30
40
50
60
30
40
50
60
10
20
30
40
10
20
30
40
1985
1991
1997
2000
1988
1994
1991
1997
2000
1988
1994
Corporates’ interest burden
Per cent of GOS, adjusted for
privatisations
%
Business private debt
Per cent of GDP
%
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