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Marianne Gizycki and Philip Lowe
There are at least two possible explanations for why competition has taken this
particular form. First, it is sometimes claimed that if a single financial institution
were to unilaterally cut its credit card interest rates the average credit quality of its
customers could deteriorate (due to adverse selection), and profitability could fall.
Second, fees such as interchange fees are set by each credit card scheme, thus
limiting the scope for individual banks within the scheme to adjust fees unilaterally.
9
Scheme-wide rules notwithstanding, there is little incentive for a bank to unilaterally
cut the interchange fee that it receives whenever its customers use a credit card, since
a reduced interchange fee would most likely depress, rather than boost, its market
share. The result has been a distorted form of competition centred on loyalty point
schemes. At the same time, there has been a five-fold increase in the number of credit
card transactions over the decade, and a trebling since 1995.
In contrast to the above examples, it is difficult to point to obvious areas of
increased competition in deposit markets over the 1990s. By the end of the 1980s,
deregulation of interest rates and the establishment of cash management trusts had
already led to the narrowing of deposit spreads, other than on transaction accounts.
Spreads on these transaction accounts did, however, fall in the early 1990s due to the
large decline in nominal interest rates. Although these spreads have subsequently
widened a little, many transaction accounts still do not generate sufficient revenue
to cover the costs of providing them.
While, overall, competition has increased despite greater concentration, the rate
of return on equity in the banking industry has remained essentially unchanged over
the second half of the decade, averaging 22 per cent on a pre-tax basis, and
15 per cent after tax.
From an accounting perspective, the sustained high returns can be explained by
reductions in operating costs and growth in non-interest income being offset by
lower interest margins. This can be seen in the lower panel of Table 3 which
decomposes changes in the aggregate rate of return on equity for the four major
banking groups plus St. George. Between 1995 and 1999, net interest income for
these five banks as a ratio to their total assets fell from 3 per cent to 2.5 per cent, the
effect of which was to reduce the average return on equity by almost 7
1
/
2
percentage
points. This negative effect on profits was offset by an increase in the ratio of
non-interest income to total assets and, more importantly, by a fall in operating costs
to total assets. A slight increase in leverage also made a small positive contribution
to sustaining the return on equity. The table also shows the significant effect on
profitability of the bad debts problems in the early 1990s.
9. The interchange fee is paid by the merchant’s bank to the bank that issues the credit card. The
merchant’s bank recoups the interchange fee and other costs from the merchant through a ‘merchant
service fee’, which averages around 2 per cent of the amount spent (Reserve Bank of Australia
1999). If an issuing bank unilaterally cuts its interchange fee it would simply reduce its revenues,
thereby reducing the scope for offering loyalty points, with the likely result that it would lose
customers.
 
197
The Australian Financial System in the 1990s
The growth of non-interest income over the second half of the 1990s is largely
explained by growth in fee income, particularly from services provided to the
household sector.
10
The most notable examples are the introduction of mortgage fees
and account-servicing fees; for example, it is now common for banks to levy monthly
servicing fees of $4 on transaction accounts and $8 on mortgage accounts, whereas
in 1990 such fees rarely existed. The introduction of these fees is part of the
unwinding of cross-subsidies that has followed the downward pressure on lending
margins. While, in aggregate, consumers of financial services have benefited from
this process, the benefits have not been evenly distributed, with some consumers of
previously heavily subsidised services clearly worse off. This has led to heavy
criticism of banks by particular groups.
Notwithstanding the often strong public reaction to higher fees and charges, it has
been the reduction in operating costs that has been the more important factor in
sustaining high rates of return. This reduction has been achieved through a variety
of means including the rationalisation of branch networks, the migration of transactions
Table 3: Explaining the Return on Equity
for the Major Banking Groups and St. George
1990
1995
1999
Rate of return on equity (after tax)
9.71
15.46
15.42
Leverage (ratio of assets to shareholders’ funds)
16.33
14.67
15.27
Ratio of net interest income to assets
3.00
2.97
2.48
Ratio of non-interest income to assets
1.71
1.50
1.58
Ratio of operating costs to assets
2.91
2.74
2.32
Ratio of bad debts expense to assets
0.83
0.17
0.21
Percentage point change from:
1990 to 1995
1995 to 1999
Change in rate of return on equity
5.75
–0.04
Accounted for by change in:
Leverage
–1.37
0.62
Ratio of net interest income to assets
–0.47
–7.38
Ratio of non-interest income to assets
–3.31
1.27
Ratio of operating costs to assets
2.65
6.30
Ratio of bad and doubtful debts to assets
10.19
–0.57
Other (including abnormals and taxation)
–1.94
–0.29
Sources: Banks’ financial statements and authors’ calculations
10. Comparisons between 1990 and 1995 are distorted by the fact that the non-interest income figures
in the early 1990s include significant revenue from assets acquired through loan defaults, and by the
treatment of surpluses in staff superannuation schemes. See Reserve Bank of Australia (1999) for
a discussion of recent changes in bank fees.
 
198
Marianne Gizycki and Philip Lowe
out of branches to low-cost electronic delivery systems and the automation of
back-office processing. The outsourcing of some information technology functions
has also played a role. Overall, the number of bank branches fell by almost a quarter
over the decade, while the number of full-time equivalent employees in banks fell
by around 20 per cent.
While the trends in profitability can be easily explained from a simple accounting
perspective, it is more difficult to explain the apparent paradox of increasing
competition and sustained high rates of return. Significant reductions in operating
costs should ultimately lead to further reductions in interest margins, rather than
sustaining high rates of return for shareholders. An important lesson from the 1990s
is that the competitive pressures needed to drive margins lower are more likely to
come from new entrants, rather than from firms with large existing market shares.
The lesson becomes even more relevant in the current environment in which there
is strong pressure for further consolidation.
While the regulatory and technological barriers to entry have been substantially
reduced, some impediments still remain. Foremost among these are the strong brand
names enjoyed by existing banks. Also important are taxes on financial transactions,
such as mortgage stamp duties and the bank debits tax, which reduce the incentive
for consumers to change financial institutions. The proliferation of electronic
banking links, including direct credit of salaries and the electronic payment of bills
has had a similar effect, as has the practice of some institutions charging various
forms of entry and exit fees. It is also possible that technological developments have
increased returns to scale. Research and development and the construction of new
network infrastructure involve substantial fixed costs and risks that may be more
easily borne by larger institutions.
One factor that has the potential to ameliorate some of these effects is the internet.
It offers the promise of making entry easier and lowering switching costs. The
experience of retail stockbroking provides a good example of how powerful a force
it can be. In Australia, however, it is the incumbent banks with their strong brand
recognition and their established customer bases that are dominating internet
banking. Whether the internet can deliver on its promise of promoting competition
is likely to be an important issue in the years ahead.
5.
The Growth of Markets and the Commoditisation of
Risk
Another major development in the 1990s was the growth in direct financing
through financial markets. This growth has not, however, reduced the overall
importance of banks in the financial system. Instead, banks are providing an
ever-expanding range of
risk intermediation
and other financial services. By
bundling and unbundling risks, and by developing instruments that allow those risks
to be traded, banks themselves have underpinned much of the tremendous growth in
financial markets over the past decade or so.
11
11. Allen and Santomero (1997) discuss how banks in the United States have recast their activities in
the face of the growth of financial markets.
 
199
The Australian Financial System in the 1990s
The clearest example of the greater role played by markets in financial
intermediation is the emergence of a market in asset-backed securities, particularly
mortgage-backed securities. The first securitisation programs were developed by
state governments in the mid 1980s to finance loans to low-income households.
When interest rates fell in 1990 and 1991, many of the fixed-rate loans made by these
programs were refinanced causing the holders of the bonds to incur significant
losses. After this troubled start, the market received a major boost with the
development (by a bank) of a securitisation vehicle to finance lending by the
mortgage managers. As discussed in Section 4.2, the high interest-rate margins of the
early 1990s gave the mortgage managers the scope to undercut the established
lenders, with the result being rapid growth in the issuance of mortgage-backed
securities. Over recent years, banks have also begun to securitise their own
mortgages as part of their capital-management strategies. The total value of
asset-backed securities now outstanding exceeds A$50 billion (equivalent to over
8 per cent of total credit; see Figure 7). Approximately two-thirds of these securities
are backed exclusively by residential mortgages, with others backed by financial
securities, credit card loans and auto loans. Around one-quarter of the outstanding
securities have been issued offshore.
Financial markets (in particular, listed property trusts) are also playing a more
important role in the financing of commercial property. Over the decade, the number
of listed trusts more than doubled and their total assets quadrupled, reducing the
Figure 7: Financing through Markets
As a per cent to total credit extended by financial institutions
0
2
4
6
8
20
40
60
80
10
0
20
40
60
80
10
0
%
%
1985
1991
1997
2000
1988
1994
1991
1997
2000
1988
1994
Asset-backed
securities
Long-term corporate
debt outstanding
Share market
capitalisation
Market capitalisation
of listed property trusts
Overseas-issued
corporate debt
outstanding
Sources: ABS Cat No 5232.0; Australian Stock Exchange
Monthly Index Analysis
; Reserve Bank of
Australia
Bulletin
(Tables D.2 and D.4)
 
200
Marianne Gizycki and Philip Lowe
share of commercial property financing conducted through banks’ balance sheets.
While these trusts do borrow from banks, increasingly they are also issuing their own
debt securities.
In line with the reduction in corporate debt, the domestic corporate bond market
contracted over the first half of the decade. The market then recovered, particularly
in the last few years, although the domestic market remains considerably smaller
than the offshore market. Both markets are dominated by security issues by financial
institutions, with banks continuing to be the main source of debt funding the vast
majority of Australian firms.
The stock market has shown more consistent growth over the decade. Since 1990,
the market capitalisation of the Australian Stock Exchange (ASX) as a ratio to GDP
has more than doubled, to over 100 per cent, bringing the value of equity in listed
companies to a level roughly equivalent to the value of credit extended by financial
institutions (see Figure 7). While the bulk of this growth is due to valuation effects,
there have also been substantial issues of new equity; over the decade as a whole new
equity issues were the equivalent of 55 per cent of the increase in credit. Despite the
growth of the Australian stock market, the value of listed equity relative to the size
of the overall economy remains well below that in the United States and
United Kingdom.
Growth in equity market turnover has also been rapid, with the ratio of annual
turnover to market capitalisation increasing from around one-third in 1989/90 to
more than half in 1998/99. Part of this increase can be attributed to changes in the
infrastructure for trading and settlement. In 1990, the ASX moved all share trading
from open-outcry floor trading to an electronic system. It also introduced an
automated settlement system, so that by 1998, all shareholdings in domestic
companies had been converted to electronic (uncertificated) form. In the past few
years, the fall in retail brokerage charges, the introduction of internet-based brokers,
and the strong performance of the stock market have also contributed to the strong
growth in turnover.
More generally, much of the recent growth in financial markets, particularly in
trading volumes, is not directly related to the increase in the value of securities
outstanding, but rather to the increasing marketability of risk through financial
instruments, particularly derivatives. Improvements in technology and data have
allowed a wide range of previously unpriced risks to be priced. Banks have played
a central role in this process, using financial markets to manage their own balance
sheet risks and to provide risk-management services for their customers. For
example, over the decade the banks’ outstanding interest rate swaps increased
around five-fold, while currency options outstanding increased around six-fold.
Moreover, banks remain dominant in the foreign exchange market, accounting for
more than 80 per cent of foreign exchange turnover in 1999 (see Table 4). Similarly,
banks remain the main providers of underwriting and placement services for
corporate debt issues and stock market capital raisings.
The trend towards the commoditisation and marketability of risk is exemplified
in the emergence, late in the decade, of a market for credit derivatives. These
 
201
The Australian Financial System in the 1990s
Table 4: Banks and Financial Markets
Instrument
Banks’ share
Percentage increase in
in annual turnover
banks’ outstandings
1998/99, per cent
Dec 1989 – Dec 1999
Spot foreign exchange
89
–
Foreign exchange forwards
89
80
Foreign exchange options
84
512
Cross-currency swaps
59
156
Government debt securities
42
0
Forward rate agreements
78
17
Interest rate swaps
61
398
Interest rate options
37
316
Equity derivatives
14
117
Note:
Banks’ share in turnover excludes in-house transactions
Sources: AFMA-SIRCA (1999); APRA
12. Three-year and ten-year government bonds, 90-day bank bills, the Australian dollar, the All
Ordinaries Index, wool and live cattle.
derivatives essentially create a market in credit risk, allowing financial institutions
to separate the businesses of originating and financing loans on the one hand, and the
acceptance of credit risk on the other. The Australian Financial Markets Association
(AFMA) estimates the size of the Australian credit derivative market at the end of
1999 at between A$3 billion and A$5 billion in gross contract value (AFMA 2000).
To date, the market has primarily involved Australian banks buying credit risk
protection from internationally active banks and securities houses. However, if
developments abroad are any indication, the development of a two-way market in
which the Australian banks both buy and sell credit risk is likely in the future.
An expansion of exchange-traded derivatives has also helped increase the
marketability of risk. At the start of the decade, the Sydney Futures Exchange (SFE)
offered just seven different contracts.
12
By the end of 1999, 25 contracts were traded,
with new contracts including futures covering 12 individual shares, a variety of stock
market indices, wheat, and electricity. The SFE also introduced several new types
of derivatives including overnight options and serial options, as well as trading in
contracts over oil, natural gas, coal and metals though a linkage with the New York
Mercantile Exchange. Similarly, the ASX introduced more flexible options (allowing
traders to customise some of the key features of the contracts such as expiration
date) and share ratio contracts (which reflect a company’s share price
performance relative to the overall market). At the same time, turnover in traditional
exchange-traded derivatives has grown enormously. For example, over the decade
turnover in bank-bill and government-bond futures and options more than doubled
 
202
Marianne Gizycki and Philip Lowe
as a ratio of GDP; by 1999, annual turnover in bank-bill derivatives amounted to
more than twelve times annual GDP, while bond derivatives turnover was almost
three times GDP.
The growth of financial markets has opened up new sources of finance and
allowed new risks to be traded. Managed properly, this process can lead to better
pricing and allocation of risk and more stable and efficient financial and non-financial
institutions. However, it also opens up greater possibilities for institutions to
purchase risk and to increase their leverage to changes in market prices. As the events
surrounding the 1997 Asian crisis and the near-collapse of the US hedge fund
Long-Term Capital Management demonstrated, the costs of mismanaging these
risks can be high. Fortunately, Australia escaped this episode relatively lightly, with
the main effects limited to a temporary increase in exchange rate volatility, a
widening of credit spreads and a decline in new debt issuance (Grenville 1999).
6.
Regulation of Financial Services
The difficulties experienced by financial institutions in the late 1980s – early
1990s highlighted shortcomings with risk-management practices within financial
institutions and the arrangements for the prudential supervision of financial
institutions. As a result, much of the first half of the 1990s was devoted to
overhauling risk-management and supervisory processes to ensure a more stable and
robust financial system. Over the second half of the decade, the focus turned to
ensuring that the regulatory framework not only contributed to the stability of
institutions, but also promoted competition, enhanced investor protection, and was
sufficiently flexible to deal with continuing innovation in the financial services
industry.
In terms of the supervision of deposit-taking institutions, the most important
responses to the problems of the early 1990s included: the introduction of targeted,
risk-based, on-site bank reviews by the Reserve Bank;
13
moves to strengthen
consolidated supervision (for example, the application of large-exposure limits to
the bank in combination with its non-banking subsidiaries); the development, in
conjunction with the accounting profession, of guidelines for the measurement and
reporting of impaired assets; the passing to the Reserve Bank of formal responsibility
for the supervision of banks owned by state governments; the clarification of the role
of auditors and bank directors in the oversight of risk management; and the
establishment (in 1992) of the Australian Financial Institutions Commission to set
uniform, national prudential standards for building societies and credit unions.
The supervision of insurance was also substantially improved. An important step
in this process was the passage of the
Life Insurance Act
in 1995, which upgraded
solvency standards and financial reporting requirements, increased the responsibilities
of the directors, auditors and actuaries of life companies, and strengthened the
13. In 1992 the Reserve Bank began on-site reviews of banks’ credit risk management. On-site reviews
of banks’ market risk management commenced in 1994.
 
203
The Australian Financial System in the 1990s
Insurance and Superannuation Commission’s (ISC) regulatory and enforcement
powers. In addition, the ISC commenced on-site reviews of life insurers in 1992, and
expanded the scope and frequency of its inspections of general insurers and
superannuation funds.
The shift to targeted on-site reviews by the Reserve Bank and the ISC reflected
a broader shift away from rule-based supervision towards supervisory practices that
focus on the way that institutions measure and manage their key risks. One example
is the approach taken to market risk. Here, banks have been allowed to use their own
risk-measurement models to determine capital requirements, provided that the
models are technically sound and the broader risk-management environment in
which they are used is robust. This same general approach has recently been applied
to liquidity risk in deposit-taking institutions. Rather than imposing a minimum
liquidity ratio, as had been the case in the past, the emphasis has moved to ensuring
that institutions have a robust liquidity-management policy, including a demonstrated
ability to meet a five-day ‘name’ crisis.
14
Recent proposed changes to the Basel
Capital Accord are likely to see this risk-based approach extended to include other
risks, including credit risk and operational risk.
With the completion by mid decade of most of the reforms needed to correct the
problems identified in the early 1990s, the Commonwealth Government established
the Wallis Inquiry in 1996. The Inquiry, which submitted its final report in
March 1997, recommended a major rearrangement of financial regulation, shifting
from a regulatory structure based on institutions, to one based on functions
(Financial System Inquiry 1997). In large part, this recommendation was prompted
by the blurring of the distinctions between different types of financial institutions
discussed above. The recommendation was accepted by the Commonwealth
Government, and there are now separate regulatory agencies with responsibilities
for prudential supervision, market conduct and the payments system.
Responsibility for the prudential supervision of banks, building societies, credit
unions, insurance and superannuation funds was assigned to the Australian Prudential
Regulation Authority (APRA), which commenced operations in July 1998. This
brought to an end the Reserve Bank’s role in bank supervision. Responsibility for
market conduct and disclosure in the financial sector was assigned to the Australian
Securities and Investments Commission (ASIC), which was also given responsibility
for the enforcement and administration of the Corporations Law and consumer
protection across the financial system. The Reserve Bank retained responsibility for
monetary policy and the maintenance of financial system stability. In addition, a
Payments System Board was established within the Reserve Bank with responsibility
to promote safety, competition and efficiency within the payments system.
To date the new regulatory structure is working well, with effective co-ordination
mechanisms having been established between the various regulatory authorities.
Communication between the Reserve Bank, APRA and ASIC is facilitated through
14. A name crisis is one in which an individual institution has difficulty in retaining or replacing its
liabilities due to events specific to that institution.
 
204
Marianne Gizycki and Philip Lowe
the Council of Financial Regulators, and by the Reserve Bank and ASIC both being
represented on the board of APRA. APRA also has a seat on the Payments System
Board. However, despite this promising start, the reality is that the ability of the new
arrangements to deal with a financial crisis has not yet been tested. Indeed, the
effectiveness of the co-ordination arrangements is likely to be an important factor in
future assessments of the Wallis reforms.
One area where the benefits of regulatory reform are already apparent is in the
harmonisation of prudential standards across financial institutions (Carmichael 1999).
Most progress has been made in developing a set of consistent standards that apply
to all deposit-taking institutions. Similarly, APRA is working towards greater
consistency in the treatment of life and general insurance by strengthening the
prudential supervision of general insurers. The process of harmonising supervisory
arrangements across deposit-taking institutions and insurance companies is also
underway, although progress here is slower, reflecting the complexity of the task.
APRA has, however, already announced a liberalisation of the range of activities that
can be carried out within a financial conglomerate containing an authorised
deposit-taking institution, and expanded the range of organisational structures
available to conglomerates.
Apart from changes in the structure of regulatory agencies, the second half of the
1990s saw increased attention being paid to the protection of retail investors and
consumers of financial services. In part, this was a reaction to the rise in the
household sector’s holdings of financial assets and the introduction of mandatory
retirement savings. A significant step in this direction was the implementation of the
Uniform Consumer Credit Code
and various industry codes of practice in 1996.
More recently, the proposed
Financial Services Reform Bill
will subject organisations
providing retail financial services to extensive disclosure requirements. It will also
require these organisations to put in place arrangements for compensating people for
losses resulting from the inadequate provision of promised services.
The increasing importance of markets and growing complexity of financial
instruments has also spurred improved disclosure in wholesale markets. In 1991, the
‘checklist’ approach to prospectuses was replaced with a requirement that prospectuses
include all information that a reasonable investor and his/her adviser need to make
informed decisions. In 1994, the Australian Stock Exchange upgraded its continuous
disclosure requirements, and in December 1996 Australian accounting standards
were widened to include disclosure requirements for financial institutions. In many
respects, the disclosure arrangements in Australia now compare favourably with
those abroad, although the requirements that apply to deposit-taking institutions are
less comprehensive than is the case in some other countries. One example of this is
that deposit-taking institutions in Australia are not required to publish their regulatory
capital ratios, while in a number of other countries the ratios are disclosed quarterly.
The Wallis Inquiry also recommended a number of reforms to promote competition
in the financial services sector, particularly in the payments system. An early
initiative of the Payments System Board was to widen access to Exchange Settlement
Accounts at the Reserve Bank to institutions other than deposit takers. The Board is
also undertaking a joint study with the Australian Competition and Consumer