Foreword 1

Executive Summary 3

1.The Role of the Financial Sector9

2.Key Financial Developments Since the Wallis Inquiry14

3.The Regulatory Response to the Global Financial Crisis43

4.Sources and Management of Systemic Risk73

5.Sectoral Trends in Funding Patterns in the Australian Economy113

6.Competition, Efficiency and Innovation in Banking154

7.Superannuation171

8.Developments and Innovation in the Payments System190

Abbreviations 247

This Submission uses unit record data from the Household, Income and Labour Dynamics in Australia (HILDA) Survey. The HILDA Project was initiated and is funded by the Australian Government Department of Social Services (DSS) and is managed by the Melbourne Institute of Applied Economic and Social Research (Melbourne Institute). The findings and views reported in this Submission, however, are those of the author and should not be attributed to either DSS or the Melbourne Institute.

The Reserve Bank of Australia has prepared this Submission for the Australian Government’s Financial System Inquiry of 2014. The Terms of Reference are broad, covering aspects such as: the consequences of developments in the Australian financial system since the 1997 Wallis Inquiry and the global financial crisis; the philosophy, principles and objectives underpinning the development of a well-functioning financial system; and the emerging opportunities and challenges that are likely to drive further change in the global and domestic financial systems.

This Submission outlines developments in the Australian financial system in the 17 year period since the Wallis Inquiry, exploring in more detail those that the Reserve Bank considers have had the largest influence in shaping the system. In keeping with the Reserve Bank’s responsibilities, a system-wide perspective is adopted in the Submission. Areas where the Reserve Bank was given an explicit mandate following the Wallis Inquiry, particularly the oversight of payment and settlement issues, are examined in some detail.

The scope of the financial sector addressed in this Submission includes all institutions that provide financial services in Australia, including both entities that are prudentially regulated (such as authorised deposit-taking institutions, insurers and financial market infrastructures) and those that are not, such as registered finance companies and investment funds. However, the treatment of issues throughout is largely on thematic lines, because many of the key forces and developments are not entity or market specific.

A good starting point for evaluating the Australian financial system is to consider the desired role of finance in our society. Chapter 1 provides an introductory discussion of the core functions of the sector and the characteristics that set it apart from other sectors of the economy.

The evolution of the Australian financial system since the Wallis Inquiry is covered in broad terms in Chapter 2. The global financial crisis emerged during this period, hence many of the trends are examined from the perspective of the decade or so leading up to the peak of the crisis in 2008 and then the period since. Given the significant international regulatory reform agenda that the crisis generated, a chapter is dedicated to describing these reforms, including Australia’s responses (Chapter 3). Systemic risk is also explored in some detail, given the renewed focus on it as a result of the crisis (Chapter 4).

Apart from stability issues, a number of other factors have contributed to the evolution of the financial system since the Wallis Inquiry, and are likely to continue to do so in coming years. At the broadest level, changes in how the different sectors in the Australian economy fund themselves are interlinked with innovations in the financial sector which serves the economy; longer-term sectoral trends in funding are discussed in Chapter 5. Competitive forces since the Wallis Inquiry have been shaped to a significant extent by financial market conditions, with changes in risk appetite among market participants being at least as important as regulatory reform or other structural change; Chapter 6 considers these issues.

Since 1997, superannuation assets as a per cent to GDP have more than doubled to be over 100 per cent. Changes in superannuation shaped the financial system and economy in a number of important ways – including the role in household and national saving, the transfer of retirement income risk to households and the relationship with the banking sector – which are explored in Chapter 7.

The government’s response to the Wallis Inquiry resulted in the Reserve Bank being assigned a number of powers and responsibilities in respect of payment and settlement systems. Many of these cover retail payments issues, where Australia has played a leading role internationally in its approach to reform; these are examined in Chapter 8 along with a discussion of innovation in the payments system. In addition, the global financial crisis also brought renewed focus on the role of financial market infrastructures (FMIs) in the financial system, resulting in a significant reform agenda and implications for the Reserve Bank’s responsibilities for oversight of FMIs.

The preparation of the Submission was overseen by a small team within the Financial Stability Department, with significant contributions from many staff in that Department as well as a number of other areas of the Reserve Bank, particularly the Domestic Markets, Information and Payments Policy Departments.

The Financial System Inquiry of 2014 presents an opportunity for a holistic evaluation of Australia’s financial system. The evolution of financial systems tends to surprise because, as in many parts of the economy, human behaviour is unpredictable and technology evolves in unexpected ways. As a result, it is important that institutional arrangements enable the financial sector to adapt and support economic activity in the most efficient manner that is consistent with the desired level of stability in the system.

The 17 years since the Wallis Inquiry have seen many changes in the Australian financial system and systems internationally. The most striking development domestically has been the system’s growth. Underpinning this expansion has been the adjustment to structural changes and technological innovation, including the deregulation of the financial sector, the opening up to foreign competition and the move to an environment of low and stable inflation. These forces have also been at work in a number of other countries since the 1980s where there have been similar, and in some cases more dramatic, expansions.

Cyclical dynamics have also shaped the growth in financial systems globally. The period since the Wallis Inquiry had distinct phases: the decade or so leading up to the onset of the global financial crisis, during which some risks were under-priced; and the period since, which has seen a reappraisal of risks generally and a renewed focus on systemic risk – that is, those risks which, if realised, would cause material damage to the economy.

The Reserve Bank’s approach to financial system stability (and the public policy framework that seeks to promote it in Australia) is that the objective should not be to prevent any failure in the financial system from ever occurring, but rather to balance the cost borne by the broader economy of such a failure against the costs of reducing the probability of failure during normal times. This recognises both the benefits to society from productive risk-taking and the significant costs of an imprudent allocation of risks.

While Australia was not immune to the events surrounding the global financial crisis, the financial system and institutional framework held up well over the period compared with a number of financial systems elsewhere in the world. And while some risks in Australia were mispriced and misallocated prior to the crisis, and some public sector support was required during it, the sound prudential framework in Australia was a source of resilience. In part, the lessons learned from earlier failures were a source of strength. For instance, the substantial losses of Australian banks in the early 1990s, and the failure of HIH Insurance in 2001, promoted a greater emphasis on risk management by financial institutions and regulators as well as providing impetus to bolster supervisory and crisis management capacity. On the whole, the period since the Wallis Inquiry has been a prosperous one for Australia and the ongoing development and resilience of the financial system played a part in this.

There were, however, important lessons for Australia from the crisis. The crisis was a reminder that there are cycles in risk-taking, and that the incentives of participants are not always conducive to prudent risk management from a system-wide perspective. Globally, the events that followed the crisis demonstrated the large social and economic costs of instability in financial systems. They showed that the costs imposed by effective regulation and supervision are more than outweighed by the costs of financial instability, even if that differential only usually becomes apparent after prolonged periods.

In the period since the crisis there has been a concerted effort internationally to address the build-up of systemic risk in financial systems that the crisis exposed. These wide-ranging reforms, given political impetus by the G20, include four core areas: building more resilient financial institutions (particularly banks); addressing the ‘too big to fail’ problem; addressing risks in ‘shadow banking’; and making derivatives markets safer, including through enhancing the role of financial market infrastructures (FMIs). As G20 president in 2014, the Australian approach, supported by the Bank, is to focus the G20’s efforts on reaching agreement and progressing implementation in the four core reform areas, and to be cautious, for the moment, in adding further reforms to the agenda. This approach has found broad acceptance.

The regulatory response to the crisis has already strengthened the resilience of the international financial system. Banks have generally increased their capital buffers and reduced their liquidity risk. Steps have also been taken to make financial markets more transparent and to reduce the scope for contagion in the event of financial institution distress, while preserving the global nature of finance. As with any reforms, however, regulators will need to closely monitor the effectiveness of the combination of new measures, including the potential for enhanced bank regulation to promote a shift in financing to the shadow banking sector.

A general principle that the Reserve Bank has sought to uphold in our participation in the various international forums is that the reforms should be practically implementable in a variety of national circumstances, and should not disadvantage particular activities or business models except to the extent justified by the relative risks they pose. For example, the Reserve Bank and the Australian Prudential Regulation Authority (APRA) argued for the Basel III short-term liquidity requirement to be met in Australia via a Committed Liquidity Facility at the Reserve Bank, as banks could not otherwise meet the requirement given the relative scarcity of government debt. Tailoring to national circumstances does not, however, imply that Australia can stand apart from the global regulatory reforms: Australia’s financial system is highly integrated with the global financial system; and Australian banks and other institutions participate in global markets and access foreign capital, so they need to demonstrate that they meet comparable standards to their counterparts abroad. It is, in any event, in Australia’s interests to adopt high standards in supervision and regulation.

Australia is well advanced in implementing many of the reforms in response to the crisis, though there are a couple of areas where work is underway in Australia which the Reserve Bank considers should be progressed.

Following the financial crisis, much attention internationally has been directed at policy frameworks to limit systemic risk and promote financial stability. In some jurisdictions this has involved reassignment or clarification of regulatory agency responsibilities for system-wide oversight, and/or creation of new bodies to perform this role. Some jurisdictions have also developed specific prudential measures to assist in managing systemic risk, sometimes referred to as ‘macroprudential tools’. Several advanced countries have implemented such tools since the crisis, but it is too early to judge their effectiveness. In any case, in Australia, existing prudential powers can already be directed at system-level risk.

It is the Reserve Bank’s job to look at the performance of the financial system and risks to its stability. In order to do so, the Reserve Bank closely monitors issues from a system-wide perspective, including how risk can be propagated. The Australian major banks are important sources of systemic risk because of their size and interconnections with the real economy and the rest of the financial system, even though their business models are relatively low risk. Similarly, compared with other assets, housing in most countries (including Australia) is not particularly risky, but the housing market poses systemic risk because of its size, importance to the real economy, and interconnection with the financial system. While not as large, the commercial property market also poses systemic risk through its cyclicality and strong connections to the banking system; historically it has been one of the main sources of loan losses during episodes of banking distress globally.

The Reserve Bank has more formal oversight responsibilities for certain FMIs. FMIs are critical to the smooth functioning of financial markets, but they can also be a source of systemic risk because of their centrality to the system and the lack of substitutability in the markets they serve. That said, enhancements to FMI design and operation pre-crisis ensured that they remained a source of stability when the crisis hit.

The Reserve Bank has exercised the powers granted to it in 1998 following the recommendations by the Wallis Inquiry in relation to the payments system. The Bank’s payments system reforms, overseen by the Payments Systems Board (PSB), have focused on improving competition and efficiency in payment systems, consistent with maintaining stability and effective management of risk. The approach of the PSB has been to encourage industry to undertake reform, only using its powers when cooperative solutions have not emerged. The Bank’s reforms have been followed by similar reforms in many other jurisdictions.

While the global financial crisis interrupted some of the trends in the Australian financial system over the past 20 years or so, many will continue to shape Australia’s financial system in the years ahead. The period since the Wallis Inquiry is yet another demonstration of the procyclical nature of competition in banking. In times of optimism, competition is often more pronounced on the lending side, whereas competition for funding often intensifies following a financial crisis. The competitive landscape was transformed by the earlier deregulation of the banking sector. New entrants, or the threat of new entrants, have since shaped the markets for banking services in important ways. For example, the arrival of mortgage originators led to a marked decline in spreads on mortgages. And the entry of foreign banks in the online deposit market saw deposit rates increase relative to the cash rate. But while the regulatory framework continues to affect competition, cyclical dynamics in risk-taking among market participants have played an important role.

Since the crisis, Australians – like their counterparts overseas – are adjusting to a world where the true cost of liquidity is better recognised. Associated with this has been a reassessment of funding risk by banks, investors and regulators globally. In response, Australian banks have adjusted their funding structures and competition for deposits has intensified.

These developments increased banks’ funding costs and lending rates relative to the cash rate. But banks’ net interest margins have remained little changed – at roughly half the levels prevailing in the 1980s. Overall, greater competition for funding is a healthy development to the extent that it enhances market discipline on financial intermediaries to manage their risks. But it is important that asset quality remains paramount in assessing financial strength, along with the allocation of capital according to risk.

A good deal of focus has been placed on competition in the mortgage market since the crisis, and a number of reforms have supported competition there. However, the market for small business loans has more structural impediments to competition than most other lending markets, because the information asymmetries tend to be more significant. Technological advances and financial innovation can help to reduce these asymmetries. In addition, measures to improve the supporting infrastructure for capital market funding can help to provide companies with alternatives to bank loans.

Another important trend over the past 20 years was that technological advances globally aided the proliferation of cross-border investment and credit, which was facilitated by the progressive removal of restrictions on foreign capital by most developed economies during the 1980s. In Australia, this enabled households and companies to access finance from abroad (either directly or via the banking system), and hedging markets developed to help manage the risks. A key reason that Australians have benefited from financial globalisation is the willingness of foreign investors to take on the risk of lending to us in Australian dollars.

The net outcome of the myriad of saving and investment decisions by Australian households, companies and governments has often been net capital inflow and a current account deficit. In the aftermath of the crisis, some commentators questioned whether enough capital would be available to meet the needs of Australians, given reduced foreign demand for bank debt globally. In the event, which was itself a severe stress test, the capital account adjusted, with the price and composition of funding shifting accordingly. This outcome provides contrary evidence to the hypothesis that the current account can only be funded by a single form of capital inflow such as offshore borrowing by banks.

In the post-Wallis period household finance became more widely available, providing greater scope to smooth consumption. Associated with this has been a rise in household indebtedness and dwelling values. The vulnerability of some households to sudden changes in financial conditions, including interest rates, has increased and Australian banks have concentrated exposures to mortgages. A corollary of this is that Australian banks have less exposure to complex securities and riskier forms of lending, such as commercial property loans.

The rise of superannuation has transformed the Australian financial system. The household sector’s direct exposure to market risk increased, as was demonstrated during the financial crisis. But at the same time, the losses incurred did not threaten the stability of the system, in part because the shift in risk allocations towards households eased the build-up of concentrated risks in institutions and governments. More broadly, the growth in superannuation has been in many ways conducive to financial stability, by adding depth to financial markets, and providing a stable, more or less unleveraged, source of finance for other sectors.

While the superannuation system is often viewed as being in the asset management business, it is also increasingly in the intermediation and maturity transformation business. The sector is therefore exposed to liquidity risk, which will increase as more members draw down their superannuation savings. Superannuation funds will need to balance managing their liquidity risk with their investment profile.

Some have proposed superannuation as a potential pool of funding for infrastructure investment. In the Reserve Bank’s view, it would not be appropriate to mandate superannuation funds to invest in particular assets to meet broader national objectives. Rather, investments must be managed in the best interest of the membership. It cannot be forgotten that the objective of the superannuation system is to provide income in retirement. More broadly, it is worth the Inquiry considering whether the current arrangements enable households to tailor their superannuation savings to suit their risk preferences and investment horizons at a reasonable cost.

Despite significant changes in the post-Wallis period, many key features of the financial system persist. The core functions of the system remain essentially the same, as do the sources of vulnerability. Well-functioning financial systems can help promote economic growth. However, financial activity is inherently subject to information asymmetries, risk concentration, imprudent behaviour and other sources of systemic risk. Hence effective supervision is critical, particularly during boom times.

The key lesson from the past two decades is not a new lesson at all: the financial cycle is still with us and risks need to be appropriately managed. Society’s attitudes towards efficiency and risk evolve and are very much shaped by the course of history – and mainly recent history. For Australia, the resilience of the financial sector in recent decades does not imply the absence of risks. It follows that the industry, the regulators, and the supervisors must ensure that institutions are resilient to short-run shocks but are also able to adjust to longer-run trends with adequate consideration for both competition and financial system stability.

In summary, the following are eight main points the Reserve Bank considers to be worth emphasising.

A good starting point for evaluating the Australian financial and payment systems is to consider the desired role of finance in our society. This Chapter provides an introductory discussion of the core functions of the financial sector, and the characteristics that set it apart from other sectors of the economy.

Although they are often thought of as recent phenomena, financial and payment systems have evolved over several thousand years. The manner in which transactions occur has changed remarkably over that time, but the underlying objectives have not. The economic functions performed by the first modern banks of Renaissance Italy, for instance, still apply today (Freixas and Rochet 2008).

1 The presentation of core functions of the financial sector differs within the literature, both in terms of the terminology employed and the number of functions that are identified. Merton and Bodie (1995), for example, identify six core functions. The spirit of that framework is similar to the one presented here. The main difference of presentation is that in this Chapter, the efficient allocation of resources is regarded as a by-product of a system that is performing the four core functions well, rather than as a stand-alone function. Merton and Bodie (1995) also separately list a function of governance, whereas this has been subsumed within the intermediation function in this Chapter.

These are all valuable tools for a community to have. The modern economy could not have developed without the financial sector also developing these capabilities. Moreover, these core functions require the financial sector to have certain supporting capabilities, such as the ability to screen and monitor borrowers. In principle, each of these functions could be performed by individuals. But there are efficiency benefits from having institutions perform them, particularly in addressing some of the informational asymmetries that arise in financial transactions.

The provision of these core functions can overlap and interact in important ways. For example, some financial products, such as deposits, combine value exchange, intermediation, risk transfer and liquidity services. With these interactions in mind, each core function is considered in more detail below.

A safe and efficient payment system is essential to support the day-to-day business of the Australian economy. There are approximately 43 million transactions in Australia every day, including cash and non-cash payments as well as transactions in financial assets. With so many payments, even relatively small inefficiencies can have significant implications for the broader economy and the living standards of Australians.

In this regard, the payment system has progressed a long way since the early Australian colonies, where the predominant means of exchange for many years was rum (Shann 1930). Today, we enjoy access to a range of convenient payment options, including cash, card and internet transfer. While future innovations are by nature uncertain, it is possible to identify some desirable qualities of an efficient payment system. It should be:

Of course, there can be tensions between these objectives. For instance, making a payments system fully accessible and easy to use absorbs resources that might increase its cost.

The financial sector plays an important role in the functioning of the economy through intermediation. Simply put, the financial sector sits between savers and borrowers: it takes funds from savers (for example, through deposits) and lends them to those who wish to borrow, be they households, businesses or governments.

Intermediation can take on many forms beyond the traditional banking service of taking deposits and making loans. For example, investment banks intermediate between investors and bond issuers. Brokers perform a similar function in connecting the buyers and sellers of equities. The common thread is that a financial institution stands between the counterparties to a transaction. Depending on the nature of the transaction, a number of supplementary functions may be required to intermediate between savers and borrowers, including:

Effective intermediation requires a number of the qualities listed above in the context of an efficient payments system; it should be accessible and reliable, for instance. If the financial system is working well, it allocates funds to their most productive use. This benefits society by expanding the productive capacity of the economy, hence raising living standards.

A well-functioning financial system also facilitates the pricing and allocation of certain risks. As discussed in ‘Box 4A: Types of Financial Risk’, these risks include the possibility that a borrower will default on their obligation (credit risk), that an asset’s value will fluctuate (market risk), or that an income stream will be required for longer than expected (longevity risk). Financial contracts may also alter the financial implications of physical risks, by providing insurance against flood or fire damage to property, for example (insurance risk), or against legal liability and similar costs (operational risk). Many of the subsidiary capabilities implied by the intermediation function are also necessary for effective risk pricing and allocation, particularly the ability to assess risk and monitor borrowers.

The financial sector should allow individuals to tailor their exposure to risk to suit their preferences. A younger person, for instance, may have more scope to adjust to a sharp fall in the value of their assets than an older person, who would have less time to build up assets to fund their retirement. Given this, a younger person may choose to invest in a riskier portfolio of assets, with the prospect of higher returns.

Importantly, the role of the financial sector is not to remove risk entirely. Rather, it should facilitate the transfer of risks to those best placed to manage them. It cannot remove many of the risks within the economy, which must ultimately be borne by individuals either as holders of real and financial assets, or as taxpayers (Davis 2013). Moreover, it is not the goal of the financial sector necessarily to minimise risk. The socially optimal amount of risk is almost certainly not the minimum feasible level, given the importance of risk-taking to innovation and entrepreneurship. Of course, the characteristics of the financial system can shape the extent of risk-taking in important ways.

The financial sector provides liquidity. If the financial system is working well, individuals, businesses, and governments are able to convert their assets into cash at short notice, without undue loss of value.

The provision of liquidity is useful to individuals for meeting unexpected obligations. It is also critical to society at large. Access to liquidity allows businesses to deploy their capital in ways that increase the productive capacity of the economy. Without it, households and businesses would be forced to hold larger sums of cash to protect against unforeseen events. The result would be fewer resources for investment and the provision of fewer goods and services to consume.

2 The private sector could potentially provide all of its own liquidity needs. But the amount of liquid holdings required to insure against a systemic event would reduce the efficiency of the financial system in normal times. Also, limited information, coordination problems, and potentially misplaced incentives, would make it difficult to act quickly enough during a flight to liquidity. For instance, on the verge of the US banking crisis of 1907, a private sector consortium considered providing liquidity to certain troubled institutions – an act that would have almost certainly lessened the impact of the crisis. They were, however, unwilling to act in time (Bernanke 2013). The role of central banks in managing the money supply and currency, make them a natural fit to be the lender of last resort.

On occasion, there may be a sudden flight to liquid assets in response to acute uncertainty about the value of financial assets. One example of this occurred in many economies during the crisis of 2008 (although there are many others scattered throughout history). In these circumstances, the central bank’s role is to supply the necessary liquidity to ensure the smooth functioning of the system. The provision of liquidity support by the central bank to an individual institution – as the lender of last resort – is a related, but separate form of intervention which central banks can make; this complex and important role has been discussed at length elsewhere (Goodhart 1988).

Each of the four core functions that were introduced in the preceding section are vital to economic progress. But these functions are not generally ends in themselves. Put another way, the financial sector is an intermediate sector. Its activities are mainly directed at promoting efficiency in other sectors. This implies that the resources used in finance are a cost to society, because they cannot be used for one of the end purposes that members of society desire. It is therefore important that these financial services be provided in the most efficient way that is still consistent with the desired levels of safety and service.

The financial sector is, however, a critical link in the functioning of the economy: every economic interaction has a financial component, such as a payment. The spillovers to the real economy from dysfunction or operational failure in the financial and payments systems can be severe. Moreover, these spillovers can add to ‘moral hazard’, whereby financial institutions take risks under the assumption that the resulting costs would be, at least partly, borne by others (for example, their creditors or society at large). The potential for undue risk-taking is exacerbated by the problem of asymmetric information, where the party ultimately bearing the risk is not fully aware of it.

In addition, the core functions of financial intermediaries make them vulnerable to a change in customer and investor confidence, more so than for most firms. In particular:

The critical role of the financial sector and its inherent vulnerabilities suggest that it should be subject to more regulation than most other industries. (Although market discipline has a role to play, past experience has shown its limitations.) Even so, it is important to recognise the limits of what regulation can achieve. The financial sector is an information-intensive industry, so the financial system can change rapidly in response to technological change. As a result, regulations may be circumvented or become outdated very quickly, and will often produce unintended consequences. This does not remove the need for a good deal of regulation. But it does point to the importance of effective supervision – especially during the boom times – rather than reliance on inflexible rules.

This Chapter provides an overview of some important developments in the Australian financial system since the Wallis Inquiry was completed in 1997. It focuses on trends in the size, growth and performance of the system and the impact of the global financial crisis on these trends.

The Australian financial system has grown rapidly since the Wallis Inquiry and, in certain respects, as is typical of finance, in ways that were not anticipated. New technologies have changed the way that services are delivered and risks are managed. The scope of choice for end users has increased, and with it the complexity of the system.

Underpinning these developments has been the protracted adjustment of the financial sector to a system where credit availability is essentially market determined, and to an environment of low and stable inflation. These forces have interacted with a range of other factors – including favourable macroeconomic conditions, increased globalisation of finance and changing demographics – to produce a number of important results. For example:

Although these shifts were underway around the time of the Wallis Inquiry, the extent of the adjustments turned out to be larger and more protracted than many had anticipated.

While the provision of financial services has also changed considerably, the traditional model of intermediation via the banking system has remained dominant in Australia. In the mid 1990s, there was a growing sense that financial markets would displace banks in providing the core functions of the financial system (Financial System Inquiry 1997, p 172). In the event, some new technologies and products, such as complex securities, were misused and their risk mitigation properties overestimated – particularly overseas. Domestically, the capacity for banks to expand and acquire other businesses (wealth management firms, for instance) was perhaps underestimated.

The remainder of this Chapter considers these and other key developments in the Australian financial system. As the title of this Chapter suggests, the primary point of reference is the completion of the Wallis Inquiry in 1997. However, in some cases it will be important to delve further back into history to provide the context in which the system has evolved. In addition, the period since the Wallis Inquiry had two distinct phases: the decade or so leading up to the global financial crisis, during which many risks were underpriced; and the period since, which has seen a renewed focus on systemic risk.

The most striking development in the Australian financial system in recent decades is its growth. A few summary measures illustrate the extent of the expansion that took place from the early 1980s until the onset of the financial crisis:

1 Part of the increase in turnover is due to the privatisation of previously public entities and the demutualisation of some member-owned organisations.

2 The timing of these changes differed across countries. For instance, the decline in inflation in Australia occurred later than in many other countries.

As it turns out, then, the Wallis Inquiry of 1997 occurred in the midst of a profound period of growth in the Australian financial system. What caused this spectacular growth? And why has it slowed in recent years?

Simply itemising causal factors ignores the complex ways that the various elements of a financial system interact. Nonetheless, one starting point is the observation that rapid growth in the financial system since the early 1980s is not unique to Australia. Most developed economies experienced similarly large, or even larger, expansions. And, in most countries, that period of rapid growth has ceased. This suggests the importance of some common, once-off factors, including:

Financial deregulation in Australia began in the early 1970s and culminated in many important changes to the financial landscape in the 1980s, including:

There is not space to chronicle these processes here; they have been extensively covered elsewhere (Macfarlane (1991) and Davis (2007), for example). But, fundamentally, the result was a shift from a situation where credit was price-controlled and quantity-rationed, to one where credit availability is market determined. The behaviour of credit providers changed accordingly as they adapted to a more competitive environment. Taken together, the easing of regulatory constraints had the predictable effect, at least in a qualitative sense, of allowing a once-off expansion of the financial sector relative to its historical trend.

Alongside the adjustment to deregulation, Australia’s shift from being a high-inflation country to a low-inflation country had profound implications for the domestic financial system. Prior to the 1990s, Australia had one of the highest inflation rates among developed economies. However, the spare capacity in the economy from the early 1990s recession saw inflation decline, and the introduction of inflation targeting helped to entrench that reduction. Nominal interest rates eventually fell in line with the lower inflation compensation required.

These dynamics were already in place prior to the Wallis Inquiry, but it was in the years around and subsequent to that Inquiry that the effects were most apparent. Nominal interest rates on housing loans did not fall as quickly as inflation in the early part of the 1990s. However, competition from new entrants to the mortgage market during the late 1990s helped to bring mortgage interest rates down in line with the structural decline in inflation.

3 As a simple illustrative calculation, assuming a debt-servicing ratio of 30 per cent on a 25-year mortgage, a household’s borrowing capacity would have risen from around two times annual income in the late 1980s to roughly four times by the mid 2000s.

The adjustment of the financial system to these once-off factors has been shaped by a number of long-run forces that reflect trends in incomes, technology, demographics, and so on. For instance, one phenomenon that has been observed is a tendency for financial systems to grow, relative to GDP, as real income levels increase (Goldsmith 1985).

4 CGFS (2006) and Kent, Ossolinski and Willard (2007) discuss some of the institutional differences across countries that may influence these adjustments in the context of housing.

Alongside income growth, technological change has exerted substantial influence on the Australian financial system in recent decades. Finance is an information-intensive industry. Its key outputs depend on the capacity to store, analyse and transmit information securely. Given this, the advances in information technology in recent decades are likely to have generated growth in finance industry productivity relative to that in less information-intensive sectors. For instance, the use of computer databases in place of paper-based filing systems has improved the efficiency of storing and retrieving customer information.

The rise in the share of value added by the financial sector in Australia is towards the upper end of the range of international experience since the Wallis Inquiry (Graph 2.2). This may reflect the larger role for traditional intermediation within the Australian financial sector, as well as the size and structure of Australia’s superannuation industry. It also reflects the resilience of the Australian economy and financial system in recent years. Credit continued to expand in Australia over this period, unlike the experiences in the United States and a number of European countries.

Associated with the advances in technology has been a lowering of the cost of transacting across borders. This aided the proliferation of cross-border investment and credit, which was facilitated by the progressive removal of restrictions on foreign capital by many developed economies during the 1980s. In Australia, this afforded households and companies greater access to finance from abroad (either directly or via the banking system), and hedging markets developed to help manage the risks. As Chapter 5 explains, a key reason that Australians have benefited from financial globalisation is the willingness of foreign investors to take on the risk of lending to us in Australian dollars.

Capital flows across borders rose rapidly from the early 2000s in an environment of low interest rates and solid economic growth globally (Graph 2.3). During the financial crisis, a number of these flows reversed, as lenders repatriated their foreign holdings and home bias reasserted itself, especially in Europe. These dynamics were less pronounced in Australia, reflecting the comparatively favourable conditions in the banking system and the broader economy.

The demographic transition that is occurring throughout the world has important implications for the financial system, including through its influence on labour supply, saving behaviour, capital accumulation, international capital flows and the relative demand for different assets (IMF 2004; Kent, Park and Rees 2006). Populations are ageing at the same time as fertility rates are declining, although the extent and speed of these changes differs significantly across countries.

In Australia’s case, a striking development since the Wallis Inquiry is the marked growth in superannuation assets. Since 1997, superannuation assets as a per cent to GDP have more than doubled to be over 100 per cent. The increase in superannuation has had important structural implications. For instance, many banks acquired wealth management businesses, which have helped to support their profitability. And households have increased their exposure to market-linked investments. Chapter 7 explores developments in superannuation.

A further category of forces that have shaped the growth in the financial system are those associated with the cyclical dynamics of credit and asset prices (Borio and Lowe 2002; Bean 2003). The financial sector has a well-documented capacity to engage in bouts of overexpansion, driven by self-reinforcing expectations, followed by periods of readjustment and consolidation (Kindleberger and Aliber 2005); this is sometimes called procylicality. Business cycles can be unpredictable in duration, and the associated credit cycles can vary in amplitude.

Cyclical dynamics help to explain the spectacular growth in the financial sector in a number of countries during the 2000s, amid an environment of low interest rates globally, and the subsequent reversals. In Australia, the macroeconomic environment from the early 1990s was particularly conducive to expansion in the financial system. There was a marked reduction in the level and volatility of the unemployment rate, for instance (Table 2.1). And Australians experienced virtually uninterrupted economic growth for a long period, which is likely to have influenced the extent to which households and businesses took risks.

The robust economic growth was to some extent self-reinforcing, as strong employment growth and rising wages drove income growth, which contributed to rapid housing price growth. This, in turn, further spurred spending, putting more upward pressure on housing prices. The strong growth in housing prices abated in late 2003, owing in part to policy initiatives (Kearns and Lowe 2011). From the mid 2000s, the household saving ratio increased – in part, because of a return to more prudent saving behaviour by the household sector.