University of Melbourne: Does Australia Need A New Banking Model?


Australian Economic Review, June 2015

Prof Paul Kofman and Dr Carsten Murawski, University of Melbourne

The main objective of the banking system is to facilitate economic activity through the effective provision of core financial services such as payment services, savings accounts and loans. Without access to cost-effective basic financial services, participation in economic activity is severely impaired, if not impossible. In a modern society, all citizens should be entitled to these services at a price that equals their cost, as they are to clean water.

In Australia, where the banking system is dominated by four major banks, core financial services are often not provided at cost and exclude significant parts of society. High net interest margins on residential mortgages, high fees on superannuation accounts, a lack of credit for small- and medium-sized enterprises or rural Australians, the unavailability of key risk management products, such as fixed-rate residential mortgages or annuities, are examples that spring to mind.

Of course, banks do not just provide core financial services. They are also employers, investment opportunities and taxpayers. That creates possibly conflicting goals.

With perfect competition, market forces manage those conflicts and ensure efficient allocation of capital. Unfortunately, financial markets are among the most imperfect markets we know. Some of these imperfections, including information asymmetry, are inherent in many financial products. Others, like market concentration, derive from competition policy and implicit government guarantees.

The provision of financial services therefore requires strong and effective regulation, but a lack of resources and enforcement powers cripples Australian regulatory agencies.

Regulators are further obstructed by the complexity of the major banks. This complexity is a result of full-service banking, the dominant business model in banking today, where each (large) bank offers the entire range of financial products.

Due to the size of these banks and their interconnectedness with the financial system and the economy, they are considered ‘too-big-to-fail’ and ‘too-big-to-manage’. But, they are also too big to be regulated effectively.

It is argued that the proliferation of the full-service model is justified with efficiency gains. Large integrated banks, so it is claimed, have more potential for diversification and can provide banking services at lower cost. But, there is a major flaw in this model. Since all business lines are integrated within a single entity and financed by the same pool of capital, risks can no longer be isolated from each other. The banks' capital providers—mostly depositors—are exposed to the entirety of a bank's businesses and its entire pool of risks.

The Global Financial Crisis (GFC) provides evidence supporting this claim. In the United States, losses at the major banks originated mainly in institutional business and proprietary trading but spilled over into other business lines and were borne by all stakeholders including depositors and—through government guarantees and support—taxpayers.

Another argument for the support and protection of the ‘Big Four’ banks is financial stability. A market structure that gives the big banks enough power to generate substantial profits, it is argued, will support the building of a stock of capital that allows the banks to withstand a financial crisis. Again, the experience of the GFC casts doubt on the validity of this claim.

The weakest argument underpinning the ‘four pillars’ policy is global competitiveness—that for Australia to be internationally competitive and make claims to be a regional financial centre, we need large banks that compete globally. While always a stretch, the emergence of the Asian economies and their financial centres undermines this argument.

How can we achieve cost-effective provision of core financial services while also pursuing other goals such as employment growth and innovation in banking? Should there be further consolidation into the ‘Big Three’ and, eventually, just one large bank? If history is any guide, it is unlikely that consolidating into even bigger institutions will achieve this aim. Instead, it would increase conflicts between the competing goals of banking and worsen outcomes at least for the less-connected stakeholders. Worse, it would increase systemic risk for, and the potential burden on, the Australian taxpayer.

An alternative solution is the break-up of large banks into low-risk (retail and commercial banking) and high-risk (investment banking) entities, as in the United States from the 1930 s under Glass-Steagall. Again, it is not clear whether such a move would address the fundamental problems.

We suggest a third solution: the establishment of a public-sector institution that provides core financial services, such as payment services, savings accounts, mortgages and other basic forms of credit, to retail customers and small- and medium-sized enterprises. We think of it as a utility that ensures cost-effective provision of basic banking services to all Australians.

The institution would be independent but backed by the Commonwealth Government and funded by (government) equity, deposits and public debt. It would be governed by an independent board, be transparent and accountable to the public. High standards of corporate governance and risk management would be critical for the success of such an institution and to avoid the experiences of the Australian state banks in the 1990s.

Comparable institutions have successfully existed in many European countries such as Germany (Sparkassen, Landesbanken), the Netherlands (Nutsspaarbank) and Switzerland (Kantonalbanken, Postfinance), where they have played a crucial role in economic development.

A major advantage of such an institution would be its focus on core banking activities, in isolation from non-core, higher risk activities. Another crucial advantage would be the alignment of the interests of the providers of capital (mainly the government and depositors) with the mission of the institution, the cost-effective provision of core banking services to the public.

The rigidity of the local banking system and its consequences have wider implications. Australia faces momentous economic challenges including the transition from an industrial to a knowledge-based economy and a large gap in retirement funding. Addressing those challenges requires an efficient, innovative and resilient banking system that facilitates the cost-effective allocation and management of capital.

But there is an opportunity, too. With one of the world's most advanced retirement savings systems and one of the world's largest pools of assets under management, Australia is well-placed to develop into a global centre in asset management, particularly for retirement savings.

Today's banking system seems ill-equipped to achieve this global position. The Big Four struggle with too many competing goals and lack incentives to innovate. The high degree of market concentration—partly as a result of government policy—limits access of new firms, stifling competition and innovation.

That translates into a lack of attractive jobs, stimulating many of Australia's brightest graduates to migrate to the major financial centres like New York, San Francisco, London, Hong Kong and Singapore.

Solely relying on ‘the market’ to unlock this potential will fail, as it has in the past. What is required is political and commercial vision and the courage to make substantial changes to the banking system. In a fast-changing and highly competitive world, a commitment to conserve the status quo will only lead to slow, withering decay.