RBA Annual Conference – 1991 General Discussion

Harper and Phelps

Much of the discussion centred on whether the financial sector is competitive. Does the free-market model fit the facts? If not, why not? Does it matter? Where is the source of the oligopoly? Is oligopoly a bad thing, or a force for financial stability?

Since deregulation had occurred, there was no doubt that competition had heated up. However, if people expected the banking industry to quickly move to the textbook model of perfect competition, they would be greatly disappointed. One area where progress was limited was in the elimination of cross-subsidies.

One participant said that he remembered that when he ran a non-bank, his aim had been to identify the profit centres of banking and to try to compete in those areas. The first example he gave was foreign exchange. Merchant banks entered in force in the mid 1970s to compete away the banks' “monopoly profits” by establishing the hedge market in foreign exchange. When this participant found himself running a new bank, he adopted a similar strategy. His bank targetted depositors with high balances and low transactions. (They offered an account that paid high interest, allowed four free cheques per month, then charged a high fee for additional cheques.)

But cross-subsidies still exist – most notably between the intermediation process and the payment system. The extent of the cross-subsidy in the payment system was reflected in what one participant described as the “1:3:5” system, whereby institutions with no payment system responsibility could operate with margins of 1 per cent, those with a mix of intermediation and payment system responsibilities required 3 per cent margin, and those with predominately payment system responsibility required a 5 per cent margin. In practice, most people get charged something like the middle rate (see Phelps) and so the users of the first group of services subsidise the users of the last. Progress in changing this is very slow because the Australian public have acquired an aversion to paying explicitly for payments system services.

In explaining this and other manifestations of less-than-perfect competition, a number of possibilities were discussed. Many observed that the system was still evolving and, for a number of reasons, the forces of competition and change took some time to work their way through. First, it takes time for the markets and the financial institutions to respond: there are constraints on the speed of institutional change, because change itself involves risk and has to be taken at a measured pace. Secondly, markets haven't yet developed to allow the complete diversification of risk.

This led to some discussion of the possibility that banking involves a natural oligopoly. Many thought that the basic factor behind this natural oligopoly was the distribution network of existing banks which made it difficult for outsiders to break in. Every banking system in the world was oligopolistic except in the United States where strict rules had been needed to prevent an oligopoly forming. (See Wojnilower's paper where he argues that the United States should have allowed an oligopoly.) The oligopoly power of a distribution network mainly made itself felt in retail banking, including lending to small businesses. Several participants felt that this barrier to entry was so strong that it was insurmountable. In corporate banking, on the other hand, the barriers to entry were smaller, and competition had become intense. In fact, it became so intense that business was being done at margins that were too low to reflect the risks involved. One participant said that before deregulation the margin for prime borrowers (e.g. BHP) was 1 per cent, and for medium risks it was 3 per cent. At the height of competition, the margins had been squeezed down to 0.1 per cent and 1 per cent, respectively.

There was also considerable discussion of what constituted the “essence” of banking. While some again stressed distribution, others felt that it couldn't be the distribution network because this could be replicated by a chain of retail stores, or a telephone network (in the United States, AT&T are now providing banking services). Others felt that it couldn't be the payments system because this could, in principle, be run through the Post Office or electronically. It was generally agreed that the essence was “information about customers”, particularly the ability to determine who was a good credit risk and to price loans accordingly. One participant said there was no substitute for the old-fashioned country bank manager who “kicked tyres and drank with small businessmen at the RSL after work”. No new entrant could acquire this type of banking information easily.[1] (See next section for further discussion of why there was a partial breakdown of this function in the 1980s.)

However, there are natural barriers to acquiring information. This impinged on various aspects of banking, but the most obvious and specific way was that old banks know their customers best, and can use this knowledge to keep the best customers. A new bank attempting to bid away customers from an existing bank does not know whether the customer has been enticed away, or whether the customer has been rejected by his old bank because of doubts about creditworthiness. Price competition between financial intermediaries is limited by the relatively narrow margins between borrowing and lending rates: it is difficult for a financial intermediary to offer a substantial cut in its lending rates to attract new business without reducing its own profit margin too much. This is particularly so as the new bank does not know as much about the creditworthiness of the new customer as it does about its existing customers.

Some participants thought that the proper response to this natural oligopoly was to try to break down the source of the oligopoly and create a more competitive climate. Others thought that there were limits to the extent to which a competitive market can be allowed to operate in the financial system: banking, intermediation and the payments system are “special”.

Part of the problem was that banks provide a public benefit in the form of the externalities associated with the payment system and readily-available intermediation services. By forcing the banks and the financial system into a competitive framework, these external benefits might be put at risk. The business of intermediation and deposit-taking should not be seen as being the same as the production and sale of physical goods, where a trader could exit from the industry without causing economy-wide disruption. If even a large bread-making company fails, there is little risk of contagion, but failure of a medium-sized bank could have large repercussions on other banks. In regulating the financial system and the banks in order to preserve their stability, this would also limit their competitive ability. The BIS capital requirements may have this effect. These requirements were seen by some as to be too indiscriminating, although others pointed out that the banks themselves were able to operate more finely-tuned internal systems, and even the BIS system could be refined over time.

Attempts to force a more market-oriented competitive system on banks might actually make them more unstable – more price variability in financial institutions' balance sheets was likely to cause instability and may make them pro-cyclical.

However, regulation itself could cause problems and further limit the competitive ability of the banks. Some saw this problem as being particularly acute because of prospective competition from superannuation. The Reserve Bank could not allow the banks to link fully with superannuation funds because it would effectively spread the “lender of last resort” into the funds management industry. Yet the superannuation funds would, through their taxation advantages, attract deposit funds away from the banks and force the banks further down the “credit ladder”. (This was thought to be an extremely interesting subject, but discussion was curtailed because it did not fit strictly within the subject area of this Conference.)

There was considerable discussion about the problems of measuring the changing profit and lending margins of the banks over the deregulation period. There was no real disagreement with the view that, allowing for changes in the lending “mix” between retail and commercial and for cyclical changes in provisioning, there had not been dramatic changes in either margins or profits (probably a fall, but not a big one). Margins may have been trimmed during deregulation, as financial institutions competed for market share: but in the longer term, it could not be expected that productivity increases would cause margins to narrow much. There was no agreement on whether margins or profits provided a better measure of the changing competitive position of the banks. The complexities of measuring margins made some commentators prefer to use profits as a measure of the changing competitive position, while others thought that margins were a more direct measure of the economic concepts of competitiveness, i.e. to see whether banks have expanded their balance sheets to the stage where marginal costs and revenues were equated. It was suggested that productivity per transaction had increased significantly, and this benefit was being received in the form of better service rather than cheaper intermediation.

There was a widespread recognition and acceptance that banks need to be able to attract equity and so profits had to be high enough to fund and support an appropriate expansion of the financial sector. Shareholders have borne a good proportion of the burden of poor lending decisions (although the shareholders concerned have mainly been State Governments and overseas banks). Banks cannot afford to let their capital fall too far, and the regulatory process may have to take this into account.


For a more formal way of making a similar point, see Eugene F. Fama, “What's Different about Banks?”, Journal of Monetary Economics, January 1985. [1]