RBA Annual Conference – 1991 Bank Deregulation in Australia: Choice and Diversity, Gainers and Losers Ian Harper[1]

1. Introduction

One of the hopes held for financial deregulation was that it would enhance choice and diversity within the banking system. There was a pervasive impression that banks conformed a little too closely to Henry Ford's famous dictum that, “You can have any colour you like so long as it's black!”. In other words, banks were perceived as dictating to their customers the types of products and services they would consume and offering a range of such products and services which was unnecessarily narrow. Heightened competition following deregulation was expected to induce banks to widen the range of choices available to their customers and to be more responsive to their customers' demands.

Deregulation was also supposed to put an end to internal cross-subsidies in banks. For years, banks had allowed some customers to consume services at prices below marginal cost while others were forced to pay prices above marginal cost, generally for different services. This was recognised as economically inefficient as well as inequitable in most cases. Again, more competition was expected to eliminate the opportunity for cross-subsidies as banks were forced by market pressure to set prices closer to marginal cost in all markets.

This paper explores the issues of choice and diversity and internal cross-subsidies in the deregulated banking system. It considers the evidence for enhanced choice and diversity and queries whether or not consumers are better off as a result. It then examines the question of internal cross-subsidies and attempts to determine which groups have gained and which have lost as a result of bank deregulation. Both issues are important in gauging an appropriate response to recent public criticism of bank deregulation.

2. Choice and Diversity

(a) Regulation Means Rationing

The system of regulations which governed the activities of banks from the late 1940s to the early 1980s grew out of special provisions legislated during the Second World War to ensure government command of the nation's financial resources during an emergency. The intent of the regulations was to enable the government to dictate both the volume of bank lending to the private sector and the direction of that lending. Like other war-time measures, regulations on banks were conceived as a means of allowing the government to ration essential goods and services, in this case loanable funds, to non-official users.

The war ended and rationing of food, petrol and other essential items was lifted. The emergency regulations imposed on banks, however, remained in force. This was not because the authorities still needed command over private financial resources to sustain the war effort (although the need to pay for post-war reconstruction no doubt influenced official thinking on the desirability of a captive market for government securities), but because the climate of intellectual opinion demanded it. The imposition of direct controls on banks, e.g. interest rate ceilings and portfolio restrictions, while precipitated by the exigencies of war, was the logical outworking of long-held beliefs that governments should exercise control over the banking system as part of their responsibility to manage the macro-economy.

Beginning with the establishment of a national currency in 1910, there is a clear progression of thinking and institutional development supporting active intervention by government in the financial affairs of the nation.[2] In the late 1940s, the banks accounted for the great bulk of financial intermediation and it was natural to concentrate regulatory attention on them. The aim was to use the banking system as the conduit for monetary policy. By influencing the volume and direction of bank lending, the authorities hoped to affect the extent and pattern of financial activity more generally.

A variety of controls was devised. The most important were:

  • controls on the interest rates which banks could offer on their deposits and charge on their loans;
  • limits on the maturity of deposits which banks could accept at interest;
  • restrictions dictating the proportions of their assets to be invested in particular securities, including government securities;
  • requirements to hold special reserves on deposit with the central bank; and
  • limits imposed from time to time on the overall rate of growth of their balance sheets.

The controls had the effect, separately and together, of constraining the banks' ability to intermediate freely between borrowers and lenders. On the liability side, they were prevented from raising funds on terms and in forms which the market demanded. For example, maturity controls effectively prohibited the banks from offering overnight and short-term deposit facilities, the demand for which was met outside the banking system. Similarly, on the asset side, banks were constrained in their ability to lend in the forms and to the extent sought by borrowers. Again, non-bank financial intermediaries and direct financiers stepped in to fill the breach.

Such restraints would not have been tolerated by banks had it not been for the government's de facto prohibition on the entry of new banks to the Australian banking system. The simultaneous closure of the banking market to new entrants assisted the purpose of the authorities in controlling bank intermediation. A small number of banks is easier to marshal and monitor than a large number. For the banks' part, the closure of the market facilitated cartel behaviour. Within the limits allowed them, it enabled banks to agree on interest rates and charges. It was also conducive to an atmosphere in which the central bank identified itself with the fortunes of the banks. The banks were, after all, the conduit for monetary policy. They needed to be protected from excessive competition which might serve to weaken them and hence weaken the authorities' control over general financial and economic conditions.

The quid pro quo for the banks submitting to detailed control of all aspects of their businesses was the protection against competition, both from one another and from potential new entrants, which they enjoyed as a result. This protection ensured that the banks remained profitable, indeed highly profitable by world standards, in spite of the intrusive regulation of their affairs. The banks became agents of the central bank. The system was not nationalised – bank nationalisation was repudiated by the electorate in 1949 – but bore many features of a nationalised system. In particular, the authorities were able to govern the output of the banking system with considerable accuracy, at least during the 1950s and 1960s, by manipulating controls which diverted funds away from banks towards the central bank and the government.

The system worked effectively so long as the alternatives to bank intermediation were few or imperfect. This was the case in the early years of the post-war era. But the more the authorities attempted to frustrate the natural desires of borrowers and lenders by governing the growth of the banking system, the more adept they became at seeking out alternatives to bank intermediation. Thus the various forms of non-bank financial intermediation and direct financing were given a new lease on life.

The steady growth of alternative outlets for financial activity imparted a bias to central bank monetary policy. In an attempt to influence the general level of financial activity, an ever-increasing proportion of which was being undertaken outside the banking system, the authorities pressed harder and harder on the banks. As the monetary brakes became less effective, the authorities applied them more often and worked them harder. This had two effects: the first was to stimulate further the growth of alternatives to regulated bank finance; and the second was to cast the banks in the role of chronic funds rationers.

The need to ration arose partly from the banks' inability to charge market-clearing rates for the funds they had to lend, but mostly from deliberate restraint imposed on the growth of banks' balance sheets by the monetary authorities. Moreover, bank finance was always cheaper than finance from alternative sources reflecting the lower cost of funds to banks (primarily a result of their perceived risklessness in the eyes of depositors). Thus, even if borrowers could accommodate their needs outside the banking system, their first preference was always to borrow from a bank. Banks, as a result, were never short of potential borrowers.

Cast in the role of rationers of funds and acting in this capacity as agents of the central bank, banks developed several notable features. First, banks did not compete actively for deposits. This was partly because they were constrained by regulations fixing ceilings on deposit interest rates, partly because they were restrained, in any case, by rate agreements concluded amongst the banks (and approved by the central bank) and partly because they had no need to manage their borrowing when the growth of their lending was governed by the authorities. Banks were asset managers rather than liability managers, and passive asset managers at that; they accepted whatever deposits came their way and invested the proceeds within the constraints imposed upon them.

Secondly, banks allocated funds to borrowers on the basis of “seller's preference”. Faced with a chronic excess demand for bank finance and denied the ability, for the most part, to charge market-clearing rates for loans, banks had little choice but to allocate funds to borrowers as they saw fit. This was the basis of the familiar practice, relinquished only recently, of banks refusing to lend to borrowers who had not established a record of saving with them, refusing to lend to women, whether in the paid workforce or not, and refusing to lend to borrowers who could not offer substantial security against their loans. This latter was most significant since it had the effect of insulating banks to a considerable extent from credit risk.

Thirdly, banks were free to cross-subsidise certain classes of customers at the expense of others. Cross-subsidies arose as a result of the banks' unwillingness or inability to price separate products and services so as to reflect their marginal costs of production. The oligopoly power conferred on banks by the regulations, including the de facto ban on new entry to the industry, sustained their profits in the particular market segments which funded the subsidies. The regulations not only created the opportunity for banks to cross-subsidise but obliged them to do so. The most significant cross-subsidies were the direct result of banks' inability to vary their deposit and loan interest rates so as to reflect the true cost of funds.

For example, given the absence of explicit fees for cheque usage, those who held a cheque account and wrote few cheques cross-subsidised those who wrote many cheques. The opportunity to cross-subsidise heavy users of cheque-payments services was created by the ban on the payment of interest on cheque accounts. But this regulation also obliged banks to cross-subsidise. Given their inability to offer higher rates of interest on cheque accounts to attract new customers, banks were forced to adopt various means of non-price competition. These included the processing of cheque-payments free of charge, the extension of branch networks so as to maximise locational convenience for customers and the provision of complimentary ancillary services, such as travel advice and safety-deposit boxes. Regulations on price competition bred non-price competition which almost always involves some degree of internal cross-subsidy.

(b) Rationing Militates Against Choice and Diversity

So long as banks played the role of funds rationers on behalf of the central bank and were protected against competition from one another and from new banks, they had neither the power to respond to consumer choice nor the will to widen the range of products and services they offered. Responding to consumer choice and expanding the product range presupposes that banks wanted to expand their balance sheets; in other words, that they were keen to borrow more so that they might lend more and thereby increase their profits. But banks under regulation could not lend more on account of the general restraint imposed by the central bank and, in any case, were content to restrain their output so that interest margins would remain high and oligopoly profits would be maximised.

Banks would only take an interest in enhancing consumer choice and product diversity when this would improve their profitability. This was not to occur until the banks faced competition, first from innovative non-bank financial institutions, and subsequently from one another, following deregulation. Only then did they have both the capacity and the need to satisfy their customers more fully.

The power of the regulatory apparatus to stifle innovation should not be underestimated. No one bank had an incentive to take the lead in innovation. Innovation would increase its costs and very likely lead to no permanent increase in market share. Given the controls/agreements on interest rates and charges, the only way for a regulated bank to increase its profitability was to increase its market share. An increase in market share following innovation would most likely be temporary for two reasons:

  • it is difficult or impossible to patent financial products and services and the innovation would soon be imitated by other banks; and
  • the central bank eliminated the element of surprise by publicising its approval of any new product, including details of its description, to all banks (Australian Bankers' Association (ABA) (1990, paragraph 179)).

Without the prospect of a permanent increase in market share and profitability following innovation, no bank was willing to burden itself with the additional cost. The “no innovation” outcome was a stable equilibrium. This was true at least of innovation in the traditional balance-sheet business of banks. Banks did innovate, but not in their core banking business.

A major impetus to innovate came from outside the banking industry – from the non-bank financial institutions. The non-banks had the freedom to operate outside the regulatory net cast over the banks and, as a result, were considerably more innovative than the banks. The simplest and most effective way for banks to compete with non-banks was to establish their own non-bank subsidiaries. The first instance came in the 1950s when banks established subsidiary finance companies to gain access to the lucrative consumer finance market. This was followed in later years by the establishment of money market corporations to enable banks to participate indirectly in the market for short-term wholesale deposits and loans.

These innovations helped to some extent to counteract the stultifying influence of the regulations. But they were poor substitutes for genuine innovation in the core business of banks. In particular, the establishment of non-bank subsidiaries did nothing to improve the range of deposit instruments and payments services available to the lending public nor did it assist borrowers seeking funds for house purchase, small business or rural investment. Improvements in these areas came with the steady expansion of independent non-bank financial institutions, like building societies and credit unions, and ultimately with the deregulation of banks.

The central bank was aware of the lack of innovation amongst banks and from time to time would encourage them to consider new developments. Ironically, it was the central bank which nudged the banks into playing a more active role in the market for commercial bills.[3] Commercial bills provided a means for banks to satisfy borrowers' demands for funds without contravening quantitative limits imposed on balance-sheet lending and without the need to raise additional deposits. Needless to say, commercial bill acceptance grew quickly and became a major source of bank finance to commercial borrowers. It was an innovation, developed by banks, but not as part of their core balance-sheet business.

(c) Deregulation Provides the Spur and Grants the Freedom to Innovate

Deregulation put an end to rationing of funds by banks. Towards the end of the regulated era, banks were desperate to obtain their freedom. The regulations which had facilitated a comfortable and profitable cartel amongst the banks now prevented them from meeting increasingly effective competition from the non-banks. The relative freedom of the non-banks to innovate enabled them to satisfy consumers' demands for choice and diversity which the banks could not or would not satisfy.

The end of rationing required a gestalt switch by the banks. From passive asset managers they transformed themselves into active liability managers. No longer were they content to accept whatever funds they were offered and allocate them across assets within the constraints laid down by the regulations. They now had the opportunity and the incentive to expand their businesses, lending where they found willing borrowers and borrowing where they found willing lenders. In the process, to entice new customers on both sides of their balance sheets, banks developed a veritable cornucopia of new financial products and services. Table 1 provides an indicative list of the types of new products and services developed by banks since 1980, the date of the first major deregulatory initiative (i.e. the abolition of deposit interest rate ceilings).

Table 1 Indicative List of Major Product Innovations by Banks since Deregulation (showing year of general availability)
1990 Mortgage Offset Account
1989 Payroll System
  Business credit cards
1988 Bankcard debit/credit card
  Enhanced retirement services
1987 Life insurance
  Fixed-rate mortgage lending
  Home banking
1986 Housing bonds
  Equity mortgage loans
  MasterCard ATM linkage
  ATM network links
  Packaged statement account
  Specialised agri-business and rural budgeting centres
  Telephone banking
  Cash management accounts
1984 Automatic sweep facilities
  Daily interest cheque account
1983 MasterCard
  Compounding term deposits
1982 Variable-repayment home loans
  Visa card for domestic and international use
  Reduced terms and minimum balances for term deposits
  PIN for credit and debit card access
1981 Monthly income term deposits Card (rather than passbook) savings accounts
1980 Automatic teller machines
Source: Australian Bankers' Association (1990)

There is no doubt that the choice and diversity of bank products and services available to consumers has increased markedly since deregulation. To begin with, there are more than twice as many banks as were in existence during the regulated era. The various submissions to the current Parliamentary inquiry[4] into the Australian banking industry are instructive on this point. Those submissions generally in favour of the performance of the banks since deregulation (excluding those of the banks themselves) cite the proliferation of new products as a benefit of deregulation. Those submissions critical of the banks and deregulation do not deny the widening of choice and diversity since deregulation but are less convinced of their advantages.

While it is true that consumers now have a wider range of banks and bank products to choose from, this would be less significant if consumers did not exercise their right to choose. One of the features of banks during the regulated era was their unwillingness to lend to other than their own depositors. Banks prized customer “loyalty” and rewarded it with access to scarce bank loans.[5]

Of course, the banks did not value loyalty as such, so much as the willingness of depositors to accept below-market rates of interest on their deposits and thereby to facilitate the payment of internal cross-subsidies to unprofitable lines of business. For the depositors' part, their “loyalty” was often merely a preparedness to accept poor returns on deposit balances for a time in the hope eventually of qualifying for a loan at controlled (i.e. subsidised) rates of interest.

Whatever the motivations of both parties, the practice served to undermine the consumer's freedom of choice. It was considered “disloyal” for bank customers to hold accounts with more than one bank. Indeed, banks were not above demanding that loan applicants close any accounts they might have with other banks or (worse still!) non-banks and transfer the balances in their favour as a precondition of granting a loan.

Thankfully, deregulation has put an end to this travesty of the “banker/customer” relationship. Banks now lend to the customers of other banks and non-banks. Moreover, market research commissioned by the banks reveals that each Australian adult uses an average of 1.92 financial institutions and that approximately 10 per cent of customers change their main financial institution each year (ABA (1990, paragraph 209)).

It is nevertheless true that some loyal (or misguided) souls continue to hold low-yielding deposits with banks when higher-yielding alternatives with identical or superior terms and conditions are available. The banks have done precious little to discourage this loyalty. More than a decade after the abolition of the ceiling which held interest rates on passbook savings accounts at 3.75 per cent per annum, the interest rate offered on such accounts by all but one of the major banks remains at that level.[6] In January 1991, the major banks held $8,364 million in such accounts, representing 4.3 per cent of their total deposits. This proportion has fallen since deregulation but only slowly.[7]

A further aspect of the changed culture of banking since deregulation is the greater decentralisation of bank administrative structures. In the regulated era, the rationing imperative required banks to decide centrally how the available supply of loanable funds would be allocated amongst the branches. In the words of the ANZ Bank's submission to the current Parliamentary inquiry:

“Head office carved up the bank's available lending and gave each manager a dollar amount to divide between the most deserving applicants” (ANZ (1991, p. 26)).

Since deregulation, there has been a devolution of decisionmaking authority within the large established banks to regional and branch managers. This has enabled the banks to respond more directly and sensitively to the needs of their customers. In particular, decisions can be based on an intimate knowledge of local conditions and clients have more direct access to senior management and specialist advice (ABA (1990, paragraph 258)).

(d) Does Greater Choice and Diversity Make Consumers Better Off?

The demonstrable widening of choice and diversity since bank deregulation has elicited three broad reactions from the consuming public. The first is that the enhanced choice and diversity is only skin-deep; behind the superficial hyperbole created by the advertising agencies lurks the same tired range of products and services.

This claim fails to stand up against the evidence. While it is true that the traditional range of products and services is still available (although not always on the same terms), these have been supplemented with new deposit and loan facilities which were unavailable during the regulated era – either because they contravened the regulations or because the banks saw no commercial advantage in offering them. Obvious examples in the retail arena include variable repayment mortgages, home equity loans, cash management accounts and electronic funds transfer at point-of-sale (EFTPOS). These products provide flexibility to retail customers which was undreamed of under regulation.

In the wholesale arena, examples include the gamut of treasury products – swaps, options, futures, etc. Indeed, the case for treasury risk management products being genuinely new is indisputable; the risks which they are designed to manage – including especially interest rate risk and foreign exchange risk – were largely unknown during the regulated era. Such risks were absorbed in changes to the size and/or composition of the central bank's balance sheet, reflecting its domestic and foreign exchange market operations.

The second reaction is not to claim that the wider choice and diversity are illusory but rather that consumers cannot take full advantage of the new options because there are obstacles to exercising freedom of choice. The obstacles are generally of two types: those erected by banks and those erected by governments. The former category includes loan application and/or establishment fees, administrative delays (both accidental and deliberate[8]) and inadequate or misleading information about product availability. Obstacles erected by governments include stamp duties, the onerous identification requirements imposed by the Cash Transaction Act and the Tax File Number system.

It is true that a choice which is too expensive to exercise or about which the potential chooser is ignorant is no choice at all. The incentive which a bank has to make it hard for its own customers to leave, or switch to more advantageous deposit or loan accounts, does not reign unopposed, however. It is counterweighed by the incentive the bank has to make it easy for the customers of another bank to leave that bank and to open an account of any type with it. Thus at least one bank has recently advertised its willingness to handle the transfer of accounts from any other bank to itself on behalf of potential customers. The end result of such competition is freer movement of customers amongst banks and the exercise of free choice.

As for fees levied on loan applications and the establishment of new loan accounts, such activities incur fixed costs in terms of labour and materials and it is appropriate that these be recouped through a lump-sum charge. Again, competition amongst banks for new loan business (including the existing business of other banks) can be relied upon to keep fees closely related to actual costs.

Attempts by governments to intervene in banks' affairs in the public interest, to impede tax evasion or illicit transactions or simply to raise revenue, certainly obstruct the exercise of free choice in the banking system; indeed, at least to some extent, they are designed to do just that. But neither bank deregulation nor deregulated banks can fairly be blamed for this outcome.

The third reaction of some consumers and/or their advocates to wider choice and diversity is to claim that they have too much of a good thing; there is now too much choice and diversity and consumers are confused and overwhelmed. This is partly a concern about the amount and quality of information available to consumers; there is not enough detailed information collated in a form which enables consumers to make fair comparisons amongst the myriad of different products on offer. It is partly also a lament over the loss of product standardisation; standardised products might be plain but they are easily understood by the aged, the poorly educated and non-English-speaking migrants.

Financial products are complex and it is difficult to make valid comparisons amongst a range of options, each with a wide variety of features. A case can certainly be made to prevent misleading advertising by banks and, to this end, “truth-in-lending” legislation, which requires all products to disclose certain standard characteristics (e.g. the effective or true rate of interest), can be justified. It can be to the banks' collective advantage to make comparisons difficult; but, individually, each bank has an incentive to make its own product as intelligible and acceptable as possible. Moreover, financial advisers, consumer advocates and other “bank watchers” can exploit the opportunity provided by the general confusion to offer their own comparisons and recommendations. Examples include the detailed comparisons of Taylor (1991) and more limited surveys published by Freeman in the Sydney Morning Herald and by Choice magazine.

While standardised products may no longer be offered on the same terms as they once were, there is no evidence of their withdrawal from the market. No consumer has been forced by the advent of greater diversity to choose more complex products than he or she consumed during the regulated era. The set of products and services now on offer includes the traditional ones as a proper sub-set. Elderly folk who cannot operate an ATM or commit a PIN to memory can continue to operate a standard passbook account, depositing and withdrawing cash via a flesh-and-blood teller during normal banking hours. Even such customers as these, however, have benefited from longer banking hours, shorter teller queues and, at least in some cases, higher rates of interest since deregulation.

So long as traditional options are not ruled out by new developments, it is hard to see how anyone could claim to be worse off as a result of the wider choice and diversity in bank products and services. At worst, consumers might be no better off; but the widespread use of the new products and services indicates that this cannot be true of all consumers. Even if a consumer is unable or unwilling to exercise choices, their existence in principle cannot detract from his or her current level of satisfaction (unless, like Ulysses strapped to his mast, the Siren song of choices unexercised is almost too much to bear!). And if the choices do not exist in reality but only in the minds of enthusiastic bankers and other supporters of deregulation, again, this cannot make a consumer worse off; except, perhaps, by teasing him or her with visions of life in a different world.

3. Gainers and Losers

Consumers as a group gained from deregulation because of the greater choice and diversity of bank products and services which deregulation allowed. But greater choice and diversity were not the only outcomes of deregulation. The more open, competitive environment ushered in by deregulation forced banks to reduce substantially, or cease altogether, the payment of internal cross-subsidies to particular classes of bank customer. Whether such customers have gained on balance from deregulation is hard to say; but it is clear that they lost, in some cases heavily, from the cessation of the subsidies.

(a) Why Cross-Subsidies?

Internal cross-subsidies arise when customers are charged prices which do not reflect the true marginal opportunity cost of the services they consume. During the regulated era, banks were constrained in their ability to charge prices related to true opportunity cost both by the regulations and by inter-bank agreements. Four distinct types of cross-subsidy arose:

  • from high-risk depositors to low-risk depositors;
  • from high-risk borrowers to low-risk borrowers;
  • from low-volume cheque-writers to high-volume cheque-writers; and
  • from urban customers to rural customers.

Cross-subsidies on the deposit side arose from interest rate ceilings and/or agreements affecting deposit and loan interest rates. The clearest instance occurred in savings banks. The main function of savings banks was to provide finance for owner-occupied housing. Ceilings were imposed on the interest rates they could offer on deposits and charge on housing loans.[9] Interest rates offered on savings bank deposits were generally below market rates, certainly towards the end of the regulated era. While all savings bank depositors paid the penalty of below-market interest on their deposits, only the lucky few would qualify for a housing loan at the controlled rate of interest. Those who did not qualify would be forced to borrow at commercial rates from trading banks or leave the banking system and borrow from a building society, life insurance company or directly from parents or the family solicitor.

The lucky few were those who could provide a substantial contribution of their own equity towards the house and whose ability to repay the loan was beyond question. These were, of course, the most financially secure of the savings banks' customers. Faced with a ceiling on the nominal rate of interest, savings banks ensured that the risk-adjusted rate was as high as possible by choosing borrowers who were least likely to default. Thus the less financially secure depositors of savings banks paid a “tax”, in the form of below-market rates of interest on their deposits, which helped to subsidise loans to the more financially secure. Of course, successful borrowers also paid the tax since they too were obliged to hold deposits with the savings banks at penal rates of interest; but they paid less than they would have done without the contributions of their less fortunate brethren.[10]

A similar but less dramatic effect arose from the imposition of a ceiling on the interest rate charged on small overdrafts from trading banks. This combined with the non-payment of interest on cheque account balances with trading banks gave rise to a transfer from more risky to less risky customers (including commercial customers) of trading banks. Small overdrafts were rationed to the most credit-worthy business customers (or those whose requests found favour for other reasons with the all-powerful branch manager) despite the fact that all cheque account holders paid to subsidise the overdraft rate by forgoing interest on their cheque account balances.

Ceilings on loan rates of interest were costly to banks. While most of the cost was passed on to depositors via the payment of below-market rates of interest on deposits (facilitated by the regulated ceilings on deposit rates), banks were also in a position, by virtue of market closure and limits on the growth of bank lending, to raise loan rates in uncontrolled market segments. A borrower who failed to qualify for a loan at a controlled rate of interest could attempt to borrow from the bank at uncontrolled rates. These rates were generally higher than they needed to be because of the impact of interest rate ceilings in controlled segments of the market.

Again, finance for housing provides the best example. Even borrowers who were successful in obtaining a subsidised loan from a savings bank often needed to “top up” their loans with additional finance. Savings banks rarely lent more than a specified maximum dollar amount to any customer, regardless of capacity to repay.[11] In such cases, customers were directed to the affiliated trading bank where they would be offered a personal loan at higher rates of interest. These rates of interest were higher, in part, because banks were obliged to charge below-market rates of interest on the remainder of their mortgage portfolios.[12] Of course, the wealthier a customer was, the less need he[13] had for supplementary finance, the balance being provided from personal sources.

Thus, on the loan side as well as the deposit side of the balance sheet, customers who did not qualify for a loan at controlled rates, or who qualified only in part, subsidised those who did. Given that risk was the overriding criterion determining who qualified for a subsidised loan, riskier borrowers subsidised less risky borrowers.

Apart from their traditional role as intermediaries between ultimate borrowers and lenders, banks also provide payments services. Indeed, banks as a group legally monopolise the right to issue cheques. Non-bank financial institutions and even some non-financial institutions produce payments services, including payment and money orders, in-house credit cards, travel and entertainment cards and electronic funds transfer. But only authorised banks draw cheques against themselves.

It is only in recent years that banks have begun to charge fees for cheque-payments services which bear any consistent relation to the cost of production. During the regulated era, to the extent that fees were charged at all, they did not vary with the number of cheques written nor did they come close to covering the full cost to the bank of providing the service. An important reason why banks under-charged customers for the use of cheque-payments services was that they were prohibited by regulation from paying interest on cheque accounts. Denied the ability to reward customers in cash (via interest payments), banks rewarded them in kind (via subsidised services).

But the value of the subsidy received by a customer in place of explicit interest depended on how intensively he or she used the service. Customers who made relatively few payments by cheque received a subsidy which was worth less than the explicit interest forgone on the amounts held in their cheque accounts. Such customers paid a “tax” to the banks which was used to subsidise the services consumed by other customers who wrote more cheques and who, as a result, received a subsidy greater in value than the explicit interest forgone on the balances of their accounts. Hence, low-volume cheque-writers cross-subsidised high-volume cheque-writers.

Why did the banks allow this to happen? There was no regulation which prevented them from designing an optimal structure of fees and charges for cheque usage. Two reasons suggest themselves. The first is that the banks had no incentive to adopt a rational pricing policy. The customers who funded the cross-subsidy had little choice but to accept the banks' arrangements if they wanted cheque-payments services at all. They could go nowhere else since the banks had a legal monopoly. In addition, it is expensive to institute a more elaborate pricing mechanism, and when the customers cannot “vote with their feet”, why bother?

The second reason is that the banks wanted to preserve the appeal of their alternative to the central bank's payments service, namely, currency notes. The banks had lost an earlier battle with the central bank (strictly speaking, the Federal government) when the banks' private issues of currency notes were nationalised and they were prohibited from competing with the central bank in the market for currency services. At that time, they hoped that the cheque would come to dominate as a payments instrument, especially since interest could be paid on the balances of cheque accounts but not on currency notes. Unfortunately for them, it was not long before they were prohibited from paying interest on cheque accounts. Determined to maintain their presence in the market for payments services – after all, the ability to transfer title to a deposit by cheque is a natural complement to intermediation and enhances the attractiveness of a bank deposit[14] – banks have subsidised the use of cheques. Those customers who have been content to hold idle balances in non-interest-bearing cheque accounts have generously helped to fund the subsidy.

But why didn't a more aggressive bank exploit the existence of cross-subsidies by offering the “taxpayers” a better deal and thereby winning their custom? The answer is to be found in the regulations. A bank could not reward customers who wrote few cheques, for example, with higher rates of interest on their cheque accounts since interest rates above the ceiling rate of zero were prohibited. The alternative was to offer higher rates of interest where they could be offered, namely, on term deposits. But this would only have attracted customers prepared to forgo the facility of writing cheques altogether, presumably a small constituency. Even low-volume cheque-writers wanted to write some cheques; otherwise they would have held term deposits in the first place.

Similarly, no bank could lure another bank's customers who failed to qualify for a subsidised housing loan with the promise of higher rates of interest on their savings bank deposits or a higher probability of receiving a subsidised loan. The ceiling on savings bank deposit interest rates precluded price competition amongst the banks and each bank rationed its available supply of subsidised housing loans according to the same criteria. A customer of one bank who failed to qualify for a subsidised loan at that bank would also fail to qualify at other banks. Each bank had a limited supply of subsidised loans and they were fully allocated to their own customers; there was no point in trying to win customers from other banks only to send them to the back of the queue.

More generally, banks had no interest in developing more flexible mortgage products which would assist a wider variety of customers into the housing market. Their problem was not a shortage of willing borrowers but rather a shortage of willing lenders prepared to supply funds to savings banks at controlled rates of deposit interest. If anything, the banks needed devices which would make it easier for them to decline requests for subsidised housing finance.

The fourth type of cross-subsidy is familiar to an Australian observer. Like the regulated domestic airlines, regulated banks were expected to maintain a presence in isolated rural communities irrespective of profitability. Noblesse oblige – the banks were protected by the government and it was only natural to expect them to show some social responsibility in return.[15] In practice, the cost of maintaining unprofitable branches in small rural locations was borne by customers of profitable branches in urban (or large rural) locations who received less interest on their deposits and paid more on their loans.

Had the banks refused to perform this wealth transfer, the government may have legislated for it anyway via income tax rebates and/or fiscal equalisation grants. In this case, the subsidy would at least have been paid by taxpayers in general and not urban bank customers in particular.

Like the other examples, urban/rural cross-subsidies were feasible only because regulations on banks, including, especially, market closure, enabled them to extract economic rent from particular groups of customers. This surplus could then be used to subsidise services provided to others at prices below marginal cost. It is no surprise that deregulation has seen the closure of many isolated rural bank branches. It is not that banks have lost their sense of social obligation but rather that the customers who bore the cost of the cross-subsidy will do so no longer.

(b) The Impact of Deregulation

Deregulation stripped away the regulatory basis of internal cross-subsidies in banks. Granted the freedom to offer and charge whatever rates of interest they chose and faced with the imperative to compete against each other and non-banks for funds, banks should have put an end to cross-subsidies.[16] In fact, there is evidence that the older established banks still have sufficient market power, in spite of deregulation, for cross-subsidies to persist.

The cross-subsidies are no doubt less substantial than they were during the regulated era. In particular, a number of groups who benefited handsomely from cross-subsidies no longer do so. These include the well-heeled, low-risk savings bank depositors who no longer have access to subsidised housing loans and the flourishing small businesses and rural investors who no longer have access to an overdraft at controlled interest rates. Then there are the high-volume cheque-writers, those who deposit and withdraw frequently from their accounts and the users of “free” ancillary services like regular account statements, periodic payments and safety-deposit boxes; their appetites have been curtailed by the imposition of fees and charges. Finally, those living in isolated communities have been faced more squarely with the true economic cost of their isolation as banks close down or consolidate their rural branches.

Of course, to match these losers from the unwinding of cross-subsidies are the gainers who are now relieved of the need to pay the associated “taxes”. For these folk – the generally less well-off depositors, the riskier borrowers, the low-volume transactors and the customers of urban branches – deregulation has meant the ability to obtain bank finance for housing and other purposes at lower rates of interest and simultaneously to be paid higher rates of interest on deposits, including current deposits. In other words, banks' interest margins have narrowed since deregulation and this is both a cause and an effect of the elimination of internal cross-subsidies.

Yet the move to rational pricing of bank services based on the principle of “user pays” is far from complete. Banks complain that customers who have long enjoyed services at subsidised prices resist the imposition of more realistic charges. Surely the more important question to ask is why banks can continue to pass on the cost of subsidising under-priced services to customers who do not use them.

A continuing source of revenue for cross-subsidising under-priced services is the tranche of “cheap” deposits still available to banks. In addition to deposits in low-interest passbook accounts, banks had $15,472 million of deposits in January 1991 (8 per cent of their total deposits at that date) on which they paid no interest at all. Some of the holders of these deposits consume under-priced services, the subsidy towards which is worth more to them than interest on their deposits. But this cannot be true of all such depositors. Why do the others continue to pay the “tax” when they receive little or no subsidy in return?

Whatever the reason, it is clear that banks, especially the older established banks, still have a degree of oligopoly power in the market for deposits which works to their advantage. The advantage is eroding steadily but is still significant more than a decade after the initial moves to deregulate banks were taken. More and tougher competition is the only force which can eliminate market power in the long run. In this context, the government should remove remaining barriers to the entry of foreign banks into the Australian market and allow them to establish operations as branches rather than exclusively as wholly-owned subsidiaries.

Deregulation will never completely eliminate cross-subsidies. Banks, like other firms, have fixed costs of production which are difficult if not impossible to attribute. But deregulation has changed the culture of banking from one in which cross-subsidies were ignored or even encouraged by interventionist governments to one in which banks are under increasing pressure to relate their fees and charges more closely to the true costs of production. This cannot fail but contribute towards a more efficient and a more equitable banking system.

(c) Deregulation and Bank Risk – the Ultimate Cross-Subsidy

Banks under regulation eschewed risk. Their status as rationers of funds on behalf of the central bank enabled them to take their pick of potential borrowers. Controls imposed on the interest rates they could charge on loans meant that, for the most part, the borrowers they favoured were those with the least risk of default. Moreover, interest rates and the exchange rate moved relatively infrequently and only in response to initiatives from the monetary authorities. The need to manage interest rate and exchange rate risk was non-existent. Even liquidity risk was “insured” by the central bank through the LGS mechanism and the lender-of-last-resort facility.

In the regulated era, risk in the banking system was largely absorbed by the central bank and indirectly borne by the taxpayers of Australia. Nowhere was this more evident than in the foreign exchange market, especially towards the end of the managed exchange rate regime. Losses incurred by the central bank in its attempt to stabilise the exchange rate were substantial and eventually accrued to consolidated public revenue.

Deregulation exposed banks to greater risk. Financial prices became more volatile and banks had to worry about funding their asset portfolios. In addition, competition induced banks to venture further along the risk spectrum in their lending than they ever had need to under regulation. Borrowers who would never have obtained bank finance under regulation were suddenly fêted by bankers keen to lend them money.

The difficulty, of course, was that banks had little knowledge or experience of the proper assessment and management of risk. Moreover, their attempts at the same time to devolve decision-making responsibility away from head office towards the branches further exposed them to the perils of ignorance and inexperience. The result was an escalation in loan losses and bad debts which is now legend. Some increase was bound to occur as banks took on a riskier profile; this much was to be expected, indeed welcomed, as a by-product of greater entrepreneurship in banking consistent with increased competition. But there is general consensus that the transition was poorly managed and efforts are under way to enhance the risk-management skills of bank staff through extensive training programs.

It is instructive to ask who gained and who lost from the increased riskiness of banks. Deregulation essentially transferred risk from the central bank and the government (i.e. taxpayers) to banks. Thus taxpayers gained and the existing shareholders, managers and depositors of banks lost.[17] Part of the value of the regulations to banks was the protection they afforded against risk. The value of the risk so absorbed was a subsidy from the taxpayers of Australia to the owners, managers and customers of banks. When banks were deregulated, this subsidy was lost.

Acknowledging the increased riskiness of banks since deregulation, the central bank has moved to protect the interests of depositors by imposing tighter capital adequacy requirements on banks. Strictly speaking, the central bank has no mandate to protect the shareholders and managers of banks. In practice, however, there is a strong temptation for central banks to view some banks as “too big to fail”.

It is vital in a deregulated system that this temptation be resisted. If the shareholders and managers of a deregulated bank are led to believe that they can enjoy the higher returns available in a deregulated market without the attendant risks, the ultimate and most destructive kind of cross-subsidy occurs in which taxpayers make a gift to the shareholders and managers of a bank of a put option on its market capitalisation.

4. Summary and Conclusion

The enhanced choice and diversity in bank products and services is one of the success stories of deregulation. Economists measure welfare improvements by estimating the increase in the size of consumers' choice sets. By this criterion, consumers as a group have benefited unambiguously from bank deregulation – even if they continue to consume the same bundle of bank products and services as before.

The evidence on internal cross-subsidies is encouraging but less conclusive. The most overt cross-subsidies due to regulation have been eliminated or at least ameliorated, leading to losses for the former beneficiaries and gains for the former “taxpayers”. There remains a significant capacity, in spite of deregulation, for the older established banks to “tax” certain classes of depositors and cross-subsidise users of services which, though now priced, are still priced below true marginal opportunity cost. In recent times, the larger banks may also have used their “tax revenue” to cross-subsidise wholesale lending during a particularly difficult period in wholesale markets. More time is required for the competition unleashed by deregulation to reduce cross-subsidies to the bare minimum consistent with non-attributable fixed costs. Meanwhile, the government should consider removing remaining barriers to the entry of foreign banks – in particular, by allowing them to establish operations as branches – in order to focus additional competitive pressure on banks.

Nevertheless, bank customers are clearly the big winners from deregulation: these include depositors, who now enjoy a wider menu of products to choose from and, for the most part, receive a more realistic reward for the use of their funds; and borrowers, who now have more ready access to bank finance, albeit at market rates of interest, and encounter a more co-operative and imaginative spirit amongst the banks.


National Australia Bank Professor of Monetary and Financial Economics, and Acting Director of the Institute of Applied Economic and Social Research, The University of Melbourne, Parkville.

The author would like to thank Jurgen Eichberger and Judy Taylor for helpful discussion and comments on this paper. [1]

This evolution is ably described by Giblin in his, Growth of a Central Bank (1951). [2]

See Grenville (1991), this volume. [3]

The inquiry is being conducted under the auspices of the House of Representatives Standing Committee on Finance and Public Administration and is chaired by Mr Stephen Martin, M.P. It is due to present its report to the Parliament late in 1991. [4]

“Loyalty” was a necessary but not a sufficient condition to qualify for a bank loan. No matter how “loyal” a customer might have been, capacity to repay and/or supply substantial security was an overriding criterion. [5]

In March 1991, the National Australia Bank announced a rationalisation of its deposit products including the abolition of the old 3.75 per cent passbook accounts. [6]

In the 1990/91 Commonwealth Budget, the Federal Treasurer announced that the Department of Social Security would henceforth deem persons of pensionable age to have received an interest rate of 10 per cent per annum on balances held in passbook savings accounts for the purposes of means-testing the age pension. This was a deliberate attempt by the government to place pressure on the banks to raise interest rates on these accounts to more realistic levels. [7]

A submission by the Australian Consumers' Association to the Parliamentary inquiry into the banking industry alleges that banks, “ … may well fine tune their systems for prospective customers while ignoring the needs of departing customers” (Drake (1991, page 15)). The same submission quotes an article published in Choice magazine (September issue, 1990, page 30) which alleges delays of up to 14 days between the time a customer orders an account to be closed and the time the funds are finally transferred to a new account at another bank. [8]

Savings banks were also prohibited from offering current deposits (including chequeable deposits) and from making commercial loans. While deposits in savings bank passbook accounts were in practice withdrawable on demand, the regulations stipulated three months' notice of withdrawal in writing. [9]

The irony of this outcome is heightened when it is recalled that the ceiling on housing loan interest rates was instituted as a putative means of assisting the relatively less well-off into home ownership. [10]

Had they done so, their rationing criterion may have become too transparent for political comfort. [11]

This effect still operates today on account of the vestigial 13.5 per cent interest rate ceiling on mortgages written by banks before April 1986. Borrowers whose mortgages were written after this date are obliged to pay higher variable rates of interest to cover the negative funding gap experienced by banks as wholesale interest rates press against, or exceed, the 13.5 per cent ceiling. [12]

It is not appropriate to add “or she” since, as noted above, banks rarely deemed women suitable candidates for housing loans. [13]

This point has not been lost on non-bank depository institutions who, to this day, continue to lobby the government and the central bank for the right to issue cheques. [14]

This view of banks as public utilities was aired most vocally during the heated debates over bank nationalisation in the late 1940s. It has surfaced again in submissions to the current Parliamentary inquiry into banking (see, especially, Carver (1991, page 8) who espouses a “social contract theory of banking”). [15]

Except, of course, the continuing cross-subsidy which results from the 13.5 per cent interest ceiling on housing loans written before April 1986, noted above. At least this subsidy is steadily eroding as the mortgages are progressively discharged. [16]

Of course, once the capital loss has been incurred, shareholders, managers and depositors of banks enjoy higher rates of return commensurate with the new higher levels of risk. [17]


Australia and New Zealand Banking Group Limited (1991), Submission to the House of Representatives Standing Committee on Finance and Public Administration Inquiry into the Australian Banking Industry, January 1991.

Australian Bankers' Association (1990), Australian Bankers' Association Submission to the Parliamentary Inquiry into the Australian Banking Industry, December 1990.

Carver, L. (1991), “Banking in the Public Interest: The Public Benefit Requirements of the Australian Banking Industry”, Submission to the House of Representatives Standing Committee on Finance and Public Administration Inquiry into the Australian Banking Industry on behalf of the Australian Consumers' Association, the Australian Federation of Consumer Organisations and the Australian Financial Counselling and Credit Reform Association, Part 3.

Drake, R. (1991), “Bank Competition and Consumer Choice”, Submission to the House of Representatives Standing Committee on Finance and Public Administration Inquiry into the Australian Banking Industry on behalf of the Australian Consumers' Association, the Australian Federation of Consumer Organisations and the Australian Financial Counselling and Credit Reform Association, Part 4.

Giblin, L.F. (1951), Growth of a Central Bank: The Development of the Commonwealth Bank of Australia 1924–1945, Melbourne University Press, Melbourne.

Grenville, S. (1991), “The Evolution of Financial Deregulation”, this volume.

Taylor, J. (1991), Submission to the House of Representatives Standing Committee on Finance and Public Administration Inquiry into the Australian Banking Industry, La Trobe University, Melbourne.