RDP 2013-15: Trends in the Funding and Lending Behaviour of Australian Banks 1. Introduction

Banks are first and foremost intermediaries between different agents in the economy. They facilitate transactions between these agents by providing a number of services. In particular, banks allow households, businesses and other organisations to transfer funds between each other through payment systems. Through the process of intermediation, banks convert savings into loans and in doing so change their characteristics, such as their maturity. As a result, banks must manage various types of risk, including liquidity and credit risk.

In undertaking intermediation, there are a number of ways in which the Australian banking system differs from many of its international counterparts. These differences have arisen from the interplay of a range of forces such as: the macroeconomic environment; household, business and financial institutions’ preferences; and the regulatory and tax framework. Gizycki and Lowe (2000) and Davis (2011) provide overviews of the evolution of the Australian banking system over the 1990s and 2000s.

This paper discusses how the Australian banking system differs from systems overseas, how it might evolve in the medium term and the potential implications. To do this, we start by focusing separately on bank funding and bank lending, before considering the implications for bank profitability.

On the funding side, one of the most obvious differences between the Australian banking system and its international counterparts is in the share of funding sourced from deposits. Deposits currently comprise just under three-fifths of Australian banks' funding liabilities. While this has increased considerably in recent years, it is below the share of funding sourced from deposits by many of their international peers (RBA 2012). The corollary of this is that wholesale funding currently makes up a larger share (about 35 per cent) of Australian banks' funding.

On the lending side, Australian banks tend to carry out more retail banking business than many of their international counterparts. To a large degree, this reflects their focus on lending to the household sector, rather than lending to the business sector, and the generally small scale of their investment banking activities. Davis (2011) notes that residential loans made up close to 60 per cent of Australian banks' total loan portfolios in 2009, but less than 40 per cent in the United States and Canada, and 15 per cent in the United Kingdom. The focus on housing lending has, in part, reflected a substantial increase in household sector leverage in Australia over the 1990s and early 2000s to a level consistent with that in most other advanced economies. This was facilitated by a larger decline in nominal interest rates in Australia, associated with a larger fall in inflation over the 1990s, and a gradual easing in credit constraints associated with both increased competition and financial deregulation (Kent, Ossolinski and Willard 2007). At the margin, the relatively low level of government intervention in the residential mortgage-backed securities (RMBS) market might have also contributed. Growth in business sector credit was more muted, largely as a result of the strong increase in external fund raising by businesses over the late 1980s, and businesses re-evaluating their gearing following the early 1990s recession.

The Australian banking system, in contrast to some other large banking systems, predominantly undertakes lending using variable rates. Unlike variable interest rates in a number of other countries, almost all variable-rate housing loans in Australia are set at the lenders' discretion, rather than as a margin over a benchmark. In Australia, between 1997 and mid 2007, advertised interest rates on mortgages broadly tracked movements in the cash rate. This reflected the stability of risk margins and lenders' funding costs relative to the cash rate. Despite this, the actual rate paid by borrowers continued to decline throughout this period, reflecting the increasing prevalence of discounts offered to new customers as lenders competed for new loans.

The Australian banking system has performed well for over two decades. Since 1993, the major banks' profits have grown at an average annual rate of about 15 per cent. Over the same period, these banks have recorded an average return on equity of about 15 per cent, which is roughly in line with the return on equity for other large domestic corporations, as well as banks in other countries prior to the global financial crisis. However, unlike many of their international counterparts, Australian banks did not suffer large falls in profits following the onset of the global financial crisis.

The rest of this paper proceeds as follows. Section 2 discusses the funding behaviour of Australian banks in more detail, exploring the historical drivers for their funding composition, recent influences on this composition, and how it may evolve. In a similar manner, Section 3 examines the historical influences on the lending behaviour of Australian banks and how it might change in the future. Section 4 discusses the implications of these changes for bank profitability and Section 5 concludes.