Topic 2 The financial services industry: depository institutions
Answers to end-of-chapter questions
1)
The financial services industry today is very different from that in 1950. In 1950, the financial
institutions (FIs) were more specialised, each offering a distinct set of products/services.
Today, however, the activities and products of the various FI types are more blurred, with
many overlapping functions and risks. The risks faced by modern FIs are becoming
increasingly similar because of this.
2)
Since the 1980s the number of banks has increased from 13 in 1985 to 63 in 2012. Moreover,
there are many foreign banks (either subsidiaries or branches), which make up 48 of the total
number of banks. However, while the number of banks has grown, there has been
considerable consolidation of the industry over the 30 years to 2012. Despite this, the industry
is highly concentrated.
Reasons for the changes are many and include the following. Many building societies gained
banking licences and most of these—plus other smaller banks—have been taken over by the
larger banks. The four major banks hold 77 per cent of all bank assets and 79 per cent of total
bank loans (as at January 2012). While there was intense competition for banks during the
1990s and early 2000s from building societies, credit unions and other mortgage originators—
particularly in the residential housing loan market—the competition diminished through the
global financial crisis (GFC).
The main reason for this was that as the GFC had been caused by the failure of appropriate
risk assessment of many mortgage-backed securitisation (MBS) programs, access to
securitisation markets essentially closed after 2008. As many of the smaller Australian
depository institutions (DIs) including building societies used securitisation for funding their
increasing asset base, they lost competitiveness as this source of funds dried up. Despite
government support for the MBS market and the same regulations for all DIs, banks were
perceived as safer institutions and they increased their market share of housing mortgages.
Moreover, the banks were also able to capture a higher proportion of deposits as Australian
households became more cautious and increased savings.
3)
Sources of funds:
local deposits
local wholesale funding (interbank funds)
international wholesale funding
equity (and other capital components).
Uses of funds:
loans and advances:
– home mortgages
– commercial loans
– bank accepted bills
– commercial bills
– promissory notes
– corporate bonds and debentures
interbank lending
securities including:
– government securities
– other bank securities
– corporate bonds
– securitised assets
foreign currency and foreign currency assets
cash and deposits with the RBA.
4)
The four major banks cover most financial services including retail banking, commercial
banking, investment banking, life and general insurance, and funds management. Regional
banks tend to operate in the retail market only—consumer and small business market.
The four major banks have a national focus and offer banking at corporate and retail levels,
not only throughout Australia but also through small operations overseas. Many of the
regional banks were building societies that converted to banks and thus tended to conduct
their activities within the confines of the region or state where they had traditionally operated.
More recently the regional banks have started to expand across state borders, moving away
from their traditional markets. Owing to their origins, the assets of the regional banks have
been predominantly in residential housing loans.
The large banks have enhanced their margins by offering a full range of services to retail,
small and large corporate customers, and through international diversification. Owing to their
size, global presence and reputation, they can access funds more cheaply than the regional
banks and can often offer funds to their customers at a slight premium because of the
additional services provided. The large banks also have greater access to the international
markets for funding because of their size and consequent reputation—which is often a key
factor in the Euro-markets for example.
6)
A trend in the structure of bank liabilities was an increased reliance on offshore wholesale
funding. In 2008 and the collapse of Lehman Brothers, credit markets essentially froze, as did
access to global funding markets. As nearly 25 per cent of bank funding came from offshore
lenders, Australian banks needed to attract more stable types of liabilities, such as domestic
deposits. The government introduced a number of measures to assist the banking (DI)
industry, including the Financial Claims Scheme and investment in local mortgage backed
securities. Prior to the GFC much of the funding for MBS had come from international
investors.
7)
Banks are improving the quality of their capital for two main reasons:
bank regulations require it—and emphasis common equity and increased capital
adequacy ratios for Tier 1 capital, as the lower quality forms of regulatory capital
were not effective in absorbing the many bank losses during the GFC
for global competitive reasons, banks have recognised that there is a need to
strengthen their capital base, knowing that many large banks failed during the GFC.
8)
Building societies were originally set up to pool small deposits from individuals and
households in order to finance mortgage lending. Residential home ownership was highly
desired by Australians and as it was difficult to obtain home finance from banks in the
regulated environment, building societies were able to fill the breach and thrived.
With the deregulation of banks and the growth of the securitised mortgage market, the value
of the intermediation function performed by building societies and credit unions (funnelling
small savings into home mortgage lending or shorter term lending) was eroded by
competition. Deregulation of the financial industry freed the banks’ capacity to extend home
loans to individuals, which resulted in increased competition from the banking sector, making
it more difficult for NBFIs to survive in their previous form.
As a result many smaller societies and credit cooperatives have merged, while larger building
societies converted to banks, allowing them to offer more services (although more recently
building societies have been able to expand the range of services on offer) and giving them
instant access to clearing house funds. This conversion from building society status to bank
status resulted in an overall loss in market share for building societies.
9)
The two types of non-bank DIs in Australia are building societies and credit unions.
Generally, both began life as cooperative organisations, regulated under state or territory
legislation (building societies increasingly now have issued share capital). However, with
regulatory restructure in the late 1990s, both are now regulated in the same way as the
banks—by APRA. Credit unions tend to provide retail finance and their members are usually
linked by a common bond such as an employer or profession, which is not the case with
building societies. While credit unions have moved into longer term lending and specifically
into housing loans, building societies have always focused on longer term lending. Now, the
difference between the two groups in lending maturity is now far more blurred than when
originally established.
Banks are the third type of DI in Australia and are far larger than building societies or credit
unions. Banks also operate in a far broader range of financial services than either building
societies or credit unions, as they can leverage their size and distribution networks effectively.
They operate in retail, commercial, investment banking as well as insurance and funds
management. All Australian depository institutions are regulated by APRA in the same way.
10)
The regulation and supervision of Australian FIs is guided by APRA's Australian Prudential
Supervision Framework, developed in 2003–4. The Framework requires the identification of
FI risks and then provides for supervisory action by APRA to keep the FI's risks at a level that
APRA deems appropriate. Since its introduction, the Framework has evolved to incorporate
new risks, changing environments and changing international standards. The scope of APRA's
supervisory framework is broad and covers all activities, supporting procedures, processes,
systems and guidelines that are necessary to form risk assessments and supervision strategies.
There are five parts of APRA's Framework for prudential supervision: supervision outcomes
and responses; entity risk assessment; supervisory activities; supporting material and
infrastructure; and quality assurance within the framework.
12)
The regulation of DIs covers a number of areas, but principally, the focus is on capital,
liquidity and credit risk management. The objective of regulation is to ensure the stability of
the banking system and the protection of depositors.
Revision Questions 2.2
1)
Life General Super Cash Money Finan Securitis
insurer insurer fund magnt market ce ation
trust corpora compa vehicles
tion ny
Liquidity
risk
Operation
al risk
Underwrit
ing risk
Interest
rate risk
Derivativ
e related
risks
Default
risk
4)
The majority of depository institutions’ liabilities are short term, while the majority of a life
insurance company’s liabilities are long term. Banks have both short-term and long-term
assets, but need to hold short-term assets to meet liquidity needs. Insurance companies match
their long-term liabilities with an emphasis on longer term assets.
Historically, both groups used their funds to finance an asset portfolio made up of debt
securities, but insurance companies have been increasing their holdings in equity at the
expense of debt since the 1960s. Banks generally do not hold equity securities in large
proportions. A similarity between the two groups is in the high degree of financial leverage.
Life insurance companies access sources of funds (from policyholders) in much the same way
as depository institutions obtain deposits. Money market corporations’ liabilities tend to be
more like those of banks—relatively short term. However, the assets of money market
corporations also tend to be short term in nature. Unit trusts, on the other hand, have longer
term asset and liability structures.
5)
Insurance companies earn profits by taking in more premium income than they pay out in
terms of policy payments. They can increase their spread between premium income and
policy payout in two ways. One way is to decrease future required payouts for any given level
of premium payments. This could be accomplished by reducing the risk of the insured pool
(provided the policyholders did not demand premium rebates that fully reflected lower
expected future payouts).
The other way is to increase the profitability of interest income on net policy reserves. Since
insurance liabilities are typically long term, the insurance company has long periods of time
to invest premium payments in interest-earning asset portfolios. The higher the yield on the
insurance company’s investments, the greater the insurance company’s profitability. Since
junk bonds offer high yields, they offered insurance companies an opportunity to increase the
return on their asset portfolio.
6)
General insurance is principally a short-term product—that is, the claims or liabilities are
short term in nature. In contrast, life insurance products are usually at least 10 years in
duration and liabilities may be much longer than this, depending on the type of product.
Consequently, general insurance companies tend to have more quality debt securities that can
easily be liquidated and shorter term assets. Life insurers have a higher proportion of ‘growth’
type assets, such as equities, and debt securities are likely to have a longer maturity profit.
7)
Type of institution Main supervisor/ regulator
Money market corporations (merchant banks) ASIC
Finance companies (including general financiers ASIC ([Link]/fin-stability/fin-
and pastoral finance companies) inst/[Link]#b)
Securitisers
Life insurance companies APRA ([Link]/fin-stability/fin-
inst/[Link]#d)
General insurance companies ([Link]/fin- APRA ([Link]/fin-stability/fin-
stability/fin-inst/[Link]#f) inst/[Link]#d)
Superannuation and approved deposit funds APRA
Public unit trusts ASIC
Cash management trusts ASIC
Friendly societies APRA
8)
Superannuation represents the second most important source of wealth generation for
Australian households behind the family home. Superannuation funds manage funds saved
throughout an employee’s working life with the aim of providing the employee with a
retirement income. Contributions to superannuation funds are usually made by both
employees and their employers. Compulsory superannuation was introduced in 1992 and
employers are required to contribute 9 per cent of employee salaries to their superannuation.
Incentives for both employees and employers to increase superannuation above the regulated
minimum has led to annual double-digit asset growth, although the equity market volatility
during the GFC impacted asset growth from 2008 to 2011.
9)
The similarity is the prominence of managed funds in their product range. Public unit trusts
are publicly offered managed funds. Within superannuation there are many managed funds,
some public and some corporate or industry related. Life insurance companies offer managed
funds as a part of their suite of financial services.
10)
The shadow banking system is made up of FIs that are not regulated by APRA—such as FIs
like the money market corporations, finance companies and securitisation vehicles.
11)
Money market companies have traditionally been called merchant banks. In 2012, however,
APRA revoked the use of the term ‘merchant bank’ to avoid confusion by customers who
may have difficulty distinguishing between APRA regulated banks (which operate under the
force of the Banking Act 1959 (Cth) and have deposit insurance in terms of the Financial
Claims Scheme) and non-APRA regulated money market companies.
12)
The main business activity of finance companies is lending, representing 75 per cent of total
assets—lending to small business and households is the main focus. Finance leases
represented 25 per cent of finance company activities in 1985, but had fallen to only 7 per
cent by 2011, whereas lending to business and households had increased from 60 per cent to
66 per cent in 2011.
