DRAFT

26 July 2019; 4:30 PM; Word Count: 5926 1

The Changing Nature of Banking in Australia

Marcus Miller and David Norman

1. Introduction

The 2008–09 global financial crisis (GFC) was a watershed moment for banking globally. Banks in a wide range of

countries either failed or required extensive government support due to their exposure to poor quality assets,

excessive leverage and insufficient liquidity buffers.

The inadequacies exposed by the GFC prompted investors and regulators across the world to demand significant

changes in the way banks operated. As investors’ appetite for risk changed, the pricing of various risks adjusted, with

some portion of that still persisting a decade later. The Basel Committee for Banking Supervision (BCBS) also

substantially adjusted the global minimum regulatory standards for the industry through the introduction of the

‘Basel III’ rules. These changes have compelled banks to adjust both their assets and liabilities – including equity –

to increase their resilience.

The subsequent changes in the structure and operation of banks globally have been profound. These changes are

comprehensively discussed in a report by the Committee on the Global Financial System (CGFS 2018). The CGFS

identifies at least six key changes occurring over the past decade: a decline in banking activity relative to economic

output; a shift away from complex activities (such as derivatives trading and other investment banking) towards

more traditional and capital-light business; a strengthening of balance sheets (through lower leverage and less

maturity transformation); increased competition from new entrants; lower profitability and growth in traditional

banking hubs; and increasing cross-border lending by emerging economy banks.

Much of this adjustment has occurred in response to changes in investor preferences and the introduction of

Basel III. However, some of the structural changes in global banking have been driven by other factors. For example,

the widespread misconduct in investment banking leading up to the crisis has resulted in significant shifts in what

international banks are permitted to do, the way they are allowed to remunerate their staff and the emphasis that

regulators place on culture. Improvements in digital technology have also had important impacts on the way that

banking is conducted and the entities that do it. And an accelerating shift in economic power from the ‘old world’ to

populous countries in the developing world (most notably China) has also contributed to shifts in banking power.

The Australian banking sector has been affected by many of these same structural changes over the past decade,

despite domestic banks emerging less scathed by the GFC than their international peers.1 While Australian banks did

not suffer from the same excesses as others, the recognition that they could in future face larger shocks than they

did and the need to assure creditors of their continued credit worthiness mean they too had to reduce their leverage

and increase their resilience to liquidity shocks. Moreover, as a member of the BCBS, Australia has been committed

to implementing changes to the global minimum standards.

Atkin and Cheung (2017) discuss the ways in which the subsequent regulatory response influenced the shape of

banking in Australia. This paper extends that work by taking a broader view, covering not just the way in which

regulation has reshaped Australian banking but also how increased digitisation, shifting economic power and an

emerging focus on culture have contributed. We document how these influences have seen banks make large

adjustments to the composition of their assets and liabilities, reduced profitability at the same time as raising the

* The authors are from the Financial Stability Department of the Reserve Bank of Australia. 1 Australian banks were not unaffected: considerable liquidity support was provided by the Reserve Bank of Australia (Debelle

2010), while the Federal Government offered funding guarantees; (Reserve Bank of Australia 2009; Schwartz and Tan 2016).

The Changing Nature of Banking in Australia

26 July 2019; 4:30 PM; Word Count: 5926 2

cost of financial intermediation, and given rise to new forms of risk (particularly cyber risk) and competition. We also

highlight the changing nature of participants in the Australian banking system, as Asian banks have rapidly increased

their share of business banking.

The paper is structured as follows. The next section discusses the key influences on banking over the past decade.

Section 3 then considers how these influences have played out in changing balance sheets, profitability, industry

composition and market functioning. Section 4 then considers emerging influences that are likely to contribute to

further structural change over coming years.

2. Key influences in banking since GFC

The structural changes that have occurred over the past decade are the result of a combination of influences. Many

of these were themselves a reaction to the GFC, while others have had their origins elsewhere.

A re-evaluation of investor preferences was the most immediate driver of change in banking as a result of the GFC.

There was a marked, but temporary, reduction in the risk investors were prepared to accept, and a more persistent

change in perceptions of the riskiness of the banking sector following the crisis. This initially led to the severe

dislocation of funding markets observed in 2008, as questions were raised over the solvency of banks and liquidity

was hoarded, resulting in large spike in the cost of funding. But even after the period of market stress subsided, the

changed perception of bank risk resulted in funding cost premia remaining structurally higher than before the crisis

(Graph 1). While this has been true across a range of wholesale funding sources, it was most marked for residential

mortgage back securities because of their role in propagating the weakness in US housing markets to the broader

financial system during the GFC. These changes in relative prices have incentivised banks to adjust their debt funding

mix. They have also encouraged deleveraging to assure investors of their credit-worthiness.

Graph 1

The initial impetus to change coming from investors was subsequently underpinned by the regulatory response to

the crisis. There had already been a step towards better regulation with the adoption of Basel II in Australia in 2008.2

However, the introduction of the Basel III accord, which was finalised in 2011 and progressively implemented over

2 The main focus of Basel II was on improving the measurement of risk-weighted assets, including by broadening the focus of

capital adequacy beyond credit risk.

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subsequent years, drove this further.3 The Basel III standards focused on three main weaknesses highlighted during

the crisis: capital; liquidity; and interconnectedness.

Improved capital standards are at the heart of the Basel III reforms. These capital reforms mostly came into effect

in Australia at the start of 2013. They involved raising minimum capital requirements, in light of the losses witnessed

internationally during the crisis being much larger than was previously believed to be feasible. The minimum Tier 1

capital requirement increased from 4 to 6 per cent of risk-weighted assets, and banks were required to hold capital

buffers over this minimum during normal times (Table 1). The reforms also tightened the definition of capital, in

recognition that some instruments previously classified as regulatory capital were not available to absorb losses

during the financial crisis (Reserve Bank of Australia 2013). Most notably, a new definition of the highest quality

form was capital was introduced, Common Equity Tier 1 (CET1) capital. Banks are now required to hold a minimum

of 4½ per cent of risk-weighted assets in CET1 capital. The definitions of non-common equity capital instruments

(additional Tier 1 and Tier 2 capital) were also tightened to ensure these instruments had well-defined processes for

conversion to CET1 or write-off during a crisis. And Basel III also introduced a non-risk-adjusted capital requirement

(the leverage ratio). APRA’s implementation of these standards in Australia were more conservative than the Basel

III standards, and several of the requirements were fully introduced earlier.4 APRA’s capital framework has since

continued to strengthen, independently of the Basel agreements. Most notably, major banks will be required to hold

CET1 capital (including various buffers) of 10½ per cent (at current risk-weights) by the start of next year (Australian

Prudential Regulation Authority 2017).

The liquidity shortage during the crisis also highlighted the need to regulate how banks managed their liquidity, as

this was not included in previous Basel standards. In response, two separate liquidity requirements were introduced

to reduce the risk of liquidity shortfalls. The liquidity coverage ratio (LCR), which came into effect in 2015, requires

banks to hold sufficient high-quality liquid assets (HQLA) that could easily be liquidated if required to meet banks’

cash outflows during a 30-day liquidity stress event (Reserve Bank of Australia 2015).5 The Net Stable Funding Ratio

(NSFR), which became binding in 2018, was added to encourage banks to better match longer-duration assets with

more stable sources of funding. APRA implemented these reforms in the same manner as the rest of the world,

other than to implement the LCR without a phase-in period.

Table 1: Basel III Reforms and Australian Implementation

Basel III Capital Australian implementation Implementation date

Global Australia

CET1 minimum: 4.5% CET1 minimum: 4.5% 2013-2015(a) 2013

Capital conservation buffer: 2.5%

G-SIB(b) surcharge: 1.0-3.5%

Capital conservation buffer: 2.5%

D-SIB(b) surcharge: 1.0%

2016-2019(a) 2016

Leverage ratio: 3% IRB(c) banks: 3.5%

Standardised approach banks: 3%

2018-2022 2022

Basel III Liquidity

Liquidity Coverage Ratio: HQLA ≥ 100% of potential net cash outflow 2015-2019(a) 2015

Net Stable Funding Ratio: Available stable funding ≥ required stable funding

2018 2018

Notes (a) Phased in from 3.5 to 4.5 per cent (CET1), 0.625% to 2.5% (CCB) and 60-100% (LCR) globally; no phase in in Australia. (b) Global/domestic systemically important banks (c) Banks using the internal ratings-based (IRB) approach to credit risk management. Sources: APRA; BCBS; RBA

3 For a more comprehensive summary of post-crisis regulatory changes, see Yuksel (2019). 4 For details on the areas of conservatism in APRA’s framework, see Australian Prudential Regulation Authority (2015). 5 HQLA are securities that offer either ‘undoubted’ or ‘proven’ liquidity during periods of stress. In Australia, this includes cash,

central bank reserves and the highest quality sovereign bonds or semi-government securities.

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Other parts of the regulatory response have received less focus, but have still be very important. Concerns around

excessive interconnectedness encouraged the Basel Committee to strengthen limits on the exposures that banks

could hold to individual counterparties, particularly other banks. There have also been efforts to strengthen

supervision, following the more ‘hands off’ approach to banking supervision that was common to many banking

jurisdictions pre-crisis (presuming market forces would discipline banks). This includes greater reporting of data to

supervisors and a requirement for supervisors to approve contingency plans for various cases of bank stress. ‘Pillar

III’ of the Basel standards, which was introduced under Basel II and emphasises market disclosure requirements, was

also strengthened under Basel III. This requires banks to publicly disclose their compliance with Basel capital and

liquidity requirements, to provide investors with greater transparency.

A third influence on the Australian banking system, and the economy more generally, has been the growing

economic importance of Asia. This region has been growing at a much faster pace, and was less affected by the GFC,

than the United States or Europe, which historically created most of Australia’s financial linkages. A striking indicator

of how this has changed banking globally can be seen in the rising share of global banking assets held by Asian banks

(Graph 2). These banks have not only been growing rapidly, but the large current account surpluses run by many of

these nations have meant that a high proportion of their funds have been invested offshore.

Graph 2

Alongside these developments, rapid improvements in technology have also contributed to major changes in the

banking industry. Faster internet and smartphones have enabled more banking to be done online, reducing demand

for in-branch banking services and, in turn, barriers to entry within the sector. The increased availability of data and

ability to analyse it, along with rising regulatory expectations for reporting and risk management, have also changed

how banks perform their back-office tasks. These developments have both compelled and encouraged banks to

make sizeable investments in technology that are having a profound influence on how they operate.

Finally, there has been an increased focus on issues of culture and accountability within banks. Globally this has been

a focus for most of the past decade but in Australia it has arisen more recently. This has been most prominent in the

Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, though APRA’s

Prudential Inquiry into the Commonwealth Bank of Australia and subsequent self-assessments of other institutions

have also been very important.

3. Impact on the Australian banking system

3.1 Balance sheet composition

Banks have significantly de-leveraged their portfolios in order to comply with higher post-crisis capital requirements.

The banking systems’ combined Tier 1 risk-adjusted capital ratio is now more than 50 per cent higher than it was

The Changing Nature of Banking in Australia

26 July 2019; 4:30 PM; Word Count: 5926 5

before the financial crisis (Graph 3). Just over half of this increase has been due to capital accumulation outpacing

asset growth, with the remainder due to a lower average risk weight, so major banks’ leverage ratios have risen by

around a third (Graph 4). This accumulation of capital has come from a mixture of retained earnings, dividend

re-investments and fresh share issuances in 2008/09 and 2015 (Atkin and Cheung 2017). The banks have also

recently received a boost to capital (with more expected) from the sale of insurance and wealth management assets,

though this comes as the expense of future profit.

Graph 3

Graph 4

In theory, higher capital ratios should reduce banks cost of equity (COE) because it lowers the risk and volatility of

returns. However, Sarin and Summers (2016) show that this has not happened internationally; market measures of

bank risk globally have been stable or risen, despite the stricter post-crisis regulation. This is also evident in Australia.

The implied equity risk premium for banks, measured by bank equity forward earnings yields relative to the risk-free

interest rate, remains well above its pre-crisis level and has drifted up over the past five years (Graph 5; Norman

2017). This drift is in stark contrast to the equity risk premium on other ASX-listed stocks, leading to a material

difference in the COE for banks and other stocks that is historically unusual. The higher forwards earning yield likely

reflects an increase in perceived uncertainty around bank future earnings for which investors require compensation,

though it is not simple to explain the ultimate source of this uncertainty. Earnings yields have moved higher for bank

stocks globally, suggesting that any explanation for this increased uncertainty has a global dimension.

Graph 5

201420092004199919941989 20190

4

8

12

%

0

4

8

12

%

Banks’ Capital Ratios*Consolidated global operations

Total

Tier 1

Tier 2

CET1

Per cent of risk-weighted assets; break in March 2008 due to the

introduction of Basel II for most ADIs; break in March 2013 due to the

introduction of Basel III for all ADIs

Source: APRA

201420102006 20182

3

4

5

6

%

2

3

4

5

6

%

Major Banks' Leverage Ratio*Consolidated global operations

Estimated prior to September 2015 as Tier 1 capital as a per cent of

assets; break in March 2008 due to the introduction of Basel II; break

in March 2013 due to the introduction of Basel III

Sources: APRA; Banks' Regulatory Disclosures; RBA

201520112007 2019-2

0

2

4

6

8

%

-2

0

2

4

6

8

%

Forward earnings yieldSpread to 10-year Australian Government Bond

ASX200 Banks

ASX200 ex banks

Sources: RBA; Refinitiv

The Changing Nature of Banking in Australia

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The requirement to hold more capital against assets has also sharpened banks’ focus on capital efficiency and

protecting their return on equity (ROE). Previous research shows that banks have long focussed on ROE as a key

performance metric, rather than earning per share as do non-financial companies (Pennacchi and Santos 2018).

Further, banks react when ROE falls below target levels (often by increasing leverage; Haldane 2011, Adrian and Shin

2014). As higher capital requirements have lower ROE, ceteris paribus, there is evidence that Australian banks have

similarly reacted by adjusting the balance sheet to protect returns.

One way that this has happened is by steadily increasing the share of lending going to residential mortgages, which

attracts relatively low risk-weights (Graph 6; Graph 7). This change has been underway for a long time, and has

primarily been driven by stronger borrowing demand from households than from business, along with a greater

liberalisation of consumer lending in the late 1980s and early 1990s (including because of the structural fall in

inflation). However, banks competed for this additional mortgage demand because of the superior returns on equity

that housing lending has provided (relative to other assets), given that the lower risk weight applied to mortgages is

not fully offset by narrower credit spreads. Likewise, banks have progressively shifted the composition of their

corporate loan book towards lower risk lending since the GFC (Graph 7). These adjustments are consistent with the

historical behaviour of banks globally; the literature shows that when banks are short of capital, they tend to meet

requirements by adjusting their portfolio towards lower-risk assets, in preference to raising additional capital

(Kanngiesser et al 2017; Imbierowicz, Kragh and Rangvid 2018).

Graph 6

Graph 7

Another way that banks have sought to preserve ROE while reducing leverage has been to divest some low return

businesses. (A secondary consideration has been a desire to reduce complexity and operational risk – in line with

banks globally.) This has seen the major banks divest a number of lower-return overseas banking subsidiaries in

recent years. Most notably, NAB divested Clydesdale in the UK and ANZ has divested a range of banking businesses

in Asia (Graph 8). In some cases, these businesses had been underperforming for a long time, and the need to tighten

capital efficiency provided the impetus to address that. The major banks have also been divesting their life insurance

and wealth management subsidiaries, with the sale of some of these businesses still underway. Many (though not

all) of these businesses also typically operated with lower ROEs. Large remediation costs for misconduct in these

businesses over the past year have highlighted the additional risks from these operations and so strengthened the

business case for their sale. 6

6 Misconduct-related fines have exceeded $4 billion for the major since 2015.

March 2008

December 2018

0 10 20 30 40 %

Other*

Life insurance

investment

Other international

NZ lending

Business

lending (Aus)

Household

lending (Aus)

Liquid

assets

Australian-owned Banks’ AssetsShare of consolidated assets

Mainly comprising derivatives

Sources: APRA; RBA

20172015201320112009 201910

30

50

70

%

10

30

50

70

%

Average Risk WeightMajor banks, on-balance sheet, internal ratings-based approach

Corporate

Other lending

Mortgage*

Break in mortgage risk-weights in September 2016 reflect changes

made by APRA to the way these weights are calculated

Sources: APRA; RBA

The Changing Nature of Banking in Australia

26 July 2019; 4:30 PM; Word Count: 5926 7

Graph 8

Other adjustments to banks’ asset allocations have been driven by the new Basel III liquidity requirements. In

particular, banks have significantly increased their holdings of HQLA to meet the requirement of the LCR, with the

later introduction of the NSFR supporting this. Australian banks’ allocation to HQLA is now three times larger than a

decade ago, reflecting increased holdings of both Australian government and semi-government securities (Graph 9).

The adjustment in HQLA would have been even larger had the RBA not introduced the Committed Liquidity Facility

(CLF) in 2011 to mitigate the likely shortfall of Australian government securities (Debelle 2011). The NSFR is also

likely to have impacted the composition of other assets by incentivising banks to hold assets with a lower required

stable funding ratio, but it is difficult to separate this from other drivers.

Graph 9

The Basel liquidity requirements, in combination with changing investor preferences, have also caused banks to

adjust their funding composition. The share of funding that is sourced from short-term wholesale funding fell sharply

in the immediate aftermath of the crisis, and has since remained a much smaller share of total funding (Graph 10).

This was largely in response to a re-assessment of the riskiness of short-term funding after the crisis by both banks

and markets, which increased the risk premium on short-term funding and reduced bank demand. However, this

was subsequently reinforced by the LCR and NSFR, which give more favourable weighting to long-term and deposit

funding. Initially the decline in short term debt was replaced with both domestic deposits and long-term debt (with

the latter supported by a temporary government guarantee; see Schwartz and Tan, 2016). The initial lift in deposit

funding came mainly through increased term deposits, as banks sharply increased the interest rate offered on these

20172015201320112009 20190

2

4

6

%

0

2

4

6

%

Australian Banks' AUD HQLA SecuritiesShare of total assets, domestic books

AGS

Semis

Total

Sources: APRA; RBA

The Changing Nature of Banking in Australia

26 July 2019; 4:30 PM; Word Count: 5926 8

deposits (Graph 11, Graph 12). Over time, banks have shifted towards greater use of transaction account deposits

and linked savings account, which are cheaper sources of funding that receive comparable LCR and NSFR treatment

due to their stickiness (Berkelsman and Duong 2014).7 They have also sought to extend the average maturity of their

long-term wholesale debt since 2012, with a desire to reduce refinancing risk facilitated by the minimal

compensation required by investors for extending term (Graph 13).

Graph 10

Graph 11

Graph 12

Graph 13

3.2 Bank profitability

Despite these attempts to preserve ROE, the stricter capital and liquidity requirements have still caused bank

profitability to decline – though it remains high by international standards (Graph 14). This is partly a mechanical

result of their increase in capital ratios, as a higher equity share of funding naturally reduces the ROE for a given

return on assets. Nonetheless, a lower return on assets (ROA) has also contributed (Graph 15). One reason for this

has been increased holdings of HQLA to satisfy liquidity requirements, since HQLA earns lower yields than other

(more risky, less liquid) assets. More recently, sales of wealth and life insurance assets and reductions in fee income

have also weighed on ROA by reducing non-interest income.

7 Some part of this shift is likely due to the opportunity cost of holding money in low interest accounts declining as the official

cash rate was lowered.

2015201120072003 20190

10

20

30

40

50

60

%

0

10

20

30

40

50

60

%

Funding Composition of Banks in Australia*Share of total funding

Securitisation Equity

Long-term debt

Domestic deposits

Short-term debt**

Adjusted for movements in foreign exchange rates; tenor of debt is

estimated on a residual maturity basis

Includes deposits and intragroup funding from non-residents

Sources: APRA; RBA; Standard & Poors

201520112007 2019-3

-2

-1

0

1

2

%

-3

-2

-1

0

1

2

%

Major Banks' Retail Deposit RatesSpread to cash rate, $10 000 deposit

Online savers**

Bonus savers

Term deposit specials*

Average of 1-12, 24-, 36- and 60-month terms

Excludes temporary bonus rates

Sources: Banks' websites; Canstar; RBA

The Changing Nature of Banking in Australia

26 July 2019; 4:30 PM; Word Count: 5926 9

Graph 14

Graph 15

Increased holdings of HQLA and equity have had a clearer effect on lending spreads. Specifically, these changes have

materially raised the cost of financial intermediation. Both funding and lending rates rose relative to the cash rate

at the onset of the financial crisis, as higher funding risk premia and a shift towards more expensive forms of liabilities

were passed onto customers (Graph 16). Since then, the spread between lending and funding rates has continued

to drift up (Graph 17). This spread measure ignores part of the cost of writing loans, since it excludes the (lower)

return on HQLA that must be held in proportion to the funding for each loan, as well as the equity portion of this

funding. Consistent with this, the trend up in this spread measure has accompanied the rising share of HQLA and

equity in banks’ balance sheets.

Graph 16

Graph 17

Technological developments offer the prospect of improving efficiency and, in turn, reversing the decline in banks’

ROA. To date, however, technological change has instead weighed on profitability as banks have invested heavily in

transitioning to a more technology-centric model (Graph 18). This spending has occurred in both front-end and back-

end systems. For front-end infrastructure, changing public expectations have required banks to spend more on

customer-facing banking systems and applications for mobile banking. In the back-end, increased regulation, the

growing availability of data and the aging of legacy systems have all required an increase in operational and analytical

capabilities, which in many cases has required upgrading existing internal systems. There is likely to be several more

years of heavy investment in IT systems, which may at some point enable banks to improve their overall efficiency.

201420102006 2018-20

-10

0

10

20

%

-20

-10

0

10

20

%

Large Banks’ Return on Equity*After tax and minority interests

Canada

Japan

United States

Europe

Australia

Ratio of profits after tax and minority interests to shareholders’ equity;

the number of banks varies by jurisdiction: Australia (4), Canada (6),

Japan (4), Europe (52), and United States (18); adjusted for significant

mergers and acquisitions; reporting periods vary across jurisdictions

Sources: Bloomberg; RBA; S&P Global Market Intelligence

2015201120072003 20190.0

0.3

0.6

0.9

%

0.0

0.3

0.6

0.9

%

Major Banks' Return on Assets*Four-quarter rolling average

The large decrease in March 2016 is due to NAB's realised loss on

the sale of Clydesdale Bank

Sources: APRA; RBA

2016201320102007 2019-100

0

100

200

300

bps

-100

0

100

200

300

bps

Major Banks' Lending Rates and Funding CostsSpread to the cash rate, outstanding loans

Lending

Funding*

RBA estimate

Sources: APRA; Bloomberg; Canstar; major banks' websites; RBA; Refinitiv

2016201320102007 2019200

220

240

260

280

300

bps

200

220

240

260

280

300

bps

Major banks' implied spread on lending*Lending rates minues funding costs, outstanding loans

RBA estimates

Sources: APRA; Bloomberg; Canstar; major banks' websites; RBA; Refinitiv

The Changing Nature of Banking in Australia

26 July 2019; 4:30 PM; Word Count: 5926 10

Graph 18

3.3 Industry composition

Various influences over the past decade have also impacted the market structure of Australian banking. At an

aggregate level, the major banks’ share of both lending and deposits increased sharply at the time of the GFC and is

still above pre-crisis levels (Graph 19). This was largely driven by the acquisitions of St George Bank and Bankwest in

2008, though the exit of other competitors also contributed. In particular, there was a notable decrease in lending

from non-ADI lenders and some regional banks, as the cost of RMBS funding made this type on lending uneconomic

(Graph 20).

Graph 19

Graph 20

At a more disaggregate level, the composition of foreign bank competition in business lending has changed

significantly. Major banks’ share of total business lending was boosted by the exit of European banks as the crisis

progressed, often due to troubles at the parent banking groups (Graph 22). However, this rise in the major banks’

market share has since been largely unwound by the expansion of Asian banks in Australia (Graph 21, Graph 22).

These banks have been able to expand overseas as they were less negatively affected by the GFC. Their expansion

was also supported by either the international expansion of their customer base (which they choose to support;

Lowe 2018) and/or by the absence of domestic growth opportunities. The increased lending from foreign banks has

been particularly focused on infrastructure and commercial property lending.

2015201120072003 201935

40

45

50

%

2

4

6

8

%

Major Bank Operating Expenses*Share of operating income, four quarter rolling average

IT services expenses

(RHS)

Total expenses

ex IT (LHS)

Excluding NAB

Sources: APRA; RBA

2015201120072003 201950

60

70

80

%

50

60

70

80

%

Major Banks' Market ShareCombined

Deposits

Business*

Housing*

Includes non-ADI lenders and securitised loans

Sources: APRA; RBA

Non-bank Housing Credit and RMBS Issuance

Estimated non-bank share of outstanding housing credit*

5

10

%

5

10

%

Non-bank Australian RMBS issuance**

2015201120072003 20190

5

10

15

20

$b

0

5

10

15

20

$b

As at year-end

2019 year to date

Sources: APRA; RBA

The Changing Nature of Banking in Australia

26 July 2019; 4:30 PM; Word Count: 5926 11

Graph 21

Graph 22

3.4 Impacts on financial markets

Tighter constraints on banks have also had a clear impact on the operations of financial markets. Specifically, greater

limitations on the ability of banks to apply leverage and to undertake significant liquidity and maturity

transformation have reduced both their desire and ability to act as market makers. This has resulted in reduced

trading volumes in many fixed income markets and a decline in market depth and liquidity (CGFS 2016). It has also

seen the emergence of persistent deviations from the predictions of traditional economic theory. Some of these

changes are the intended effects of tighter regulations, which are meant to force banks to more carefully consider

the cost of expanding their balance sheets and of taking on liquidity risk. Nonetheless, in some areas it is now

acknowledged that there have also been unintended effects (BCBS 2018). These changes have been most apparent

in other jurisdictions, where banks had been especially aggressive pre-crisis and where regulation (most notably the

leverage ratio) has been more binding (Cheshire 2016). Nonetheless, these effects have also been observed to an

extent in Australia.

The impact of tighter regulation on financial markets has been most apparent at quarter-ends and in markets where

scale is required to achieve reasonable returns from low margin activities. For Australia, this has been perhaps most

apparent in the cross-currency swap market. Historically this market traded close to the predictions of covered

interest parity – the cost of borrowing Australian dollars in the foreign exchange swap market was similar to the cost

of borrowing it domestically. However, there have been persistently large deviations from this theory since the

financial crisis, most notably in the yen swap market (Graph 23). Moreover, this ‘basis’ has been especially large at

quarter-ends, as global banks withdrew liquidity to inflate their reported regulatory ratios (which only need to be

met on these days). The emergence of this basis has created opportunities for investors to earn excess risk-free

returns. While some investors, including the Reserve Bank of Australia, have chosen to take advantage of this, banks

have typically been unable to do so because of the cost of expanding their balance sheet. Non-banks have similarly

been limited by the willingness of banks to provide funding for these arbitrage trades. (For a full discussion of this,

see Debelle (2017).)

These developments in the swap market have also had a marked impact on the Australian repo market (along with

arbitrage opportunities in bond futures; see Becker, Fang and Wang (2016)). Historically, the cost of borrowing via

repo (i.e. secured) was equivalent to the cost of borrowing in the cash market (i.e. unsecured). However, that has

not been the case since early 2016, with repo recently costing around 50 basis points more. Similar trends have been

apparent internationally, mainly because the leverage ratio has restricted global banks’ ability to supply more

funding to repo markets (CGFS 2017). While that constraint has not been a key factor driving Australian repo rates

up, the absence of arbitrage activity is partly a reflection of the limits banks now face when seeking to significantly

increase leverage (even for low risk activities).

2015201120072003 20190

50

100

150

200

Index

0

50

100

150

200

Index

Business Credit*Index, January 2010 = 100

Other Australian Banks

(5%)

Foreign Banks

(21%)

NBFIs

(7%)

Major Banks

(67%)

Seasonally-adjusted and break-adjusted; includes securitisation

Share of total business credit as of May 2019 are bracketed

Sources: ABS; APRA; RBA

Foreign Bank Business Credit in AustraliaBy region of headquarters, share of total business credit

Asia

20142009 20190

2

4

6

%

Japan

China

Other

Non-Asia

20142009 20190

2

4

6

%

Europe

North America

Sources: APRA; RBA

The Changing Nature of Banking in Australia

26 July 2019; 4:30 PM; Word Count: 5926 12

Graph 23

4. Ongoing changes to Australian Banking

Most of the changes to the Australian banking system discussed in the previous section were a reaction to the events

of the GFC, and are now either complete or nearly complete. Nonetheless, there are a number of emerging

influences that may contribute to further changes in the nature of banking going forward.

The most obvious one is ongoing improvements in technology, which continues to change the way that banking is

conducted.

One way in which increased digitisation will re-shape banks is by creating new sources of risk. Cyber risk (or, more

generally, the risk of technology failures) is now considered a key risk for banks to manage. This risk has increased

due to a rapid rise in the digitalisation of services and greater use of third-party service providers (Reserve Bank of

Australia 2018). Both banks and supervisors have therefore begun to give greater focus to the operational risks

stemming from their reliance on IT. In Australia, APRA recently introduced its first prudential standard for

information security management. The heart of this is to require all APRA-regulated institutions to maintain

information security management controls that are commensurate with their size and the extent of the threat to

information assets, and to have appropriate mechanisms in place to detect and respond to breaches in a timely

manner.

Increased digitalisation of banks also creates opportunities to increase competition within the industry. The

legislation of Open Banking in Australia now compels major banks to provide customer data to other institutions

upon the request of the customer, and the expansion of Comprehensive Credit Reporting will enable all institutions

to increase their visibility of potential customers’ financial situation. These developments are likely to erode the

historical information advantage enjoyed by incumbent banks when assessing customers’ borrowing capacity and

creditworthiness. This may lead to more competition in lending markets by enabling customers to shop around for

more favourable borrowing rates. However, the UK experience cautions that any changes are unlikely to occur

rapidly (van Steenis 2019).

Improvements to technology could also improve competition in the banking sector by making it easier for new

entrants. The increased willingness of consumers to undertake commerce and financial services over the internet

has created additional opportunities for new digital-only firms to enter markets typically controlled by banks. These

firms propose to compete with existing banks through lower operating costs (due to a lack of physical presence) and

improved services and usability for customers. In Australia, some subsidiaries of major global banks have made

significant gains in market shares using an online-only model, but new entrants lacking the backing of big parents

are yet to have a major impact. Nonetheless, as ‘fintech’ and ‘bigtech’ increase their reach into the provision of

Profit Opportunities in

Australian Financial Markets

Return on swapping AUD

into FX*

20122005 2019-80

-40

0

40

80

120

bps

Into USD

Into yen

Into euro

Into yen

Repo spreads to OIS**

20162013 2019-80

-40

0

40

80

120

bps

2-year cross currency basis spread

3-month maturity.

Sources: Bloomberg; RBA

The Changing Nature of Banking in Australia

26 July 2019; 4:30 PM; Word Count: 5926 13

payments services, they could fundamentally disrupt the relationships between banks and their customers. It is

possible that tech firms could use this access to customers (and the associated information) as leverage into the

provision of deposit and lending services as well.

Regulators have facilitated new entrants by adjusting licensing frameworks to allow for partial, temporary licences.

This approach allows potential entrants to begin offering services at a small scale without lowering the resilience

standards required for a full licence. ASIC’s approach involved the introduction of a fintech regulatory sandbox

framework in 2016. This allows eligible fintech businesses to test new products and services without the need for a

financial services or credit licence (ASIC 2016). Participating businesses can only offer their products for up to

12 months and to no more than 100 retail clients. Similarly, APRA introduced a restricted ADI licence in 2018. This

has lower capital, liquidity and risk management requirements than a regular ADI licence, is valid for a maximum of

two years, and is only available for firms with less than $100 million of assets (APRA 2018a).

Another factor that could have a significant influence on the future of banking is the increased focus on operational

risk and internal bank culture. The Royal Commission into Misconduct in the Banking, Superannuation and Financial

Services Industry highlighted many instances of misconduct and operational failure that have occurred in recent

years. Internal cultural problems (including complacency, a lack of accountability and poorly designed remuneration

frameworks) and poor processes have been identified as the cause of many of the failures. One way in which APRA

has attempted to address this is through its prudential inquiry into CBA and the subsequent self-assessments

required of other institutions. The Banking Executive Accountability Regime (BEAR), which was passed into

legislation in 2018, will build on this by requiring banks to establish which senior executives and directors are

accountable for operational failures and strengthening APRA’s powers to penalise misconduct (APRA 2018b).

These incidents have already adversely impacted bank profits through sizeable customer refunds and higher costs

to comply with inquiries. APRA has also demonstrated a willingness to increase the amount of regulatory capital that

banks must hold against their operational risk until these issues are addressed. These are just two of the ways in

which the increased focus on cultural could change Australian banks in future. The remainder of this conference

provides an opportunity to consider the potential impacts more broadly.

5. Conclusion

Australian banks have changed markedly over the past decade or so. Most importantly, they now hold much more

capital than they used to and have significantly strengthened their resilience to liquidity shocks (both by shifting to

more stable liabilities and increasing their holdings of liquid assets). Their exposures have become more

concentrated as they divested international and wealth management business, while growing rapidly in housing

lending. Profitability has declined, though remains high by international standards, yet the cost of financial

intermediation has risen. And the composition of the industry has shifted, as major banks have increased their

market share in deposits and housing lending (at the expense of non-banks and smaller banks), while Asian banks

have taken a growing share of the business lending market.

Banks continue to face lots of external pressures that will influence how the industry evolves from here. A key

prospective change will be their loss of information advantage with the introduction of Open Banking and

Comprehensive Credit Reporting combined with the emergence of technologically advanced competitors. The

impact this will have on banking heavily depends on both the ability of established banks to keep up with

technological advances (through investment or acquisition) and the importance of their funding cost advantage. A

further consideration in thinking about the future of banking is the major banks’ ability to offer the quality of service

that customers wants and customers’ willingness to switch to emerging competitors in the post-Royal Commission

environment.

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