Is competition crucial to the health of the financial sector? You can bank on it

To ensure a sound financial system, policymakers should balance the twin objectives of stability and competition.

Reactions to my call this week for another inquiry into Australia’s financial system have been mixed. Most commentators seem to accept that there’s logic in having another inquiry, even if some think that specific issues - such as the funding difficulties experienced by smaller financial institutions - could be handled within existing policy frameworks quite easily.

Several point out that the timing of the call reflects the desire of the mutuals to make a point ahead of the Senate hearings on banking competition due to begin this week. It’s certainly true that the report that sparked this week’s commentary was commissioned by the mutuals industry association, Abacus, and places the call for another inquiry against the backdrop of their particular issues.

Yet the key point of this report is that the mutuals, operating on the margins of the system as they do, provide something of a litmus test of the state of competition in the financial system. If they’re struggling, then things are probably out of balance.

Calls to shore up competition and innovation in the financial system are easily drowned out by dire warnings about the need to secure financial stability. No doubt financial stability is important, and we witness every night on TV the consequences of financial instability in the continuing travail of the southern European states.

Sound financial systems cannot be built on the single pillar of stability, however. Competitive and innovative financial systems are fundamental to the dynamism of market economies. The costs of too little competition and innovation may not be as obvious as those of instability but, in the long run, they can be just as expensive.

This is especially true for consumers, who are the ultimate beneficiaries of both financial stability and competition.

For thirty years following World War II, the highly regulated Australian banking system experienced not a single failure in which any Australian bank depositor lost a cent. Yet this same banking system could offer consumers only one type of mortgage, was rated as the most expensive banking system in the world in 1980, and would not lend to women.

When the system was deregulated following the Campbell Report in the early 1980s, it became both more competitive and more innovative but also less stable—the first bank failures in more than half a century were recorded in the early 1990s. But by then consumers (including women!) had experienced a whole new world of innovative mortgages, card payments products and market-linked investment accounts.

Indeed, the benefits of competition and innovation are too easily overlooked or forgotten. Financial instability, by contrast, plays well in the theatre of political economy and draws attention like competition and innovation never can. And so our regulatory apparatus is tuned to under-gird financial stability far more finely than it is to secure competition and innovation.

For this reason alone we need to stand back from time to time and take a wide-angle view of the trajectory of our financial evolution so as to ensure that the right balance between stability and competition is built into the regulatory framework.

There’s another reason why I think it’s time for a financial system inquiry. Australia’s existing regulatory framework is built on an assumed view of the evolution of financial systems that has been found wanting by subsequent events. After all, it’s now fifteen years since the Wallis Inquiry reported and things move quickly in financial markets.

Moreover, in the intervening years, we’ve lived through the largest global financial crisis since the 1930s. It’s only logical that we would seek to review Australia’s experience of the GFC to glean lessons for the future regulation of our financial system.

Specifically, the Wallis Committee assumed that financial markets would come to dominate financial systems and overshadow financial intermediaries, like banks and insurance companies. In the event, the exact opposite occurred, as the implosion of financial markets globally sent people scurrying back to traditional intermediated finance.

If this is more than a temporary phenomenon, which appears likely, then we need to think afresh about how financial systems might evolve from here onwards and how best to regulate them for efficiency as well as stability.

Indeed, the same experience has sucked confidence away from modern finance theory upon which many of the Wallis recommendations were founded. Clearly it cannot be expected that a public inquiry would reconstruct modern finance theory. However, the need to consider the implications for public policy of a fundamental re-thinking of financial economics is surely appropriate.

Finally, notwithstanding Australia’s superior performance during the GFC—no bank failures, for example—we have been obliged to sign up to a raft of international regulatory reforms motivated by experiences elsewhere in the world that we did not share.

How can we know that these are the right moves for regulating the Australian financial system without a blueprint for how we want to see our system develop? This is especially so when the global reforms are motivated by considerations of stability and pay scant attention to the dual need to promote competition, efficiency and innovation.