Malcolm Edey: The financial system in the post-crisis environment
Remarks by Mr Malcolm Edey, Assistant Governor (Financial System) of the Reserve Bank
of Australia, to the Australian Centre for Financial Studies (ACFS) and Financial Services
Institute of Australasia (Finsia) Leadership Luncheon Series, Melbourne, 22 March 2013.
* * *
I want to talk today about how the financial system has changed in the post-crisis
environment. In order to think about that, it is useful first to look back at the enormous
changes that took place in the roughly quarter-century period between financial deregulation
and the onset of the global financial crisis (GFC). Then I want to ask how far those earlier
trends might be expected to reassert themselves as conditions normalise.
Perhaps the most obvious aspect of that earlier period of change was in the financial sector's
relative size. To give a few summary measures:
•
The ratio of credit to GDP increased from around 50 per cent in the mid-1980s to
around 160 per cent in 2007.
•
Over the same period, the total assets of the banking system rose from around 50 to
around 200 per cent of GDP (Graph 1).
•
Measures of financial market turnover increased dramatically on a range of fronts.
To give just one example, foreign exchange turnover increased by a factor of more
than 30 in nominal dollar terms over that quarter-century, when the nominal
economy itself expanded only by a factor of 41⁄2.
Graph 1
The system also changed profoundly in other ways than just size. One was in its degree of
openness to competition and in the nature of that competition. The post-Campbell reforms
allowed market forces to work, and opened up the system to new competitors. The Wallis
reforms followed that up by placing the regulation of banks and non-bank intermediaries on a
more equal footing.
We can see the consequences of these forces in the cost and availability of financial services
to end users. Deregulation ended the artificial rationing of bank loans, making credit much
more widely available. Another consequence that we are apt to forget is that the cost of
financial intermediation came down very substantially. In the late 1980s the average net
interest margin of the major banks was more than 5 percentage points. By the middle of the
last decade it had fallen to a level less than half that - where, broadly speaking, it still is
today. So finance became both cheaper and more widely available (Graph 2).
Graph 2
These forces also had the effect of changing the focal point of competition. The rationing that
existed in the old regulated environment had encouraged banks to compete on a "whole of
institution" basis, rather than at the level of individual product lines. In effect, banks offered a
package of loan, deposit and payment services and competed for customers at the level of
the package as a whole. In this situation, wide interest margins were used to cross-subsidise
payment services, and customer mobility was limited because loyalty to a bank was one of
the critical factors in obtaining access to scarce loans.
Deregulation changed that model by allowing innovators to compete separately for the most
profitable lines of business. Cross-subsidies in the banking system were competed down,
and this helped to drive the reduction in net interest margins.
It is interesting to note that for much of the pre-crisis period, competition among financial
intermediaries was focused mainly on the lending side of the business. In effect,
intermediaries could operate with a business model that assumed the availability of funding,
and mainly competed for market share in lending out the available funds. This is one of the
things that has changed since the GFC. With investors now much more discerning in their
risk assessments, banks have had to compete harder in the deposit and other funding
markets, and this is changing the way they do business. I will return to this point later when I
conclude.
A final area to mention in briefly rounding up the pre-crisis environment is the growth of the
wealth management sector. Funds under management (principally in superannuation and life
offices) expanded from around 30 to around 130 per cent of GDP between 1985 and 2007,
broadly matching the growth rate seen in the deposit and loan sector. And, of course, there
has been a huge growth in services related to asset and risk management, including
securities and derivatives trading.
Many of these developments had their counterparts in overseas financial systems, which is
not surprising because the same sorts of forces were at work. The majority of high-income
economies experienced high rates of credit growth and in some cases financial activity
expanded even faster than was the case in Australia.
In the post-crisis environment these trends have slowed down, halted or in some cases partly
reversed. In Australia the credit and debt measures that I cited earlier have been broadly
stable for the past five years. Internationally, credit has contracted in nominal terms in some
markets. There has also been a big change in attitudes and perceptions about financial risk.
Although confidence in global markets has partly returned, risk appetite now is clearly not
what it was. And certain kinds of financial activity, particularly in wholesale, securities and
derivatives markets have settled at much lower levels than they were in the pre-crisis period.
All of this raises the question as to what the new normal might look like in our financial
systems. Has the world changed forever? To what extent can we expect the earlier causal
factors driving financial change to reassert themselves?
In thinking about this, I find it useful to categorise these causal factors into three groups. I
see these as being conceptually distinct even though they are likely to interact in complex
ways in practice.
In the first group are the long-run forces driven by trends in incomes, technology and
demographics. Viewed in the abstract, there are a number of reasons to think that financial
activity might be able to grow faster than the general economy for sustained periods, and
even that this configuration might be some kind of norm.
On the demand side it seems plausible that, as people get richer, more of their income can
be spent on financial services, including debt servicing, as proportionately less needs to be
spent on necessities. Associated with this, the relative value of scarce assets that are
financed by debt might be expected to rise over time. And the combination of increasing
wealth and greater longevity in our societies is likely to generate rising demand for services
in the wealth management and retirement income sector.
On the supply side, the key point is that finance is an information-intensive industry. Its key
outputs depend on the capacity to store, analyse and transmit information securely. We're
not actually very good at measuring the real value of financial outputs and hence not good
either at measuring productivity in the sector. But it would be surprising if the ongoing
advances in information technology were not generating significant growth in finance industry
productivity relative to that in less information-intensive sectors. This is a process that can
continue as long as the technology itself goes on improving.
So there are some valid reasons to think that both supply and demand for financial services
can grow faster than nominal incomes over time, other things being unchanged.
The second set of forces to consider are the one-off factors that made this particular quarter
century, in financial terms, unique. One of these I have already alluded to: the financial
deregulation that took place around the world mainly in the late 1970s and early 1980s.
Fundamentally, we have moved from a situation where credit was price-controlled and
quantity-rationed, to one where credit availability is market determined. It is probably fair to
say that the credit expansions that followed this shift around the world were larger and more
protracted than many had expected. Nonetheless, it was by nature a one-time adjustment,
and one that has probably now run its course.
Another factor in the one-off category is the transition to low inflation and the consequent fall
in nominal interest rates. In the late 1980s, mortgage interest rates in Australia reached a
now unimaginable 17 per cent. Although that peak was partly cyclical, it also partly reflected
the inflation premium built into the interest rate structure. As inflation expectations and
nominal interest rates came down in the 1990s, there was a corresponding increase in the
average household's capacity to borrow.
As a simple illustrative calculation, if we assume a debt service ratio of 30 per cent on a
standard 25 year mortgage, a household's borrowing capacity would have gone from around
two times annual income in the late 1980s to something like four times income a decade and
a half later. Taken in combination with the removal of regulatory constraints on credit supply,
this would go a long way towards explaining the quarter-century rise in household debt
ratios.1 The adjustment to this new reality seems to have been spread over a fairly lengthy
period of time. But again, with inflation having been low and stable for more than two
decades now, it can be seen as essentially a one-off factor that has probably run its course.
My third category of forces are those associated with the cyclical dynamics of credit and
asset prices. The financial sector has a well-documented capacity to engage in bouts of
overexpansion, driven by self-reinforcing expectations and followed by periods of
readjustment and consolidation. Credit cycles of this nature can be unpredictable in duration,
ranging from the short and sharp to longer episodes spanning a decade or more. But we can
think of these dynamics as being superimposed on the longer-term forces that I've already
described.
Even though these forces might be conceptually distinct, they are in practice likely to be
highly interconnected. A financial bubble doesn't usually come out of nowhere. Typically it
starts as a well-based reaction to some genuinely new event, but then develops a
selffulfilling momentum of its own, often with elements of irresponsibility, dishonesty and outright
fraud as part of the mix.
Globally, there were certainly elements of bubble-like behaviour in the few years leading up
to the GFC. But we can also pose the question of whether the world financial system
overexpanded on a longer timescale, maybe a quarter-century scale, in reacting to the
various forces that I've been describing. Did the financial sector in aggregate become too big
relative to the size of the real economy? And if so, does that mean we are in for a period of
ongoing correction to restore the balance?
It is hard to be definitive about these things, but a few observations seem relevant:
•
First of all, it seems clear that at least some parts of the world financial system did
overexpand by a significant margin. To cite some extreme cases, the total assets of
the Irish banking system peaked in 2009 at a ratio of 9 times that country's annual
GDP, a figure way outside its own (and other countries') historical experience.
Iceland's ratio peaked at 7 times. In the UK, the peak was around 5, and in
France 4. All of these numbers are high by the standards of longer-run experience
(Graph 3).
Graph 3
•
Behaviour in the post-crisis period in most economies is consistent with a period of
private sector financial consolidation. Ratios of credit or banking assets to GDP
have tended to stabilise or decline, particularly in the countries where they had
previously been highest.
•
The combination of regulatory and private sector responses around the world seems
likely to result in reduced financial risk-taking in the foreseeable future. Regulators
are taking much-needed action to ensure that risks are better managed, and the
appetite for financial risk in the household and business sectors now is clearly much
less than it was.
•
In Australia the banking sector did expand relative to the economy, but it remains
significantly smaller than many others. On the rough metric of banking assets to
GDP, Australia's ratio is about 2, which is well within the international range and well
below those in the euro area, the UK and Japan. So to the extent that any
generalised financial overhang exists, it is less likely to be a problem here than
elsewhere.
•
That said, attitudes to risk and debt accumulation in the Australian household sector
have clearly changed. Saving rates are up, the appetite for new debt is down, and
attitudes to both the level and composition of household saving have become more
conservative (Graph 4).
Graph 4
So what of the future? To return to my three sets of causal factors:
•
There are some reasons to think that longer-run trends in income and demographics
can contribute to further growth of the financial sector over time.
•
However, much of the expansion over the pre-GFC quarter-century was driven by
one-off factors, notably the adjustments to deregulation and low inflation. These
adjustments have now run their course.
•
And, while we can't be definitive, it is plausible that the world financial system has
overexpanded in relative terms and needs a period of readjustment, though this is
less likely to be a major factor in Australia than elsewhere.
The ongoing development of the financial system in the post-crisis period will depend on the
interplay of those three factors. On any reading, it seems clear that this will be an
environment where it is harder in general for banks and for the system as a whole to grow.
While it is difficult to specify what that might mean in numerical terms, a return to financial
sector growth rates consistently higher than the growth of nominal GDP seems unlikely for
the foreseeable future. That is my first concluding comment.
My other comment concerns the nature of competition. The pre-GFC quarter century was an
unusual period, in that competition in financial intermediation came to be focused mainly on
the lending side of the balance sheet. That now looks to have been an aberration, and we
seem to be entering a period where significant competition on both sides of the balance
sheet becomes the norm. It might take some time to get used to this new reality. But in
general I see it as a healthy development because it will mean banks being under greater
market discipline to manage their risks.
And of course, regulators will be doing their part on that front as well.