Chapter 2 The financial services industry: depository institutions

Chapter outline
Banks
Size, structure and composition of the industry
Balance sheet and trends
Bank performance
Credit unions and building societies
Size, structure and composition of the industry
Balance sheet, performance and trends
The regulation of Australian depository institutions
The key legislation
The regulatory agencies
Australian prudential supervision framework
Overview of the regulation of depository institutions

Learning objectives
2.1 Learn the different types of depository institutions in Australia and how they compete in
the same market and face similar risks.
2.2 Gain an understanding of the major activities of banks and the industry structure.
2.3 Gain an insight into the balance sheet of banks and the trends in assets, liabilities and
capital.
2.4 Appreciate the key performance ratios of banks and the trends in bank performance.
2.5 Learn the history of the industry comprising credit unions and building societies and the
structure of their industry.
2.6 Gain an understanding of the changing shape of the market for credit unions and building
societies and how they have performed.
2.7 Appreciate the regulatory framework governing the activities of Australian depository
institutions and the key regulatory agencies.
2.8 Understand the key areas of regulation and the reasons why these areas are targeted for
regulation.

Appendix 2A Financial statement analysis using a return on equity framework (online)

Overview of chapter
This chapter provides an overview of the major activities of Australia’s banks, building
societies and credit unions. The size, structure and composition of banking and the mutual
organisations is covered along with a discussion of recent trends in balance sheet structure
and performance. It also describes the regulation of Australian depository institutions (DIs)
and the various agencies that regulate them. DIs rely heavily on retail deposits to fund their
activities, although wholesale borrowing and offshore funding are increasingly important
sources of funds, particularly for the major banks. Historically, banks have offered a full
range of services to both retail and corporate customers and Australia’s major banks
concentrate much of their effort in the provision of banking and investment banking services
to businesses. Building societies and credit unions, on the other hand, focus on retail business,
with loan portfolios dominated by residential mortgage lending. These differences are being
eroded due to competitive forces, regulation and changing financial and business technology.

Chapter 2 Teaching Suggestions (including some comments on Chapter 3)

For simplicity, some lecturers may wish to commence any course on bank/financial
institutions’ risk management with this chapter and Chapter 3—which are both descriptive in
nature and provide the institutional arrangements and background for the discussion of
bank/FI risks and their management.

I would strongly recommend against this approach for many reasons, but principally for one.
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While relatively simple for students new to the study of institutional risks, essentially the
discussion of the institutional arrangements is very dry—and not a good way to stimulate
students in preparation for the intensive examination of the key issues discussed in the course.

Higher level courses may leave this chapter as reading matter only—and not directly covered,
but drawn upon during the ensuing discussion of the various risks and their management.

If both Chapters 2 and 3 are covered in lectures, then I suggest that they form a part of the
introductory lecture where balance sheets of the various FIs can be examined in light of a
discussion of either ‘specialness’ or other aspects of the lecture built around the issues in
Chapter 1.

The start of the lecture is to identify the various services offered by a bank (Tables 2.1A and
2.1B), and relate these to the evolution of banking over the past few decades, and the
specialness aspects discussed in Chapter 1.

A good way to approach the discussion of the institutional arrangements is to either use the
material in the book, or alternatively get copies of a major bank’s latest annual report (say
Westpac), and focus on the items in the typical balance sheet and performance reports.

From this, you could then ask questions such as:

• What is the concentration of Australia’s major banks in terms of assets?

• How profitable are the Australian banks and how does their performance compare
with the credit unions and building societies?
• What is the largest asset type in the Australian bank balance sheet? (Housing loans)
• Does the concentration of housing loans in the balance sheets of Australian DIs put
them at more risk than their international competitors? (This question gives you a
chance to commence discussion of the various credit related risks in the balance
sheets—that is, credit risk, concentration risk, etc.) At this point, you may also wish
to comment on the findings of the Financial System Inquiry 2014 that suggest that the
smaller banks are at a disadvantage to the major banks in the housing loan market.
(Also look at the Learning from the Financial System Inquiry box in Chapter 2, ‘The
too big to fail subsidy’, page 52.)
• What are the main types of liabilities in the balance sheets? (You can refer this to the
ensuing discussion of liquidity risk and interest rate risk.)

The issue of capital and its adequacy could be introduced by referring to the Financial System
Inquiry Report 2014, which recommended that the major banks hold higher levels of capital
than that currently required by APRA. While the discussion of capital and its role is left for
Chapter 18, it is important to introduce students to all risks, including survival risk—
solvency risk—at this stage, so that they realise the importance of capital and the maintenance
of equity value for the DIs.

An examination of the performance reports allows a discussion of the ways DIs make their
profit, and with this a discussion of interest rate spread and fees. The issue of which is more
important for the Australian major banks, other Australian DIs, foreign banks, etc. can also be
explored. The risk of interest rate spreads versus fees is also a good discussion point.

Again, with the examination of income-earning potential, the risks to earning capacity can be
broached. Clearly, the risks are the same as those from the discussion of the balance sheet, but
the question about how these risks affect profitability can now be addressed.

For example, you could ask:

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 • Which income type (interest rate spreads or fees) has the higher risk potential?
• What risks are inherent in each income type?

Finally, Chapter 2 covers the regulation of DIs, and the regulatory agencies. Note that the
Australian Prudential Supervision Framework is also covered in Chapter 2 and that this
framework is relevant to all APRA regulated institutions—that is, it includes the insurers and
superannuation funds which are discussed in Chapter 3.

A key discussion point at this juncture is the role of regulation—that is, what is the regulator
trying to achieve?

Depending on the course content, if it is a bank or DI related course, then the next relevant
chapter is Chapter 4 which introduces all the major risks of FIs. If the course has broader
coverage of all FIs, then a quick overview of the other FIs (see Chapter 3) is required.
However, please remember that the Prudential Supervision Framework discussed in Chapter 2
is relevant to the key institutions covered in Chapter 3.

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Answers to end-of-chapter questions

Questions and problems

1 How have the risks and products sold by the financial services industry changed since
1950? LO 2.1

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 Describe the structure of the banking industry and discuss the reasons for any changes.
LO 2.1, 2.2

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 What are the major sources of funds for banks in Australia? What are the major uses of
funds for banks in Australia? LO 2.3

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

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 • securities including:
– government securities
– other bank securities
– corporate bonds
– securitised assets
• foreign currency and foreign currency assets
• cash and deposits with the RBA.

4 Contrast the activities of the four major Australian banks with those of the regional banks.
LO 2.2, 2.3

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 Euromarkets for example.

5 Why did bank net interest margin fall from 2000 to 2013? Why wasn’t bank ROE
affected? LO 2.4

Australian bank net interest margins have been falling since the 1980s due to deregulation of
the financial markets and new technologies as well as regulatory change and the focus on
improvements in quality capital. However, their return on equity has remained at a long-term
average of 16 per cent. Total bank returns are made up of interest income and fee income, and
fee income has represented one-quarter of bank operating income since 2004.

6 Why was the structure of Australian banks’ liabilities in 2008 found to be a weakness?
What have the banks done to change this? LO 2.3

A trend in the structure of bank liabilities was an increased reliance on offshore wholesale
funding. In 2008 with 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 What is driving the banks’ changing capital base, and in particular the emphasis on
common equity? LO 2.3, 2.8

Banks are improving the quality of their capital for two main reasons:

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 • bank regulations require it—and emphasise 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 Describe the factors influencing the decline in the number of building societies. LO 2.5

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 What are the similarities and differences between the three major groups of authorised
deposit-taking institutions in Australia? LO 2.1, 2.2, 2.6

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. The
difference between the two groups in lending maturity is now far more blurred than when
they were 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 and investment banking as well as insurance
and funds management. All Australian depository institutions are regulated by APRA in the
same way.

10 What is the Australian Prudential Regulation Framework and what does it aim to do? LO
2.7

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The regulation and supervision of Australian FIs is guided by APRA’s Australian Prudential
Supervision Framework, developed in 2003–2004. 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.

11 How has the regulation of building societies and credit unions changed since 1999?
LO 2.8

Regulation of bank interest rates and exchange rates was dismantled in the 1980s, leaving
banks free to determine product prices. At the same time the regulatory approach changed
from control bank activities to prudential supervision. Responsibility for prudential
management lies with the banks’ management, while RBA’s role was to ensure it is carried
out effectively. At that time building societies and credit unions were regulated by the
Australian Financial Institutions Commission (AFIC). In 1998, regulation of the financial
services industry was restructured and the Australian Prudential Regulation Authority
(APRA) was established to supervise the activities of all depository institutions previously
covered by the RBA and AFIC. From 1999, the regulation of banks, credit unions and
building societies was exactly the same and was the responsibility of APRA.

12 What is the key focus of DI regulation? LO 2.8

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.

The following questions refer to Appendix 2A.

13 What is the likely relationship between the interest income ratio and the non-interest
income ratio? LO 2.4

Interest income and non-interest income are not independent. For example, loans generate
interest income and also non-interest income (fees and servicing fees etc.). Thus the
relationship between the interest income ratio and the non-interest income ratio is likely to be
positive—that is, they are most likely to move in the same direction. Thus the more loans
sold, the higher the loan interest income and the higher the loan fees and servicing charges.

14 Given the following balance sheet and income statement for Mega Bank, calculate:
LO 2.3, 2.4
(a) return on equity
(b) return on assets
(c) asset utilisation
(d) equity multiplier
(e) profit margin
(f) interest expense ratio
(g) provision for loan loss ratio
(h) non-interest expense ratio
(i) tax expense ratio.
Mega bank balance sheet ($ million)
Assets Liabilities and
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 equity
Cash and due from
bank 9 000 Cheque accounts 19 000
Investment securities 23 000 Savings accounts 89 000
Repurchase agreements 42 000 Negotiable CDs 28 000
Loans 90 000 Debentures 19 000
Fixed Assets 15 000 Total liabilities 155 000
Other Assets 4000 Share capital 16 000
Retained earnings 12 000
Total liabilities
Total assets 183 000 and equity 183 000

Mega bank income statement ($ million)

Interest on fees and loans 9 000
Interest on investment securities 4 000
Interest on repurchase
agreements 6 000
Interest earned on deposits 1 000
Total interest income 20 000
Interest on deposits 9 000
Interest on debentures 2 000
Total interest expense 11 000
Net interest income 9 000
Provision for loan losses 2 000
Other income 4 000
Other expenses 1 000
Income before taxes 10 000
Taxes 3 000
Net income 7 000

a return on equity 25.00%

b return on assets 3.83%
c asset utilisation 4.92%
d equity multiplier 6.54 times
e profit margin 53.85%
f interest expense ratio 84.62%
g provision for loan loss ratio 15.38%
h non-interest expense ratio 23.08%
i tax expense ratio 23.08%

Note that total operating income = net interest income plus other income = $13 000

15 Bold Bank has the following ratios:

(a) profit margin 21 per cent
(b) asset utilisation 11 per cent
(c) equity multiplier 12 times

Calculate Bold Bank’s ROE and ROA. LO 2.3, 2.4

ROA = PM x AU = 2.31%
ROE = ROA x EM = 27.72%

Web questions

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16 Go to APRA’s website and find the latest information on Australian bank, building
society and credit union asset concentration. LO 2.6

Go to the APRA website (www.apra.gov.au) and click on ‘Authorised Deposit Institutions’,

and then on ‘Statistics’. You can then go to the various statistics for each of the ADIs—that
is, ADI Quarterly Performance Statistics for banks, building societies and credit unions. The
answer will depend on the date of the assignment.

17 Go to the APRA website and update the balance sheets shown in this chapter for banks,
building societies and credit unions. LO 2.3, 2.6

Go to the APRA website and get the latest data for Tables 2.4 and 2.10. Go to the APRA
website (www.apra.gov.au) and click on ‘Authorised Deposit Institutions’, and then on
‘Statistics’. You can then go to the various statistics for each of the ADIs—that is, ADI
Quarterly Performance Statistics for banks, building societies and credit unions. The answer
will depend on the date of the assignment.

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