COMPETITION IN FINANCIAL SERVICES Research Report August 2015 This research was supported by the Centre for International Finance and Regulation which is funded by the Commonwealth and NSW Governments and supported by CIFR’s Consortium partners (see www.cifr.edu.au). This work is copyright. All rights reserved. This publication is distributed for the purposes of comment and discussion only. This publication, and any part of it, may not be reproduced without prior written permission of the relevant copyright holder. Published in 2015 by the Centre for International Finance and Regulation Level 7, 1 O’Connell Street Sydney NSW 2000 Australia +61 2 9931 9342 www.cifr.edu.au For copyright information please contact the publisher. IMPORTANT DISCLAIMER The contents of this publication reflect the views of the respective authors and do not represent the official views or policies of the Centre for International Finance and Regulation, any of its Consortium partners or any members of the Steering Committee. The information contained in this publication is of a general nature only, is not necessarily complete, comprehensive, accurate or up to date and should not be relied upon without seeking prior professional advice. The Centre for International Finance and Regulation and its Consortium partners, and the authors of the papers, exclude any and all liability arising directly or indirectly from use or reliance on the contents of this publication. www.cifr.edu.au PAGE D RESEARCH REPORT Competition in Financial Services FOREWORD August 2015 The Centre for International Finance and Regulation and UNSW Australia jointly funded this research under CIFR Project T20. The Centre for International Finance and Regulation is funded by the Commonwealth and NSW Governments and is supported by other Consortium members. The research question for this project was ‘What are the optimal competition law and policy settings that should apply to the financial services sector?’ The research question was driven by two Australian Government inquiries which will affect competition policy in the financial services sector: the Financial System Inquiry chaired by David Murray and the Competition Policy Review, chaired by Professor Ian Harper. The project has three objectives. The first is to investigate the nature of competition in certain sectors of the financial markets. Meeting this objective will provide Australian evidence on which decisions as to the competitive settings in the sector can, or should be, adjusted. The second is to consider the mechanisms by which competition in the financial services sector can be promoted. This includes an analysis of the approaches used on an international basis for the promotion of competition in financial services. Meeting this objective will provide evidence on which decisions as to allocation of responsibility for promoting competition can be made. The third is to consider the sector-specific competition settings in the financial sector, including the balance between competition and stability. As the global financial crisis did not provide Australia with direct experience of the practical limitations of this balance, the work investigates theoretical approaches and international experience. Meeting this objective will provide evidence for appropriate policy settings if there are to be any sector-specific competition policy exemptions. RESEARCH REPORT Competition in Financial Services PAGE 1 TABLE OF CONTENTS Foreword 1 Table of Contents 2 Executive Summary 5 The Authors 8 1 Introduction 10 2 Positioning the work 13 2.1 Introduction 13 2.2 Sources 13 2.3 Before the financial crisis: period of liberalisation 14 2.4 The effects of the financial crisis 15 2.4.1 Regulatory overview 16 2.4.2 Systemic risk 16 2.4.3 Supervisory and prudential regulation 17 2.4.4 Competition law 19 2.4.5 Basel II 21 2.4.6 Anticompetitive policies 22 2.5 To promote competition 28 2.5.1 Strength and independence of regulators 28 2.5.2 Competition and consumer policies 29 2.5.3 Barriers to entry and exit 33 2.6 Conclusion 38 3 The nature of competition in financial services 39 3.1 Introduction 39 3.1.1 Life after the financial crisis 39 3.2 The Shape of Financial Services in Australia 43 3.3 The Regulatory Environment 47 3.4 Purpose and Approach 48 3.5 Market Definition 49 3.6 Market Characteristics 54 3.6.1 Players 54 PAGE 2 RESEARCH REPORT Competition in Financial Services 3.7 Market Metrics 57 3.7.1 Indicators 57 3.7.2 Stability: Assessment by the International Monetary Fund 65 3.8 Evidence from Observation 66 3.9 Informing Policy Options 70 3.10 Enabling Economic Prosperity 71 3.10.1 Managing inherent risk 72 3.11 Summary 74 4 Facilitating competition in financial services 75 4.1 Introduction 75 4.2 The contribution of competition to financial services 76 4.2.1 The importance of a competitive retail banking sector 76 4.2.2 Consumer position 76 4.2.3 The position of SMEs 77 4.2.4 Innovation 78 4.3 Concentration 79 4.3.1 Concentration: Herfindahl–Hirschman Index 79 4.4 Competition in banking 83 4.4.1 Measurements other than HHI 83 4.5 Indicators of competition in Australian banking 84 4.5.1 Overview 84 4.5.2 H-Statistic 84 4.5.3 Lerner Index 85 4.5.4 Boone Indicator 86 4.5.5 Data envelopment analysis 86 4.5.6 Return on assets 89 4.6 Applying competition law in the banking sector 91 4.6.1 Coordinated conduct – difficulties in cartel action 91 4.6.2 Mergers and acquisitions 91 RESEARCH REPORT Competition in Financial Services PAGE 3 4.7 Increasing competition – account number portability 93 4.7.1 Introduction 93 4.7.2 Benefits of bank account number portability 94 4.7.3 Possible implementation of bank account number portability 94 4.7.4 Portability implementation in Australia 95 4.7.5 Additional detailed option for bank account number portability 96 4.7.6 Summary 97 4.8 Returning customer data 97 4.8.1 Introduction 97 4.8.2 The data 97 4.8.3 Australian perspective 98 4.8.4 Next steps 98 5 The Rise of Crowd Equity Funding: Where to Now? 99 5.1 Introduction 99 5.2 The rise of crowd equity funding 102 5.2.1 A Kingdon model 102 5.2.2 Application of the Model to CEF 106 5.3 Australia’s position – what alternatives to adopt? 112 5.3.1 The Status Quo 112 5.3.2 Law on Fundraising 113 5.3.3 Australian Small Scale Offering Board 115 5.3.4 What Level of Regulation is Required? 116 5.3.5 Getting the Balance Right 118 5.3.6 Proposals and Alternatives 121 5.4 Conclusions 132 6 Issues in competition and stability in financial services 133 6.1 Introduction 133 6.2 Examining banking sectors 133 6.3 Is there a money creation problem? 135 7 Conclusions 137 8 References 140 PAGE 4 RESEARCH REPORT Competition in Financial Services EXECUTIVE SUMMARY International work from central banks, international financial institutions and academic sources in this field is still dominated by the effects of the financial crisis. There are three critical themes: (a) an increased focus on macroprudential regulation; (b) a focus on regulations that respond to the globalisation of the financial markets; and (c) the introduction of anti-competitive policies such as government intervention and consolidation after the financial crisis. These sources have also offered key policies to promote competition, which include the independence and strength of regulators, consumer policies such as the facilitation of switching, financial literacy, and easing entry and exit restrictions. There are three characteristics of retail banking in Australia: (a) the stability of the sector is sound and retail banking had a relatively soft landing in the aftermath of the financial crisis; (b) there is limited competitiveness and this is reflected in the static state of market share between the four major banks and very slow and marginal improvement gains even by strong second tier competitors; and (c) product and service innovation is limited. There are two important implications that flow from these issues: (a) the absence of vigorous rivalry, whilst providing stability, is likely to mean that the welfare of retail banking consumers is not optimised; and (b) the level of innovation may not be as high as is feasible and barriers, including prudential regulatory barriers to entry or expansion, mean that the extent of rivalry is unlikely to change without some form of promotion of competition. RESEARCH REPORT Competition in Financial Services PAGE 5 We recommend the removal of the ‘four pillars’ policy for the following reasons: J^[\ekhcW`ehXWdaiWh[fhej[Yj[ZXoWd_cfb_Y_j]el[hdc[dj]kWhWdj[[j^Wj_cfWYji market operation with little observable benefit to consumers, and may be a source of consumer disutility. J^[\ekhf_bbWhifeb_Yo^Wifhecfj[Z_dYh[Wi[Zl[hj_YWb_dj[]hWj_edm_j^_dj^[i[Yjeh" particularly in the area of mortgage products. J^[h[Wh[ik\ÓY_[djc[h][hfhej[Yj_edifhel_Z[ZXoFWhj?Le\j^[Competition and Consumer Act 2010 (Cth). 9ecf[j_j_edWdZYedj[ijWX_b_joWh_i[m^[dj^[h[Wh[h[WiedWXbobemXWhh_[hije[djho and exit from the sector. It is not clear that low barriers to entry exist in Australia, and evidence to support this view comes from the failure of international banks to gain a significant toehold in the retail banking sector in Australia. One deterrent to entry is the regulatory focus on the four pillars. We recognise that this position is at odds with the view of the Financial System Inquiry. The rationale in the report of the Inquiry was to prevent mergers between the four pillars, and the current competition law achieves this objective.