Paul Dickie: Banks far too dominant

We have great banks here, all four of them. And that is also a problem. Those four Australian-owned banks dominate our financial sector.

We get financial services tailored to our needs delivered at high prices with lackadaisical service.

Those financial services also deliver high profits that buttress their capital bases and, in turn, ensure relative financial stability. A modest success.

Like most things Australian, we have a love-hate relationship with our four big banks. We live with them somewhat uneasily.

But there must be more and there is potentially much more, if we only had a government and a regulator that would think and act a little outside the box.

What we are missing are robust financial markets. Financial markets directly connect savers and investors and are thus distinguished from banks, which act as intermediaries between these two parties.

Like banks, financial markets such as the New Zealand Stock Exchange can play a vital role in ensuring economic growth - they attract savings from households and firms, and then allocate those surplus funds to investors who have projects but lack the necessary financing.

But the more efficient this process is, the larger the contribution those investments will make to economic growth and the lower our cost of capital.

Well-structured and well-regulated financial markets perform these roles more efficiently than banks for larger-scale, standard financial products.

Markets perform these services with open and transparent pricing, lower transaction costs and more effective allocation.

Although markets and banks compete for business, they also complement each other. In particular, banks play an important role in the evolution of financial systems through their development of new financial products.

But as these products develop, they can be supplied in a standardised format through financial markets at lower cost.

That is partly because of lower "brick and mortar" costs required for centralised markets as compared with the branch networks of banks and partly because of the reduced need for regulatory capital to protect savers.

This evolution towards financial markets has gone farthest in the United States, where the banks account for less than 25 per cent of financial sector assets.

In contrast, banks dominate the financial sector here with an estimated share of financial sector assets of more than 90 per cent at the end of last year. So how badly off are our financial markets?

The stock exchange has the highest public profile. While there has been rapid recent growth, the total value of the outstanding issues on the NZX accounted for only 43 per cent of gross domestic product at the end of March.

This compares with Australia at more than 70 per cent and the United Kingdom and the US at over 100 per cent. Clearly there are historical reasons for this, but we need not be captive to that history.

Although the sharemarket has made big strides in the past few years, many of these gains also reflect the tougher government regulations, including those against insider trading and other market abuses, as well as increased information through the system of continuous corporate disclosure that has strengthened the accuracy and timeliness of the market information.

The Securities and Exchange Commission has stepped up and effectively implemented these new regulations.

However, our debt markets are even more retarded than our equity markets. Our debt securities (commercial paper, note and bond markets) amounted to only an estimated 9 per cent of GDP in 2003.

This compares with Ireland at 25 per cent, Australia at 35 per cent, Britain at 45 per cent, the US at 126 per cent and Denmark at 153 per cent.

Banks naturally don't like competition nor do they like to lose their corporate clients to the financial markets.

When banks are as dominant as ours are, they can more easily influence the Government and the regulators.

The Government and the Reserve Bank are simply not playing an effective role in supporting the development of financial markets. Some examples from the long list may be in order.

Private sector bonds are normally priced off a government bond rate of equivalent maturity so that the interest rate differential reflects their increased risk.

The Treasury does not undertake its government bond funding with the view of maintaining a benchmark yield curve against which the private sector debt offerings can be priced in the primary and secondary markets.

The Government needs to avoid the bunching of maturities, and with some additional effort it could meet the private capital market needs for a benchmark yield curve.

The creation of a bond-lending facility by the Reserve Bank nicely overcomes the market failures confronted by the banks, but the demand is also reflective of the continuing inefficiencies in the government bond market.

At the short end of the yield curve, the Reserve Bank has effectively shut down the market.

During most of the 1990s, the Reserve Bank used open-market operations to achieve its monetary policy objectives.

In 1999, it decided to set the official cash rate (OCR). The combination of narrow bands for the OCR and collusive behaviour by the banks - banks began to deal in overnight funds at the OCR rate, irrespective of the demand and supply conditions for funds, while the Reserve Bank looked the other way - mean the short-term money market is a shadow of its former self.

Markets live on information and their effective functioning depends on the timely provision of accurate and relevant statistics. The provision of this information is predominantly the Government's and the regulator's role.

That role has not been fulfilled. But it should also be noted that the Reserve Bank recently started publishing foreign-exchange market information and may now be developing domestic debt market statistics - both key moves to be welcomed.

But the key lessons from our neighbours have not been learned. As one response to the Asian crisis, the countries of east Asia have been actively promoting domestic debt markets.

Hong Kong is similarly dominated by banks. But in co-operation with banks, the Monetary Authority in Hong Kong has developed an active, mortgage-backed securities market.

Why can't the Reserve Bank take the initiative to develop a mortgage-backed securities market in New Zealand?

Not only would this market reduce the maturity mismatches of banks, but the highly rated mortgage-backed securities would help develop benchmarks for our debt securities markets as well as benefit our corporations by reducing their cost of capital.

Besides, the single best way to increase New Zealand's financial resilience is to increase the role of domestic financial markets.

And since all financial risks are ultimately borne by households, we all have a major stake in more effective Government and Reserve Bank solutions.

* Paul Dickie teaches international finance at the Victoria Management School. This article is based upon his two-article series in the Competition and Regulation Times from the New Zealand Institute for the Study of Competition and Regulation.