Federal Treasurer Wayne Swan knows that he needs to get more competition back into the Australian banking market. The only question is how.

Back in February 1985, the solution seemed simple. All the then Treasurer, Paul Keating, needed to do to shake up the cosseted local bankers club was to hand out foreign banking licences to 16 carefully selected banks.

Few thought that the big local players — Westpac, the Commonwealth Bank, ANZ Bank and National Australia Bank — would have any chance of defending their turf from top international competitors such as Citibank and Bank of America.

As it turns out, however, the local banks fared better than expected. Much better. Indeed, the power of the country’s big four banks now stands at its highest point since Keating handed over the foreign banking licences almost 25 years ago.

And that spells trouble for Swan, because the big banks are not being bashful about flexing their muscles with their customers.

So what’s Canberra to do about this dearth of competition in the banking sector?

In the short-term, I suspect we’ll see very little action. The local banks have emerged from the GFC as beacons of responsible lending, so any attempt to regulate them would likely backfire.

This means the government will likely wait to see whether competition returns to the banking market as the global financial crisis recedes.

In the wake of huge losses incurred during the GFC, many big US and European banks chose to pull back from the Australian market and to focus on their home markets. At the same time, offshore capital markets dried up as sources of funding.

This meant many Australian companies were forced to go cap in hand back to their local banks. And the big four were quick to exploit this shift in market power.

They quickly moved to widen their interest rate margin – the difference between their cost of funds and the interest rate they charge — on business loans. They also grabbed the opportunity to demand increased security from business borrowers, and to tighten up the conditions of the loans.

And the big banks also saw the chance to rake in huge profits by widening the spreads on the foreign exchange and interest rate hedging transactions they undertake on behalf of their captive corporate clients.

All of the major banks are enjoying a massive spike in profits from their trading arms and this largely reflects the windfall gains the banks are making from carrying out their client’s foreign exchange and money market deals.

The GFC also improved the big banks’ position in the retail market. Capital markets dried up, and non-bank mortgage lenders such as RAMS and Wizard found it increasingly difficult to raise funding at competitive rates.

As a result, the big banks picked up a bigger slice of the home loan market.

Canberra is watching carefully to see whether the securitisation market comes back to life, allowing non-bank mortgage lenders to again offer serious competition to the banks.

In the corporate market, the hope will be that some of the stronger global banks become attracted to the super profits on offer in this market, and decide to challenge the dominance of the big four banks.

But the GFC isn’t the only reason that bank competition has dwindled. The consolidation of the banking sector – particularly Westpac’s $19 billion takeover of St George, and the Commonwealth Bank’s $2.1 billion acquisition of BankWest — has also played a part.

This was emphasized by Gail Kelly’s flagrant move last month to raise Westpac’s home loan rate by almost double the official 25 basis point increase by the Reserve Bank.

Even more alarming was Westpac’s justification that it needed to raise its rates so aggressively because it was winning too large a share of the home loan market.

It is, of course, too late to turn back these mergers. But Canberra is likely to be much more wary about allowing the big banks to swallow up their regional banking competitors in future. And it will also think long and hard before allowing one of the big four banks to take a tilt at acquiring AMP.

In the meantime, Canberra will probably maintain the government guarantee on bank borrowings to ensure that the remaining regional banks can continue to fund themselves at competitive rates to the major banks, and so can provide competition in lending markets.

Apart from this, you should expect to hear Swan try to cajole the big banks into showing at least some compassion for their customers when it is time again to raise interest rates.

Peter Fray

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