A turning point in the banking industry?
Competition is set to increase in the banking sector - and it's likely to put the major banks' profitability under further pressure.
Banking industry news this week has revolved around the Royal Commission as the major banks were put under the microscope for past misdeeds.
But away from the spotlight there's been an important announcement from the nation's banking regulator.
APRA has given approval for ING Bank (Australia), the local subsidiary of the multinational Dutch bank, to use its own internal models to calculate regulatory capital.
In plain-speak, ING is now subject to less onerous regulation. And more importantly, it's on a more level footing with the major banks – ANZ, CBA, NAB and ANZ – and Macquarie (let's call them the Big 5).
Let's see how that works.
Bank regulation basics
The basic function of a bank is to lend money, and then to get it back, plus a bit. But sometimes that doesn't happen.
To be confident that a bank can survive even if it can't get all its money back, regulators require them to hold minimum levels of shareholder capital to act as a buffer.
For the Big 5 that minimum level is proportionally much lower than their peers. They're allowed to use their own internal models to determine regulatory capital, with capital buffers lower than the wider industry.
To illustrate, the industry historically had to hold at least 25-50% more capital for mortgage loans relative to the Big 5.
As a result, the Big 5 can earn fatter profits by lending more for each dollar of capital.
Smaller banks have been shouting that this is unfair and unjustified. Indeed, they are at a competitive disadvantage, but there is some justification for it, because the Big 5 have invested tens of millions developing sophisticated risk-management tools and processes. In theory, this should make them better able to manage risk.
The significant cost in achieving such status has historically excluded smaller banks, though some have been trying. Regulatory approval was likely to extend beyond the Big 5 at some point, although the timing was uncertain.
ING has now become the first to gain approval.
In combination with expected revisions to the industry's capital framework, this may be a big step to more even competition.
We have no idea when further approvals may be granted. Hopeful second-tier banks say they don't know either – but it will happen.
A significant change in the major bank's share of the industry is not expected in the near term. The Big 5 still have many sources of advantage, including scale.
But perhaps within the next five years, we can expect a material increase in the industry's competitive intensity.
That would place the profitability of the major banks – considered to be the highest in the world – under some pressure.
The Royal Commission may bring about material changes. But we consider competition – whether it be by regulation or technology – to be the biggest threat to major banks in the longer term.
We may have seen an important step to that future this week.
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