Whatever happened to competition?

COMPETITION is now the festering sore in an Australian banking industry that has, so far, sidestepped the worst effects of the credit markets' "Ice Age".

Through a combination of luck, tough regulation and solid management, the local banks have not only remained profitable, the largest of them now rank with the best in the world in terms of their credit ratings.

They have also avoided the ignominy of many once-global giants that were forced to beg their respective governments to become their largest shareholders in exchange for the billions of dollars the giants needed to survive.

Australia may have largely steered through the crisis, but the local market remains fundamentally changed. The big four Westpac, ANZ, National Australia and Commonwealth have used their strength to snap up weaker rivals. With that comes a shift in market dynamics where banks will have greater pricing power and are less likely to innovate

For now, at least, those four control more than 90 per cent of the nation's mortgages, compared with about 60 per cent before the crisis and their real grip on the market is closer to 100 per cent when you factor in all the indirect lending they fund on behalf of non-bank lenders and mortgage brokers.

Of the smaller lenders that have been mopped up by the majors over the past 18 months (RAMS, St George, Aussie Home Loans, Bankwest and Wizard), Commonwealth Bank's $2.1 billion swoop on Bankwest probably stands to change the nation's banking most.

The acquisition eliminated one of the most aggressive second-tier banks.

Further choking off the smaller bank sector has been the very same weapon that the Government deployed to underpin the financial strength of Australia's financial system: the wholesale funding guarantee.

This guarantee enabled banks to use the Government's AAA rating to raise money offshore so they could keep lending.

Australian banks fund just 43 per cent of their lending from their own deposits and, according to the Reserve Bank, rely on offshore wholesale sources for about 80 per cent of their long-term funding.In the first six months of this year, industry publication DCM Review estimates Australian banks raised about $64 billion in overseas capital markets, putting them well on the way to eclipsing last year's record.

When offshore funding markets froze over Australia was clearly left vulnerable and the Government stepped in with its funding guarantee.

A direct consequence, however, is that the regional banks are charged an interest rate nearly double that of the majors to secure access to global markets. This has made it simply too costly for small banks to secure fresh funds, and limited their ability to compete with the big four.

"We had no problem, with the Government dealing quickly with making sure global funding was secured in the domestic economy, but if you want competition you do need to think about the settings put in place to make sure it's not disrupting competition," says former Bendigo Bank boss Rob Hunt.

In the more than two decades Hunt spent running Bendigo Bank, until his retirement in July, he turned the regional lender into a key low-risk player and was instrumental in developing its community bank model that allowed branches to open in areas on which the big banks had turned their backs.

"Even though we still had four large players before the crisis, it really was quite competitive. We had the non-bank sector, the foreign banks in there as well," says Hunt.

"The first priority of the Government was to protect the system and protect the economy. But my belief is they probably underestimated the potential impact on competition."

Competition regulator Graeme Samuel says he had "no choice" in approving the Bankwest transaction at the time, given the significant funding problems of its British parent, HBOS. But the Australian Competition and Consumer Commission chairman has vowed to scrutinise any future bank mergers.

"Now, if we were looking at a potential bank merger, we'd be looking very carefully at all the policy positions taken by government, the prospective policy positions, the dynamics of the sector," he said.

"We would be subjecting any merger to the most rigorous scrutiny," Samuel says. Many analysts and even bank executives fear this means a buy-out of Brisbane-based Suncorp-Metway's banking arm could be off-limits to a major player.

Samuel will not comment specifically, but notes: "We're now in a different environment to what we were in in 2008."

The big banks are expected eventually to cede some of their market share as credit markets reopen, but it will be many years before competition makes substantial inroads.

For his part, Hunt strongly believes small banks can become viable as long as they recognise the limitations and do not try to run themselves as a big bank.

As an industry, Australia's bank executives have had to confront the fact their operations were neither immune nor uninvolved in the activities that sparked the crisis, and are changing the way they now do business.

Two of the big Melbourne-based banks, ANZ and NAB, were caught out holding the same sort of unusual credit instruments on their balance sheets that undid many overseas competitors. Fortunately, they had enough capital to absorb the hundreds of millions of dollars in losses.

These were the collateralised debt obligations sliced and diced packages of mortgages and other types of loans that were supposed to give the owner a guaranteed income of interest as they were repaid. But the CDOs became so complex that banks and ratings agencies were no longer sure how to value them.

EVEN now it seems remarkable that the sheer force of the trillions of dollars flowing through the world's financial system is largely driven by one simple human trait: trust.

Trust was already in short supply among the world's bankers long before the collapse of Wall Street brokerage Lehman Brothers almost tore apart the world's banking architecture.

Global credit markets were skittish about the growing tide of defaults among low-income borrowers across the US.

Think of the financial system as the plumbing for the economy. Billions of transactions take place daily requiring the smooth transfer of funds. Borrowers require banks to have funds to cover everything from the cost of lunch on a credit card to a house. Big business often issues bonds to help fund ambitious expansions or to provide bridging cash while they wait to be paid for the goods they sell. Investment banks brought the financing together while traditional banks sat at the heart of the transactions.

It all worked during boom times and few questioned it until it stopped.

Bankers have been pilloried. After all, it was seen as greed and an unquestioning belief in their own ability and the financial system that allowed the bubble to get bigger and bigger.

ANZ chief executive Mike Smith defends the industry, pointing out that life can get pretty tough without banks.

"The thing that banks don't get across properly to the community is the importance the banking sector plays to the economy," he says. "It's impossible to have a well-functioning economy unless you've got a sound, stable, profitable and well-run banking system. You only have to go to North America or to Europe to see the effect of that."

One year on, with many big banks back on their feet thanks only to their governments, regulators from Reykjavik to New York are looking at how to keep them standing.

After underestimating the impact of the the Lehman Brothers collapse, regulators concluded many banks were too important to fail, forcing governments to plough billions of taxpayers' dollars into propping them up.

In its latest Global Financial Stability Report, the International Monetary Fund estimated the total bill for write-downs and losses could reach more than $US4 trillion ($A4.65 trillion) over the next two years with banks wearing about two-thirds of that cost.

After global banks have taken their medicine, and been nursed backed to health, comes the even tougher challenge to try to rebuild the architecture of the financial system in a way that avoids a repetition.

Economist Paul Krugman wrote in The New York Times Magazine this month that economists missed the warning signs of the biggest postwar bubble, because the field was seduced by maths and the vision of a perfect system.

Likewise, the Bank for International Settlements (BIS) has called for greater questioning of financial markets.

The financial disaster has revealed myriad limitations in micro-economic financial arrangements, according to the BISThis extends to problems with remuneration and bonuses, problems in measuring, valuing and even tracking credit instruments as well as problems with monitoring and regulating products.

Regulators like the BIS now recognise that the financial system needs higher-quality rules to keep it functioning relatively smoothly.

Westpac learnt its lesson from its acquisition of Bank of Melbourne 10 years before, resulting in the loss of a well-known brand and customers. Its $12 billion purchase of St George last November allowed it to trump Commonwealth as market leader,

testing CEO Gail Kellys claim that a major bank can run a House of Brands at retail level in a group that now spans Westpac, St George, RAMS Home Loans, Bank SA and funds arm BT Financial Group. Westpac has recently signalled its commitment to

the St George business with plans to expand its footprint with new branches.

Until, this year National Australia Bank had been the most cautious when it comes to domestic acquisitions, having done little since its $4.5 billion purchase of MLC in

2000. However its has since been one of the most active in acquisitions, paying $825 million for the local life insurance assets of Aviva, entering a stockbroking joint venture with Goldman Sachs JBWere and more recently acquiring Challengers

mortgage broking business and lending book.

Commonwealth Bank has been the most active in the domestic acquisition

stakes in the past decade and engaged in a company transformation deal when it bought the Colonial group for $9 billion in 2000. Its purchase last October of

BankWest for $2.1 billion continued its trend of snapping up regional banks. Elsewhere it has taken a stake in mortgage broker Aussie Home Loans and acquired a portfolio of home loans from the former Wizard franchise.

Cashed-up ANZ has focused most of its acquisition efforts offshore in recent years, with its $4.9 billion move on National Bank of New Zealand making it the biggest bank in that market and then a string of mid-sized banking acquisitions through south-east Asia. Late last year ANZ made a move on Suncorp- Metways banking operations, but Suncorp baulked at the lowball offer. While ANZ is watching the domestic market, its expansion plans lay in Asia, most recently paying $687 million

for Royal Bank of Scotlands Asian businesses and in the process further boosting its footprint in the region.

Bendigo Bank launched from its Victorian base to a national footprint with the

move on Queenslands First Australian Building Society nearly a decade ago. Bendigo consolidated its position as the big little bank following the 2007 merger with Adelaide Bank. This was a defensive move aimed at thwarting a takeover offer from Bank of Queensland.