A recent post over at ThinkMarkets about the negatives of having big banks in an economy got me thinking about banking in Australia. Unlike the U.S., Australia has a four-pillars banking policy which prevents any of the ‘big four’ banks from merging, something that would supposedly reduce competition in the sector. While that may well be the case, a more important effect it has on the sector is to virtually ensure an oligopoly equilibrium, with the big four able to use this ‘too big to fail’ position to extract rents from the rest of society.
People in the banking sector are quick to point out that the Return on Assets (ROA) of the big four is only about 1%, a very low return which, as Haldane (2009) states, means banks must resort “…instead to leveraging their balance sheets” to meet Return on Equity (ROE) targets, currently between 16 and 20% in Australia.
Bankers would argue that this is perfectly fine; after all, “…the social benefits of successful banks” are profound, as “…profitable and well capitalised banks provide finance for businesses and, therefore, keep people employed”.
But this is simply a rehashing of an age-old fallacy. Just because people are employed doing a certain thing does not mean that that employment is socially beneficial (which I will assume here to mean productive, i.e., wealth-creating, pie-expanding jobs). Likewise, just because a bank makes a profit is no sign of efficiency since its oligopolistic position allows it to achieve, within reason, a desired ROE that will appease shareholders and keep the government off their backs. To find out whether banks are actually socially beneficial we must look at profitability after subsidies. These subsidies include but are by no means limited to restrictions on entry and exit as well as implicit (government) and explicit (RBA) guarantees. The benefits the Australian banks receive from these policies are no doubt the reason for their individual success.
Standard efficiency indicators used by the banks to highlight their social benefits fail to factor this in and are at most useful for analysing changes through time at a given bank but not for cross-sectional comparisons with other Banks which operate under different circumstances. Therefore, given the institutional situation of the Banking industry in Australia, it is more likely than not that the big Australian banks are inefficient rather than efficient when compared with international banks. Progress – that is, true dynamic efficiency – has been stifled and replaced with stagnation, where we have substituted “…uniform mediocrity for the variety essential for that experimentation which can bring tomorrow’s laggards above today's mean”.
While the big Australian banks will have you believe that they are performing a socially beneficial function, in reality they are trading rents extracted from the rest of society owing to a state-mandated lack of competition in their industry. The solution is not to levy new taxes or forcefully break the banks up, all of which are likely to be unsuccessful, futile or actively harmful but instead to appreciate the institutional factors involved where unless there is true competition between banks, a policy of profit maximisation by the big four is likely to be socially harmful.