Chapter 1

The Financial Services Industry:

Depository Institutions
Overview
In this chapter, we explore two major depository
institution (DI) groups:
Banks, and
Non-bank depository institutions.

We focus on the major characteristics of each group:
Size, structure and composition of industry group,
Balance sheets and recent trends,
Regulation.

In Australia, the Australian Prudential Regulation
Authority (APRA) authorises financial institutions to
carry out financial intermediation.

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Products Sold by the
Financial Services Industry
Comparing the products of DIs in 1950 and 2006:
Much greater distinction between types of DIs in terms
of products in 1950 than in 2006.
Blurring of product lines and services over time.
Wider array of services offered by all DI types.
Refer to Tables 1.1A and 1.1B in the text.
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Size of Banks in 2005
In 2005, the Commonwealth Bank of Australia was
the largest bank in terms of total assets ($258.93
billion).
Ranks 2, 3 and 4 were taken by the National
Australia Bank, Westpac and ANZ Banking Group
respectively.
The largest four banks in Australia are also referred
to as the Big 4.
All the banks listed in Table 1.2 in the text were larger
in terms of assets than non-bank Dis.
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Banks

Banks are the largest depository institutions
in terms of size.
Major difference between banks and credit
unions/savings institutions: banks have
more varied assets and liabilities.
Differences in operating characteristics and
profitability across size classes for
instance, with regards to the size of the
commercial loan portfolio.
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Banks: Recent Trends
In 2005 Australia had 49 banks, compared
to 13 banks in 1985.
Overall increase in number of banks driven
by:
relaxation of entry requirements
changes in the regulatory requirements of non-bank
depository institutions.
In 2005, the Big 4 banks plus St George
Bank held 73.9% of the assets of all
Australian banks, which points towards a
highly concentrated industry (see Table 1.3
in text).
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Major Banks
There are 5 major banks in Australia.
Asset composition in November 2005:
Cash and securities: $165,106 million
Loans: $709,569 million
Other assets: $121,571 million
Inference:
Focus on lending
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Regional Banks
There are 6 regional banks in Australia.
Asset composition in November 2005:
Cash and securities: $13,495 million
Loans: $90,861 million
Other assets: $9,648 million
Inference:
Focus on lending
Minor overall share compared to major banks
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Operational Foci of Banks
Four largest banks:
National focus.
Offer complete corporate and retail banking
services in Australia, NZ and Papua New Guinea.
They also operate in Asia, the US and the UK.
Smaller (regional) banks:
Regional focus with operations across state
borders.
Large proportion of assets invested in residential
housing loans due to their origins as building
societies.
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Profitability of Four
Largest Banks
Full-service provision by major banks has led to
enhanced margins.
Enhanced margins led to:
Higher performance, as reflected in their return on
shareholders funds.
Greater cost efficiencies.
However, in the late 1980s banks implemented
poor credit strategies, leading to poor
performance in the early 1990s.
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Profitability of Four
Largest Banks
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Balance Sheet and
Recent Trends: Banks
Shift from commercial lending to lending for
residential housing over the last 20 years:
Changes in the structure of the banking industry.
Implementation of capital adequacy regulations in
1989.
Growth of foreign currency assets and liabilities:
Relaxation of regulations with respect to banks
holdings of foreign currency deposits.
Banks enabled to access funding in Eurodollar
markets.
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Balance Sheet and
Recent Trends: Banks
Large drop of liabilities raised through Australian dollar
deposits due to retail savings growth in superannuation
accounts.
Increased importance of off-balance sheet (OBS)
activities:
OBS activities = items that move onto the balance sheet
when a contingent event occurs.
Used to generate additional income.
Four major types of OBS business:
Direct credit substitutes.
Trade- and performance-related OBS activities.
Interest rate derivative contracts.
Foreign exchange derivative contracts.
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Off-Balance-Sheet Activities:
Banks
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Building Societies:
Size, Structure and Composition


Building societies are DIs that usually operate
on a cooperative basis.
Depositors are members of the society.
Licensed under Banking Act to undertake the
business of banking.
Subject to Corporations Law for corporate
governance.
In 2004 there were 14 building societies,
compared to 31 in 1992.
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Credit Unions:
Size, Structure and Composition
Mutually cooperative organisations.
Members are usually linked by a common
bond, such as a trade union or locality.
In December 2004 there were 180 credit
unions in Australia.
In 2004, the five largest credit unions held
approximately 25% of total sector assets.
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Building Societies and
Credit Unions:
Balance Sheet and Trends
Significant growth period in 1960s and 1970s at
expense of banks.
Growth in building societies ensured sufficient supply
of funds for housing loans at reasonable prices.
Growth in credit unions ensured availability of
relatively low-cost unsecured and secured personal
loans.
Both industries could offer high-rate deposits, while
banks were subject to interest rate ceilings.
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The 1980s
Market share of building societies and credit unions
was threatened due to deregulation of banking sector
in 1980s.
Responses to loss in market share by non-bank DIs:
Mergers for efficiency and scale reasons.
Adoption of improved technology.
Diversification of products and activities.

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Building Societies and Credit Unions:
Performance
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Regulation
Australias current financial regulatory
framework has its origins in the late 1990s
Financial System Enquiry (Wallis Committee).
Full implementation of recommendations by
1999.
The Wallis Committee recommended the
introduction of three agencies, each with
specific functional responsibilities.
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Regulation: APRA
APRA = Australian Prudential Regulation
Authority.
Responsible for the prudential regulation and
supervision of the financial services industry.
Specific responsibilities include development
of prudential policies that balance:
Financial Safety,
Competition,
Contestability, and
Competitive neutrality.
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Regulation: APRA (cont)
APRA regulates Australian DIs under one licensing
regime.
Institutions regulated by APRA are called authorised
deposit-taking institutions (ADIs).
ADIs are covered by the Banking Act 1959.
APRA considers its approach to regulatory
supervision as:
Forward-looking,
Risk-based,
Consultative,
Consistent, and
In line with international best practice.
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Regulation: ASIC
ASIC = Australian Securities and Investments
Commission.
Responsible for market integrity and consumer
protection across the financial system.
Sets standards for financial market behaviour
with the aim to protect investor and consumer
confidence.
Administers the Corporations Law to promote
honesty and fairness in companies and markets.
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Regulation: RBA
RBA = Reserve Bank of Australia.
Responsible for the development and
implementation of monetary policy and for overall
financial system stability.
The aim of monetary policy is to achieve low and
stable inflation over the medium term.
Lender of last resort function.
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Regulatory Framework
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Prudential Standards for ADIs
1. Capital Adequacy.
2. Capital Adequacy: Measurement of Capital.
3. Capital Adequacy: Credit Risk.
4. Capital Adequacy: Market Risk.
5. Funds Management and Securitisation.
6. Liquidity.
7. Credit Quality.
8. Large Exposures.
9. Equity Associations.
10. Audit and Related Arrangements for Prudential
Reporting.
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Web Resources
For more detailed information on the regulators, visit:
http://www.apra.gov.au
http://www.asic.gov.au
http://rba.gov.au
Web Surf
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Financial Services Reform Act 2001
(CLERP6)
CLERP = Corporate Law Economic Reform Program
Issued by government in response to recommendations
made by Wallis Committee.
Outcome of CLERP6 consultation process: Financial
Services Reform (FSR) Act.
Aim of reforms:
Flexible and simple licensing of group structures, and
Flexible and simple delivery of financial services.
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Major Components
of the FSR Act
Uniform Regulation of Financial Products.
Licensing of Financial Services Providers.
Financial Service Provider Conduct and Disclosure.
Licensing of Financial Product Markets.
Other Reforms.
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Web Resources
For more information on Australias large banks, visit:

ANZ Bank:
www.anz.com.au

Commonwealth Bank of Australia:
www.cba.com.au

National Bank of Australia:
www.nab.com.au

St.George Bank:
www.stgeorge.com.au

Westpac:
www.westpac.com.au
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Web Resources
For more information on individual regional banks in
Australia, visit, for example:

Adelaide Bank:
www.adelaidebank.com.au

Bank of Queensland:
www.bankofqueensland.com.au

Bendigo Bank:
www.bendigobank.com.au
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Web Resources
For more information on individual credit unions, visit,
for example:

Australian National Credit Union:
www.australiancu.com

Credit Union Australia:
www.cua.com.au

Police & Nurses Credit Society:
www.pncs.com.au

Police Credit Union:
www.policecu.com.au
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Web Resources
For more information on individual building societies,
visit, for example:

Heritage Building Society:
www.heritageonline.com.au

IMB Building Society:
www.imb.com.au

Newcastle Permanent Building Society:
www.newcastlepermanent.com.au

Wide Bay Capricorn Building Society:
www.widebaycap.com.au
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Financial Statement Analysis
using a ROE Framework
ROE = return on equity
ROE = ROA EM,
where ROA = return on assets
and EM = equity multiplier
ROA = PM AU,
where PM = profit margin
and AU = asset utilisation
The decomposition of ROE into its different
components allows us to identify a firms
strengths and weaknesses.
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Financial Statement Analysis
using a ROE Framework
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ROE: Example
A bank has $100m in total assets. Twenty per
cent of these assets are funded through debt,
while the remaining eighty percent are funded
through equity capital. Assume the banks net
income is $5m, while total operating income is
$30m.
a. Calculate the banks ROE.
b. Decompose the ROE into its different
components.
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ROE: Example (continued)
Solutions:
a. Calculate the banks ROE.
ROE = net income / total equity capital
ROE = $5,000,000 / $20,000,000
ROE = 0.25 = 25%.
This means that shareholders earn a 25% return on
their invested funds.
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ROE: Example (continued)
Solutions:
b. Decompose the ROE into its different
components.
We know that ROA EM = ROE
and that PM AU = ROA.
Thus: ROE = PM AU EM
ROE = (net income / total operating income)
(total operating income / total assets)
(total assets / total equity capital)
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ROE: Example (continued)
Solutions:
ROE = ($5,000,000 / $30,000,000) ($30,000,000 /
$100,000,000) ($100,000,000 / $20,000,000)
ROE = 16.67% 30% 5.0
ROE = 5.00% 5 = 25%

Note: Ideally performance should be compared over
time (time-series analysis) and in comparison to
similar institutions (cross-sectional analysis).

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