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According to the ASX, the financial sector is the largest industry sector of the Australian stock market by capitalisation. It consists of trading and investment banks, asset managers, insurance companies, REITs and other providers of financial services. Due to compulsory superannuation, Australia has the fourth largest pension fund pool in the world, creating a favourable environment for banks, asset management, financial planning and insurance companies.

Stock Exchange Merger Rejected

Given the importance of the financial sector to the Australian economy, it is not surprising that Treasurer Wayne Swan showed special concern for financials in announcing his decision to prohibit the acquisition of the country’s primary securities exchange operator, stock exchange, ASX Limited, by the Singapore Exchange Limited. “At the end of the day this takeover was more about growing Singapore’s financial sector than Australia’s” Swan told reporters in Canberra. “I am open to the right deal for Australia if it comes along.”

Regulatory Concerns

Swan explained that the Foreign Investment Review Board’s recommendation “was that not having full regulatory sovereignty over the ASX-SGX holding company would present material risks and supervisory issues impacting on the effective regulation of the ASX’s operations, particularly its clearing and settlement functions.”

Yet in a December report prepared by Access Economics for ASX, Ian Harper argued that such protection of the exchange’s regulatory sovereignty was unnecessary. “Whether ASX is 0% or 100% owned by Australians has no bearing on how ASX is regulated” said Harper.

Regulatory sovereignty wasn’t dependent on exchange ownership, Harper explained. “In Australia and Singapore the regulation of exchanges is of fundamental importance” said Harper. “It is a matter of national sovereignty. Ownership of exchanges is of secondary importance. That is why the fact that ASX is privately owned has never been regarded as a problem in the past. Nor has the fact that approximately 20% of ASX’s issued capital is already owned by foreign shareholders. Exchange groups cannot operate in Australia without valid licences, and they remain subject to government and regulatory agency oversight and Ministerial direction no matter who owns them.”

In addition, Doug Clark, head of policy at the Stockbrokers Association of Australia, expressed concern with the current clearing and settlement system, in which retail brokers can only turn to two third-party clearers: Berndale Securities, which is withdrawing from the market, and Penson Financial Services. “If the third party clearer fails, or several of its clients, it could threaten the settlement system” Clark said. “It’s called concentration risk.” The importance of third-party clearers increased when, following the delay in settlement by Tricom in 2008, the ASX increased core liquidity requirements for brokers who clear their own trades from $100,000 to $5 million (and then to $10 million in 2013).

Rapid Sector Growth at an End

In its recently issued Financial Stability Review, the Reserve Bank acknowledged that “the challenge for financial institutions and regulators in Australia will be to manage an expansion under post-crisis conditions.” While the very rapid growth in the financial system in the years that preceded the crisis appears to be over, the Reserve Bank said, “There is no reason why the financial system cannot adapt smoothly to a slower rate of expansion.”

Bank share prices have done well in recent months, tracking the broader share market. “Confidence in major banking systems has recovered further over the past six months” the Reserve Bank said. “Assisted by generally improving economic conditions, large banks have continued to report profits and repair their balance sheets. In particular, many banks have further strengthened their capital positions; this, together with previous gains, has left many banks better placed to withstand future adverse shocks and meet tougher upcoming regulatory capital requirements. Partly in response to this, bank share prices generally increased over the past six months, along with broader share market indices, though they have fallen in recent weeks reflecting the unrest in North Africa and the Middle East, and the natural disaster in Japan.”

Said Assistant Reserve Bank Governor Malcolm Edey, “Australian banks are in good shape. They came through the crisis profitable and well capitalised.”

A UBS analyst noted late last year that “the vast majority of the growth during 2010 was purely a result of lower provision charges for bad and doubtful debts as the Australian economy emerges from the GFC. If we look at the profit of the banks before charges for bad debts and tax, it fell 0.8 per cent during 2010. This is a fact that has been missed/ignored by many observers (but not shareholders).”

Floods Hit Regional Banks Hardest

The Queensland floods primarily affected regional banks, the Reserve Bank indicated. “Private-sector equity analysts have downgraded their profit forecasts for two of the regional banks that have the largest relative exposures to Queensland – by around 15 per cent since the start of the year – in light of the recent natural disasters. Accordingly, the share prices of the regional banks have underperformed the broader market since November, while those for the major banks have been similar to the broader market over this period.”

Australian insurers had also weathered the storms well, said Ivan Colhoun, head of the ANZ’s economic and property research team. However, he warned that premium rate increases might be on the horizon. “When they looked at the Australian situation, they were looking at the recent floods and cyclones together being the biggest combined insurance claim that Australia’s ever seen” said Colhoun. “But feeling that the Australian insurers were well placed to meet that, particularly because of the use of re-insurance, I guess from our perspective the other thing we have to think about is that there’s likely to be premium rises so that will push up the cost of many insurance claims in the next year or two.”

Concerns about Competition

The four major banks – ANZ, Commonwealth, National Australia Bank and Westpac – play a dominant role in the sector, and indeed in the economy as a whole. The “four pillars” doctrine prevents the Big Four from combining through merger and acquisition; however, the policy does nothing to prevent the Big Four from eliminating competition from smaller, upstart banks. UBS banking analyst Jonathan Mott blamed the nation’s housing affordability crisis, not a lack of competition, for the perceived problems in the banking sector. “What is the symptom? Competition. What is the disease? Affordability,” Mott said at a Senate inquiry into banking competition.

Mott denied that the banks were making excess profits, comparing the sector’s average return on equity (16%) with other major Australian corporates such as BHP (28%), Rio Tinto (29%), Brambles (30%) and Woolworths (28%).

The Australian Prudential Regulation Authority, which supervises the registration of financial corporations, has limited entrants to the banking market, not to discourage competition, but to promote stability and sustainability within the industry, says APRA chairman John Laker.

“We put new entrants through quite a rigorous authorisation process because I don’t want a new institution running on to the field, getting tackled and limping off after the first move. That does not help the integrity of our banking system. So when our institutions go on and play they need to be able to survive the hurly-burly,” Laker said.

Financials Still a Good Investment

While the sector’s year-on-year performance in the ASX lagged, dropping 7.2% through the last quarter, the most recent quarter saw a sharp turnaround, helped by progress on the National Broadband Network, as financials went up 3.5%.  Said Michael Hevern, head of research for TraderDealer.com, “Investors should gain confidence from the Financials sector which is starting to participate in the ASX performance as it pushes towards new yearly highs, beyond the 5000 level in 2011.” Despite the predictions of slowed growth and the questions regarding regulatory changes and competition, the financial sector remains well placed for continued strong performance, as it is expected to continue tracking the sustained growth of the broader economy. Next week we’ll look at another strong sector – energy stocks.