Economics of Banking Essay

High level of capital is considered to have diminished Australia's Banking Industry return on Equity, after 2014, which absolutely resulted in a withering market competition of the four big banks. By the statement on the draft report on competition in the financial system, it was clear for PC that the four banks ability to pass on cost increases and set prices that maintain high levels of profitability without losing market share and prudential regulation substantially would limit the scope for traditional price competition. The Australian Government has asked the productivity commission to undertake a 12-month inquiry into competition in Australia's financial system. First, what is the impact of high-level capital on Return on Equity and its relation to completion? This article represents the effects of high-level capital on return on equity and the competition in Australia financial systems, which in turn leads to falling off the banks.

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Previous research shows that Australia Banks have a return on equity which is about twice, if not more than, something that happens in other parts of the advanced developed economies of the world. Guriev and Kvasov (2005) say that they have come up with a simple model of imperfect competition in financial markets with capital with indigenous capital structure. According to them, the model builds on packing order theory that assumes to be better informed about their growth opportunities to the outside investors. However, any issue of equity sends investors negative signal about the firms quality; arguing that the cost of equity is normally higher than that of debt finance. They supported their reasoning by clearly stating that financial markets are perfectly competitive, enabling all the imperfections of equity finance to automatically be passed back to the firm in form of higher cost of capital.

According to Levine (2011), banks in the US and Europe sustained large losses, during the global financial crisis, leading to negative returns for a couple of years. The analysts expect Australian bank's ROE to maintain an average 12.5% over the next couple years, which is proven high by international standard and appear to be above bank's cost of equity. However, it is lower than the return to which Australia banks and their investors have become accustomed.

According to Guriev and Kvasov (2005), having analysis of two kinds of empirical implications, first both across countries and over-time, a higher concentration of financial markets power which should result in greater reliance on equity finance. Indeed, it is true that financial markets are concentrated, and the rate of return on equity (ROE) investments is still positive in the presence of diluted cost of equity financing. Below is the graph illustrating how ROE affects the four big banks market competition?

According to Bikker and Bos (2008), a remarkable result is that which the dominant determinant in the theoretical literature, banking market concentration does not have a significant impact on competition. They stated that market concentration impairs competition whereas a modern and dynamic interpretation of this variable is that competition may con whereas a more modern and dynamic interpretation may consolidate so that competitive banks end up in a concentrated market.

The following is the bank capital structure and its competition:

Jiang, Levine and Lin (2016), in new paper evaluated conflicting theoretical perspective if competition among bank would increase, decrease, or would have no effect on liquidity creation. They indicated that some models on their research reduce liquidity creation by lowering the risk absorption capacity of banks. According to analysis by Jiang, Levine and Lin (2016) on Boyd and De Nicolo (2005) concept of squeezing profit margins and deplete g buffer against losses, competition can induce banks to reduce risk-taking that liquidity creation is risky therefore banks will suffer loses if they must quickly dispose of illiquid assets to meet the demand of those holding liquid liabilities. They all agreed that competition can open doors easily for firms to change banks and this will be difficult for banks to recoup the cost of enabling long-run relationship with firms.

According to Brander and Lewis (1986), models by Alchian (1950) and Stigler (1958) show how the greater product, market competition will coerce firms to adopt corporate governance mechanisms. The research was done by Jiang, Levine and Lin (2016) also shows how competition can boost the quality of financial statements by facilitating peer-firm comparisons, and the availability of benchmark facilitates effective corporate governance as emphasized by Levine (2011) and Levine, Lin, and Xie (2016).

Following Jiang, Levine and Lin's (2016) conclusion, they found some evidence that seems to correlate with the view that a regulatory induced intensification of completion reduces bank liquidity creation both by squeezing profit margins and by impeding relationship lending. On a specific note, they realized that more profitable banks, as measured by net interest margins, experience a smaller reduction in liquidity creation in response to interstate bank deregulation. They also found out that an intensification of competition reduces liquidity creation more among small bank.

This article also focuses on finding out whether the return on equity of the four Australian Bank is closely related to the ones of big or large companies in Australia. What if the returns become lower when there is a low risk of banking? Given that ROE (Return on Equity) is a function of RAO (Return on assets) leverage, it is not in order one to compare the ROE of banks with other larger companies. The high leverage brings higher risks on delivering high returns on assets to meet their ROE targets. In this paper's view, banks are known as risk managing companies and their central banks are the rule as purveyors of credit and financial flow in the economy makes banks distinct from other firms such as the manufacturing companies. Therefore, the best comparison of these four big banks would have been for banks in other countries.

The five-year average shareholder returns of Australia banks were about 4.5% highest in OECD Countries (Cihak, Demirguc-Kunt, Feyen, & Levine 2013). This is rated to be twice what was charged previously, creating abnormal returns that are due to uncompetitive market. With the high ROE, many investors have been pushed away, because it is perceived that any issue of equity sends investors negative signals about the firm's quality. Indeed if a large investor reduces lending and invests more in equity, the interest rate on the debt goes up.

The comparison of the four banks in Australia and other big companies in Australia is only important when one looks through the lens of risk and non-divertible risks. From this research angle on the check, there is a small portion of investor can do for system-wide risk. In making a comparison, it is the total risk that would matter upon focus on non-divertive risk made. Expansion of banks into multiple business lines, through business diversification, reduces the volatility of their portfolio. The truth however is, that community does not care about banks specific risk, however, is that community does not care about banks specific risks, however much concerned with market-wide risk which is non-divertible

With the rise in return on equity, Australia's banks are said to be the least profitable. The four banks have reported a four basis point increase in bad debt charges, which Moody state that increases in corporate bad debt also caught the attention of the rating agency from which the big four banks currently have a stable Aa2 rating (Jiang, Levine, & Lin 2016). Difficulty in operation condition by the four big banks has been noted to give deteriorating credit quality among some large companies.

A report by Levine, Lin, and Xie (2016) gives a realistic chance of share price breaking out on the downside, if the asset quality weakness broadens, competition intensifies, interest rate fall (towards 1%) or regulatory capital continues to rise. Moody says that the Divisional returns on Equity remain above average despite a reduction due to increase in capital levels, for example, he says, Westpac's ROE for its consumer and business operations is 16.1%, higher than the banks overall ROE of 14.2% (Jiang, Levine, & Lin 2016).

March Quarter 2017 returns on equity, costs of equity and the implication for banks return on equity for the four big banks have lately been declined, following the equality rising in 2014. It is clear that the two developments is in better hands to explain why Australian banks stocks are declined, but still, a sizeable premium to their books value.

What Is Return on Equity?

It is a measure of how shareholder is being used to generate profit and is the most widely used metric to assess banks profitability. Banks are said to commonly setting their ROE targets both at the institution and product level and these targets are often a central element of executive remuneration. Westpac's Chief Finance Officer, Peter King, told the country's productivity last month that, however true, as a sector, they make large dollar profits, it does not necessarily equate to being highly profitable. In response to King, the productivity commission said that the big four are more profitable than their small rivals, partly because the banking regulation had focused on stability at the expense of competition. This was to affirm the report given by the CFO. Westpac, on the other hand, posted that a record cash profit of A & 8.06 billion ($0.3billion) for the year ended September 30th, to have missed market expectation. It is net interest margin, a barometer of profitability which was down 4 basis points to 2.06% as competition eroded the benefits of higher mortgage rates (Eyers 2018).

Capital structure in the banking industry by Shirley J Ho Department of Economics National Changchi University Taiwan assumes debt to vary with banks current return and taking equity as the control variable for financial decisions. Brander and Lewis (1986), also say increasing debt has two impacts on the firm value to decrease the critical value of shock and to increase the debt payment. Since debt is predetermined before the competition, she says that the repayment will not be made before the competition and that the repayment will not affect the firm output levels (Jiang, Levine, & Lin 2016). The only impact on the critical value of shock will lift up the expected demand, increase marginal revenue and increase output and profits.

In her model, the equity level is constant and set prior to risky competition (Jiang, Levine, & Lin 2016). Equity issuing has three impacts on the bank cash value reserve, which also decreases the critical value of shock. The former increases the bank value directly and the latter will lift up the expected demand and marginal revenue and also increases risky investment and returns. Second higher equity level means more dividend s to give away to equity holders, and this will decrease the marginal revenue, their investments, and returns. The third impact is on the debt repayment, indirectly through its impact on the return and the debt level.

In this research, Boyd and De Nicolo (2005) also concluded that equity issuing will decrease bank's equilibrium risky investment. She showed the domination of the latter two impacts. However, the fully debt or equity financing is not optional since issuing equity can increase the cash flow reserve and decrease the chance of bankruptcy especially when the business status is bad. Demirguc-Kunt and Levine (2009) also demonstrate that the equilibrium equity level is higher in...