A key component of the Financial System Inquiry handed to Treasurer Joe Hockey this week was that “the financial system should be subject and responsive to market forces, including competition”. But on both market forces and competition, inquiry chair David Murray and his team squibbed it.

Much of the discussion of the Murray report in the financial press has been on the push back by the major banks against the inquiry’s insistence they hold more capital and properly account for the risks in mortgage lending. But the issue of the optimal structure of the Australian financial system, as opposed to its internal workings, was completely ignored.

Despite talk in Australia of coming “structural reforms”, Murray has set his face in stone against such reforms in the banking sector. And he’s not alone - the report points out that neither APRA nor the RBA nor the banking industry saw a strong case for such reforms.

“The Inquiry does not recommend pursuing industry-wide structural reforms such as ring-fencing. These measures can have high costs, and require changes for all institutions regardless of the institution-specific risks."

The inquiry did not consider the considerable risk-reduction benefits of reforms such as ring fencing as against the putative costs. Murray points out that although Australia did dodge the global financial crisis, it is not immune to “financial shock” and as a result the banking system must be made more resilient, hence the call for more capital. These were precisely the same arguments made for major structural reforms, such as ring fencing in the UK, and the “Volker rule” in the USA, but such arguments were dismissed in the Australian context.

Ring fencing, recommended by the UK Independent Commission on Banking in 2011, is often portrayed as cutting loose the investment banking cowboys but, in fact, it is a very sensible crisis management tool for bankers and regulators. As outlined by the Commission, and in the process of being implemented by the UK government, certain banking functions, such as payments and deposit taking, would be designated as being “permitted” inside the ring fence, and everything else would be outside. It is like having a “safe” bank within a bank.

Four pillars distortions

The elephant in the room in Australian banking is the “four pillars” policy, which is the unwritten rule that the pillars (originally six but now the four major banks) cannot acquire one another. The policy is not without its critics. In response to the Wallis Inquiry, which recommended scrapping the policy for competition reasons, Peter Costello maintained the prohibition on local takeovers, but left the door open (very slightly) to international acquisitions.

The four pillars responded to this near-death experience by increasing their importance and, in the almost 15 years since Wallis, have acquired smaller banks, such as Westpac’s take-over of St. George. They also branched out to acquire retail super funds. In 2013, the superannuation subsidiaries acquired by the four pillars, such as BT and First State, were 4 of the top 5 retail funds by assets (one of the original pillars, AMP was first). But getting bigger does not mean getting better, as evidenced by the financial planning scandals facing some of the major banks.

The Murray inquiry took a diametrically opposed position to Wallis on the four pillars, with a somewhat bizarre argument for a free-market advocate:

“To prevent further concentration, the longstanding ‘Four Pillars’ policy, which precludes mergers between the four major banks, should be preserved as outlined in the Interim Report.”

While the four pillars policy has been credited with helping Australia survive the global financial crisis, its impact is somewhat overrated as it relies on the argument that four CEOs cannot be as stupid as one or two - a fact that has been proven wrong elsewhere.

There are a number of questions that the FSI team failed to ask - “Why four pillars, why not two, three or six?” and “Why not international banks as part of the four/three or two?”

A different kind of four pillars.Tracey Nearmy/AAP

Too many branches

Australia is chronically over-banked. The latest APRA statistics show there are 69 firms with licenses as Authorised Deposit-taking Institutions (ADIs) with full service branches or other “face to face” customer contact operations. Between them, these ADIs operate 6,332 branches, which means there is a full service branch for every 3,650 people in Australia. It’s one service outlet for every 1,918 individuals if you count Australia Post (Bank@Post) stores. And there is one ATM for every 1,500 people, one Eftpos terminal for every 30 people.

With such overbanking and associated costs, how do Australian banks make such super profits? It can hardly be lack of competition as Murray believes, as there is competition a plenty. Fees of course are one answer, such as the credit card surcharges that have recently come under scrutiny, not least by the Murray report which recommends banning unnecessary surcharges.

But bank bashing is national sport and it is much harder to answer the question: “What should a modern banking system look like in Australia?” First of all – it should be modern!

What a modern banking system looks like

The Murray inquiry makes great play of financial innovation, introducing concepts such as “crowdfunding” and “peer-to-peer lending”. These fashionable but largely irrelevant notions are little more than DIY advertising for someone to lend you money, a sort of banking dating site.

Surprisingly, the Murray report does not address one of the major disruptors in the Australian financial system – internet/mobile banking.

With 72% of online Australians and 35% of mobile phone customers using online/mobile banking, why are so many physical branches and banks needed - surely they will go the way of the corner shop? In future the competitors to the banks for payments, credit cards and insurance will not be other banks, but instead companies such as Woolworths and Coles.

In the US, JPMorgan Chase, one of the world’s largest banks, operates around 5,700 branches for some 70 million customer accounts. So technically, only one bank is needed to handle banking for Australia’s population of 23.1 million. Australian banks bring little innovation to banking, as they source the bulk of their technology from foreign suppliers and proven technology from one major bank could reduce costs considerably across the system.

The question of ownership and control is of course important. Having one bank, albeit as illustrious as JPMorgan, could be dangerous. But maybe two would be sufficient? One local to provide backup in the case that the other international bank failed?

What are the arguments for four pillars? None, other than status-quo.

The issue is not ownership nor the number of banks, it is regulation. If one of the banks was undoubtedly stronger than local banks could be, it would actually diversify the sector, which should reduce its riskiness overall.

But the Murray Inquiry did not consider how technology will radically change ordinary banking in the next decade, wasting the chance of making the structural reforms needed to adapt to such changes.

Pat McConnell does not work for, consult to, own shares in or receive funding from any company or organisation that would benefit from this article, and has no relevant affiliations.