This article originally appeared in the NZ Herald.

The Australian Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry was relatively easy on the banks.

This has been reflected in their strong share price performances since the report was released on Monday.

Yes, Commissioner Kenneth Hayne said that the banks were naughty, sometimes very naughty, and they would have to be good corporate citizens in the future.

But they will continue to dominate the Australian and New Zealand economies as Hayne didn’t recommend any changes to their structures or basic operating models.

This domination has been facilitated by the banking sector’s ability to create money and earn huge profits from this activity.

“Broad money” is a measure of the total amount of money held by households and companies. It comprises notes and coins held by the public, call deposits used for daily transactions and savings, and term deposits with a maturity of one day or more (see table).

There is a widely held belief that the Reserve Bank creates money, partially because Sir Edmund Hillary, Kate Sheppard, Queen Elizabeth II and Sir Apirana Ngata are on our $5, $10, $20 and $50 notes.

These notes and coins are issued by the Reserve Bank but they represent only 2 per cent of total money. The remaining 98 per cent is effectively created by the banking sector.

This broad money is a medium of exchange that can be converted into its full nominal value. It doesn’t include land, houses, shares or other non-financial assets.

At the end of 2018 New Zealand had total broad money of $311.4 billion, with notes and coins representing only $6.1b of this.

As with most other modern economies, notes and coins created by central banks comprise only a small proportion of the total.

Banks create money by lending to individuals who immediately place these borrowings on deposit.

For example, an individual invests $500,000 in a bank term deposit and the bank then lends $450,000 of this to another party who deposits the proceeds in their account.

The depositor still has $500,000 but the borrower now has $450,000. Thus, a $500,000 deposit has been converted into $950,000 of broad money.

The borrower may subsequently use the $450,000 to buy a house but the seller of the home is likely to deposit these proceeds back into the banking system. The banks can then lend most of this new deposit to create even more money.

Central banks have been reluctant to highlight the banking sector’s money creation activities but this silence was broken in 2014 by two studies from the Bank of England, the UK central bank.

These papers are: Money in the modern economy: an introduction and Money creation in the modern economy.

The latter paper noted: “Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money”.

A major feature of most modern economies has been the massive expansion in broad money through the banks.

Broad money as a percentage of New Zealand’s GDP has surged from 52.6 per cent at the end of 1988, to 69.0 per cent 10 years later, 84.3 per cent in December 2008 and 107.0 per cent of GDP at the end of 2018.

The latest OECD figures show that New Zealand’s broad money has increased by 28 per cent since 2015 while total OECD broad money has risen by 21.4 per cent over the same period.

These figures illustrate why banks play a massive role in the New Zealand and other modern economies.

A key issue is what eventually happens to the newly-created money. Does it find its way into productive or non-productive areas?

This is an important issue as broad money is rising much more rapidly than general prices, as measured by consumer price indices.

The problem with New Zealand and Australia is that the majority of new bank credit eventually finds its way into the existing housing and apartment markets. This is a non-productive use of the new money and is a major contributor to the surge in house prices.

Reserve Bank of New Zealand figures show that residential mortgages have soared from $158.7b in December 2008 to $261.4b at the end of 2018. The latter figure consists of $185.8b of owner-occupier loans, $70.2b of loans to property investors and $5.4b of business loans secured by residential property.

This $261.4b of residential mortgages represents 59.3 per cent of total bank domestic lending, a high figure by international standards.

New Zealand-based banks have a much greater exposure to residential property than in most other countries, particularly Germany.

Germans don’t like debt and have fewer credit cards than any other major country. Thus, the 2000-plus German banks mainly lend to the business sector and this has been a significant contributor to Germany’s industrial success.

By contrast, New Zealanders are comfortable with debt and borrow heavily to purchase existing houses. It means residential property borrowers crowd out the business sector as far as bank loans are concerned.

This is a major drawback for New Zealand companies wanting to borrow money to grow their businesses.

The ability of the banks to create money, and earn massive profits from this activity, has enabled them to diversify into insurance, funds management, superannuation and other financial services. This includes KiwiSaver in New Zealand.

It is relatively easy for the banks to cross-sell KiwiSaver to customers with a home loan, and the four major banks, plus Kiwibank, have a combined KiwiSaver market share of 66.7 per cent. This has been achieved even though their investment performances have been relatively modest.

The Australian Royal Commission’s report was about misconduct, rather than the money creation and lending activities of the banks. Nevertheless, there was an expectation that some of their core and non-core activities would be reined in.

This was not to be, as the Australian Financial Review highlighted on its front page: “It seems bizarre. But the big four banks are winners because their core business, earning 200 basis point margin on taking deposits and lending to households and businesses, remain intact. The oligopoly is alive and well”.

The big question is, why have we allowed our banks to become so big and powerful?

This column pointed out in November that the four largest New Zealand banks — ANZ, ASB, Bank of New Zealand and Westpac — reported combined statutory profits after tax of $5128 million for the 2017/18 year compared with a combined $1693m for the 10 largest NZX-listed companies.

These four banks also dominate their sector with a combined market share of 82.7 per cent. In addition, the banks receive positive ticks from regulators as illustrated by the Commerce Commission’s decision to allow the two large overseas-owned banks, ANZ Banking Group and The National Bank of New Zealand, to merge in 2003.

The commission wrote at the time: “In the supply of personal loans, the merger is unlikely to result in a substantial lessening in competition because there are several other competitors in the market, including non-bank financial institutions. Further, barriers to entry into the supply of personal loans are not significant and the combined entity would be constrained by potential competition”.

This so called “competitive environment” has allow the NZ banking sector to raise its total after-tax earnings from $2667m at the time of the 2003 merger to $5830m in the latest year.

Meanwhile, the commission recently turned down the proposed Fairfax/NZME and Vodafone/Sky TV mergers even though the merged entities would face huge competition from existing and new competitors, with the latter group having relatively low barriers of entry.

The Royal Commission clearly shows that the four major Australian banks, and their NZ subsidiaries, lead charmed lives. The Commission’s report will be quickly forgotten and the major Australasian banks will be back in full harness again creating money and delivering massive profits for their shareholders.