Month: February 2015

Government Consulting On Foreign Investment Reform

The Government is seeking views on proposed reforms to strengthen Australia’s foreign investment framework, particularly around residential real estate and agriculture.  DFA welcomes this, as we know overseas investors are impacting the market, and evading current light touch regulation. The proposed reforms include:

  • increasing compliance and enforcement activities around foreign investment in residential real estate through the creation of a specialised investigative and enforcement area within the Australian Taxation Office; and
  • introducing new civil penalties and increased criminal penalties for foreign investors and third parties who breach the foreign investment rules.

Enforcement

The House Economics Committee report made a number of recommendations to improve data collection, compliance and enforcement activities around foreign investment in residential real estate. It recognised that while the Foreign Investment Review Board and Treasury were well placed to continue undertaking the upfront screening of residential real estate applications, its internal processes and lack of specialist investigative and enforcement staff have weakened the enforcement of the foreign investment rules.

The Government believes there would be benefits to creating a new specialist, dedicated compliance and enforcement area to support the functions of the Foreign Investment Review Board and Treasury Secretariat. Having considered a range of possible alternatives, the Government considers the Australian Taxation Office to be the best place to undertake this role, as it has staff with appropriate compliance and enforcement skills, sophisticated data-matching systems and experience in pursuing court action. This would involve the creation of a new unit within the Australian Taxation Office. The costs of administering this new function would be offset through the introduction of application fees on foreign investment proposals (see the section below on application fees).

The Australian Taxation Office (in consultation with Treasury and relevant agencies) would be tasked with using its sophisticated data matching systems to detect instances of potential non-compliance with the foreign investment rules, drawing on land titles data from the states and territories, its own taxpayer information, foreign investment approvals data and immigration movements data. Possible breaches would be followed up by compliance staff, with a range of penalties available to be applied as appropriate (see the section below on penalties).

The Government is also proposing to amend the Foreign Acquisitions and Takeovers Act 1975, the Taxation Administration Act 1953, an Instrument under the Migration Act 1958 and any other relevant legislation to ensure that data can easily be shared between agencies. The Foreign Acquisitions and Takeovers Act 1975 would also be amended to ensure that the Australian Taxation Office is able to issue statutory demands for information where it has reason to believe that a person has information about a matter that may breach the foreign investment rules.

Penalties

The Government is considering extending civil pecuniary penalties and infringement notices to business, commercial real estate and agricultural investment applications. While there is limited evidence to suggest non-compliance in these areas, civil pecuniary penalties and infringement notices will supplement the current criminal penalties and provide additional enforcement options should the need arise.

Civil pecuniary penalties could apply where a foreign person acquires a business or acquires rural land without approval. As with residential real estate the infringement notice regime could be tiered and could apply to more minor breaches, for example where a foreign investor voluntarily comes forward.

The penalty regime being considered for breaches of the rules around business, commercial real estate and agricultural investments are set out in the table below. The indicative new penalties would supplement the existing criminal penalties (currently, 500 penalty units ($85,000), imprisonment of two years or both) — with corporations subject to a multiplier of five.

Fees

Consideration is also being given to the introduction of an application fee on all foreign investment proposals, based on the type of investment.

  • Residential real estate properties less than $1 million – $5,000
  • Residential real estate properties equal to or greater than $1 million $10,000
  • Residential real estate properties equal to or greater than $2 million $20,000
  • Residential real estate properties equal to or greater than $3 million $30,000
    Residential real estate properties equal to or greater than $4 million $40,000
  • Residential real estate properties equal to or greater than $5 million $50,000;
  • then $10,000 incremental fee increase per additional $1 million in property value
  • Advanced off-the-plan certificates – Fee based on rates above and number of units sold to foreign purchasers

Currently, property developers can apply for an advanced off-the-plan certificate to sell new apartments in a development of 100 or more to foreign investors (the investor does not then need to obtain separate approval). These certificates are granted on the condition that the apartments are marketed in Australia, as well as overseas, to ensure that domestic buyers have the same opportunity to purchase the apartments. However, there are currently no penalties for breaching this condition.

The House Economics Committee report recommended a tightening of the rules around advanced off-the-plan certificates to ensure developers comply with their obligations to market properties to domestic buyers, including the introduction of penalties to deter non-compliance.

Recognising these concerns, the Government is proposing to strengthen enforcement options by subjecting developers to civil and criminal penalties under the Act in line with other offences (see the section above on penalties).

In addition, the Government is proposing to tighten the rules around the use of advanced off-the-plan certificates by limiting the value of all apartments that can be bought by a single foreign investor to $3 million in any single development. If foreign investors want to purchase apartments above this value, they would have to seek individual approval. This would reduce the scope for any criminal behaviour (such as money laundering) by ensuring that high wealth investors are subject to the upfront screening process.

The Government also intends to introduce a new $55 million screening threshold for foreign investment in Australian agribusiness, subject to public consultation on the definition of agribusiness.

The closing date for submissions is Friday, 20 March 2015.

The Impact of Low Interest Rates

In the UK interest rates are artificially low, and in Australia, rates were cut last month. What are the potential implications of a low interest rate policy? Is it good strategy, or a gamble?

In a speech given by Kristin Forbes, External MPC Member, Bank of England, the various impacts of ultra-low interest rates are outlined. It is worth reflecting on the significant range of implications.

By way of background, the UK, recovery is now well in progress and self-sustaining – despite continual headwinds from abroad, unemployment has fallen rapidly, from 8.4% about 3 years ago to 5.7% today, and is expected to continue to fall to reach its equilibrium rate within two years. Wage growth appears to finally be picking up, so that when combined with lower oil prices, families will, at long last, see their real earnings increase. However, one piece of the economy that has not yet started this process of normalization, however, is interest rates. Bank Rate – the main interest rate set by the Bank of England – remains at its emergency level of 0.5%. This near-zero interest rate made sense during the crisis and early stages of the faltering recovery. It continues to make sense today. But at what point will it no longer make sense? Low interest rates provide a number of benefits. For example, they make it easier for individuals, companies and governments to pay down debt. They make it more attractive for businesses to invest – stimulating production and job creation. They have helped allow the financial system to heal. They have played a key role in supporting the UK’s recent recovery. Increases in interest rates – especially after being sustained at low levels for so long – can also involve risks.

But there are also costs and risks from keeping interest rates at emergency levels for a sustained period, especially as an economy returns to more normal functioning. Interest rates sustained at emergency levels could lead to significant issues. We summarise the main arguments.

(1) inflationary pressures
Low headline inflation and stable domestically-generated inflation are unlikely to persist if interest rates remain low. The output gap is closing and there is limited slack left in the economy. The rate of wage growth is increasing – with AWE total pay growth in the three months to December of 2.1% relative to a year earlier, but 5.4% (annualised) relative to 3-months earlier. Since wages are an important component of prices and their recent pick-up has not been matched with a corresponding increase in productivity, these wage increases will support a pickup in inflation. If this pickup is gradual, as expected, inflationary pressures should only build slowly over time, so that interest rates can be increased slowly and gradually as necessary.

(2) asset bubbles and financial vulnerabilities
As rates continue to be low, especially during a period of recovery, the risks to the financial system could grow. More specifically, when interest rates are low, investors may “search for yield” and shift funds to riskier investments that are expected to earn a higher return – from equity markets to high-yield debt markets to emerging markets. This could drive up prices in these other markets and potentially create “bubbles”. This can not only lead to an inefficient allocation of capital, but leave certain investors with more risk than they appreciate. An adjustment in asset prices can bring about losses that are difficult to manage, especially if investments were supported by higher leverage possible due to low rates. If these losses were widespread across an economy, or affected systemically-important institutions, they could create substantial economic disruption.

(3) limited tools to respond to future challenges
There is less “firepower” to respond to future contingencies. There is no shortage of events that could cause growth to slow and inflation to fall in the future – and the first response is normally to reduce interest rates. Reductions in interest rates can be an important tool for stabilizing an economy. If Bank Rate remains around its current level of 0.5%, however, there is obviously not room during the next recession to lower it to the degree that has typically occurred. Bank Rate could go a bit lower than 0.5%. But rates could not be lowered by the average 3.8 percentage points that occurred during past easing cycles without creating severe distortions to the financial system and functioning of the economy. Regulators could instead use other tools to loosen monetary policy – such as guidance on future rate changes or quantitative easing. These tools are certainly viable, but it is harder to predict their impact and harder to assess their effectiveness than for changes in interest rates.

(4) an inefficient allocation of resources and lower productivity
Is there a chance that a prolonged period of near-zero interest rates is allowing less efficient companies to survive and curtailing the “creative destruction” that is critical to support productivity growth? Or even within existing, profitable companies – could a prolonged period of low borrowing costs reduce their incentive to carefully assess and evaluate investment projects – leading to a less efficient allocation of capital within companies? Any of these effects of near zero-interest rates could play a role in explaining the UK’s unusually weak productivity growth since the crisis. These types of concerns gained attention in Japan during the 1990s after the collapse of the Japanese real estate and stock market bubbles. During this period, many banks followed a policy of “forbearance”, during which they continued to lend to companies that would otherwise have been insolvent. These unprofitable companies kept alive by lenient banks were often referred to by the colourful name of “zombies”.

(5) vulnerabilities in the structure of demand
A fifth possible cost of low interest rates is that it could shift the sources of demand in ways which make underlying growth less balanced, less resilient, and less sustainable. This could occur through increases in consumption and debt, and decreases in savings and possibly the current account. Some of these effects of low interest rates on the sources of demand are not surprising and are important channels by which low interest rates are expected to stimulate growth. But if these shifts are too large – or vulnerabilities related to over consumption, over borrowing, insufficient savings, or large current account deficits continue for too long – they could create economic challenges.

(6) higher inequality
A final concern related to an extended period of ultra-accommodative monetary policy is how it might affect inequality. Changes in monetary policy always have distributional implications, but these concerns have recently received renewed attention – possible due to increased concerns about inequality more generally, or possibly because quantitative easing has more immediate and apparent distributional implications. How a sustained period of low interest rates impacts inequality, however, is far from clear cut. There are some channels by which low interest rates – and especially quantitative easing – can aggravate inequality. As discussed above, lower interest rates tend to boost asset values. Recent episodes of quantitative easing have also appeared to increase asset prices – especially in equity markets – although the magnitude of this effect is hard to estimate precisely. Holdings of financial assets are heavily skewed by age and income group, with close to 80% of gross financial assets of the household sector held by those over 45 years old and 40% held by the top 5% of households. As discussed in a recent BoE report, these older and higher income groups will therefore see a bigger boost to their financial savings as a result of low interest rates and quantitative easing. But, counteracting these effects, are also powerful channels by which lower interest rates (and quantitative easing) can reduce inequality and disproportionately harm older income groups. More specifically, one powerful effect of low rates is to reduce pension annuity rates, interest on savings, and other fixed-income payments. This disproportionately affects the older population (who relies on pensions and fixed income as a larger share of their income) and people in the middle of the income distribution (who have some savings, but less exposure to more sophisticated investments that can increase in value from lower rates). In addition to affecting the asset and earnings side of individual’s balance sheets, there can also be distributional consequences on the liability and payment side. As interest rates and the cost of servicing debt fall, individuals with mortgages and other borrowing can benefit. These benefits tend to disproportionately fall on the middle class – for which mortgage and debt payments are a higher share of total income – but can also benefit the wealthy if they have high levels of borrowing.

The full PowerPoint presentation is available here.

APRA, Start Disclosing Better Data

Each quarter APRA publishes Property Exposure for ADI’s and at first blush it looks like useful data. However, it does not provide the right lens on the the data, so some critical dimensions are missing completely.

First, we get nothing at all about Loan to Income ratios, either at a portfolio or new written loan level, when this is regarded as an essential tool is assessing true risks.

Second, we need a split between the key characteristics of investment loans versus owner occupied loans. What share are interest only loans, and how does the LVR splits stand between the owner occupied and investment sector? How do loan sizes compare between the two types?

Third, DFA believes, in the interests of good disclosure, and also as part of macroprudential management, the data should be provided at the individual lender level. They already do this for the monthly banking statistics. We know that some banks are more exposed to investment lending (and potentially exceeding 10% growth), yet the whole situation is opaque.

It is really time for proper disclosure, rather than myopic slices of data (even if contained in multiple layered spreadsheets) which mask as much as they hide. Come on APRA, lets get to the true picture.

 

$40.1 Billion (43.0 per cent) Interest-only Loans Written In 4Q 2014

APRA released their quarterly Property Exposure data to December 2014 today. We see continued strong growth in interest only loans. From DFA research we know these are mostly investment loans, despite the fact that APRA does not split out loan characteristics by investment and owner occupation. We think they should.

At a portfolio level, as at 31 December 2014, the total of residential term loans to households held by all ADIs was $1.28 trillion. This is an increase of $28.3 billion (2.3 per cent) on 30 September 2014 and an increase of $105.4 billion (9.0 per cent) on 31 December 2013. Owner-occupied loans accounted for 65.7 per cent of residential term loans to households. Owner-occupied loans were $840 billion, an increase of $14.8 billion (1.8 per cent) on 30 September 2014 and $57.6 billion (7.4 per cent) on 31 December 2013. Investment loans accounted for 34.3 per cent of residential term loans. Investment loans were $438.9 billion, an increase of $13.6 billion (3.2 per cent) on 30 September 2014 and $47.8 billion (12.2 per cent) on 31 December 2013.

Looking across the various types of ADI:

  • major banks held $1,037.3 billion of residential term loans, an increase of $23.0 billion (2.3 per cent) on 30 September 2014 and $83.7 billion (8.8 per cent) on 31 December 2013;
  • other domestic banks held $142.6 billion, an increase of $7.2 billion (5.3 per cent) on 30 September 2014 and $20.5 billion (16.8 per cent) on 31 December 2013;
  • foreign subsidiary banks held $54.3 billion, a decrease of $0.6 billion (1.1 per cent) on 30 September 2014 and an increase of $1.3 billion (2.5 per cent) on 31 December 2013;
  • building societies held $16.6 billion, an increase of $0.0 billion (0.1 per cent) on 30 September 2014 and a decrease of $0.1 billion (0.6 per cent) on 31 December 2013; and
  • credit unions held $27.9 billion, a decrease of $1.3 billion (4.5 per cent) on 30 September 2014 and an increase of $0.0 billion (0.1 per cent) on 31 December 2013.

Note that the higher growth of other domestic banks and lower growth of building societies and credit unions is in part due to the conversion of eight credit unions and one building society to banks.

ADIs with greater than $1 billion of residential term loans held 98.4 per cent of all residential term loans as at 31 December 2014. These ADIs reported 5.2 million loans totalling $1.26 trillion. The average loan size was approximately $241,000, compared to $234,000 as at 31 December 2013; $463.8 billion (36.9 per cent) were interest-only loans; and $31.5 billion (2.5 per cent) were low-documentation loans.

APRA-ADILoanPortfolioDec2014ADIs with greater than $1 billion of residential term loans approved $93.2 billion of new loans in the quarter ending 31 December 2014. This is an increase of $7.8 billion (9.2 per cent) on the quarter ending 30 September 2014 and $9.1 billion (10.8 per cent) on the quarter ending 31 December 2013. $58.4 billion (62.7 per cent) were for owner-occupied loans, an increase of $4.9 billion (9.2 per cent) from the quarter ending 30 September 2014; $34.8 billion (37.3 per cent) were for investment loans, an increase of $2.9 billion (9.1 per cent) from the quarter ending 30 September 2014;

Brokers accounted for 44.7% of loans by value, a record, since 2008. They reached an all time high of 46.7% prior to the GFC. However, if you take loan size into account, brokers continue to have a field day at the moment, thanks to high volumes and high commissions.

APRA-ADILoanNewDec2014$10.6 billion (11.4 per cent) had a loan-to-valuation ratio greater than or equal to 90 per cent; and $0.6 billion (0.7 per cent) were low-documentation loans.

APRA-ADILoanNewLVRDec2014

 

 

 

 

 

 

Backdoor Listing Up, Says ASIC

ASIC has today published the second report in its series on the regulation of corporate finance issues in Australia.

The report, which covers the period July to December 2014, provides companies and their advisers with insights into ASIC’s regulatory approach in the corporate finance sector and aims to assist them with their associated legal and compliance obligations.

ASIC is responsible for the regulation and oversight of corporate finance activity in Australia, with a particular focus on corporate transactions such as fundraising, takeovers, schemes of arrangement, share buy-backs, compulsory acquisitions, employee incentive schemes and financial reporting. The Corporations and Emerging Mining and Resources (EMR) teams are responsible for regulating disclosure and conduct by corporations in Australia in these areas.

In this period there was a 39% increase in the number of disclosure documents lodged with ASIC (compared to the period 1 January to 30 June 2014, and a slight increase in applications for relief from Ch 6D. The table below depicts the top 10 public fundraising transactions by value of the offer based on disclosure documents lodged with ASIC in this period. Hybrid securities make up a notable portion of these fundraisings.

ASIC-Top-TenWhen reviewing prospectuses in this period, among other things, ASIC responded to the following trends:

  1. financial information (including pro-forma financial information) that is not sufficiently complete or adequately reviewed by a third party such as an auditor;
  2. an increase in backdoor listing prospectuses;
  3. poor quality information about companies operating in an emerging market; and
  4. an increase in the number of listed investment companies seeking quotation.

Financial disclosures

Financial disclosures are of significant concern to ASIC, as they paint a picture of the history of the performance of the company and effectiveness of management. Financial information, both statutory and pro forma, is essential to informing investors about the past performance and future prospects of the company. Some of the concerns with the disclosure of financial information we identified include:

  1. pro-forma adjustments described as one-off events;
  2. a lack of prominent disclosure of material differences between statutory and pro-forma financial results; and
  3. multiples not being included for all forecast

Backdoor listings

In this period ASIC reviewed disclosure by 30 companies seeking admission to ASX by way of a backdoor listing—that is, a company seeking to access capital by selling their business into a company that is already listed on an Australian exchange.

Businesses offering web-based products and services or start-up technologies are the most common type of business currently seeking admission by way of backdoor listing. These often have unique businesses requiring technical explanation of a high proportion of intangible assets in their financial statements. With these characteristics it is difficult for investors to make an informed decision unless:

  1. considerable care is taken in explaining the business without the use of jargon; and
  2. a justification for the valuation of intangible assets is provided.

ASIC raised concerns with 22 (73%) of these offer documents, with concerns being addressed by way of supplementary disclosure. In six instances ASIC made interim stop orders in relation to backdoor listing prospectuses; two stop orders were revoked, one had a final stop order made and three prospectuses are still subject to those interim stop orders.

Other concerns identified in a number of backdoor listing prospectuses include:

  1. insufficient financial disclosure, including a lack of operating history, lack of audited financial information, and disclosure of information presented other than in accordance with accounting standards (non-IFRS financial information);
  2. insufficient disclosure of a company’s business model and use of proceeds;
  3. disclosure of directors’ history not consistent with our policy in disclosure of directors’ history not consistent with our policy in RG 228; and
  4. risk disclosure not adequate or appropriately tailored to a company’s circumstances.

Half of the businesses seeking a backdoor listing come from a foreign jurisdiction, with the majority of these from an emerging market. ASIC continues to consider the challenges facing these entities when reviewing a prospectus, and will raise concerns where we consider disclosure is inadequate or misleading.

With the slowdown in the mining sector ASIC expects backdoor listing activity to remain strong.

Listed investment company disclosure

In the last year ASIC  saw an increase in the number of initial public offerings of listed investment companies. These are entities that seek to make a return for investors through their investment activities rather than through operating a business. This raises a few disclosure concerns unique to listed investment company prospectuses.

Firstly, listed investment companies often have similar characteristics to a hedge fund, and may use complex strategies like leverage, short selling and derivatives. These can be quite challenging to explain, and ASIC is concerned that retail investors may struggle to understand how a company intends to make money—particularly when jargon is used excessively. If a listed investment company has similarities to a hedge fund, then it should make disclosure that is similar to that provided by a hedge fund.

Another feature of listed investment companies is that they can have an external manager that may be a related party. The fees charged by the external manager can have a material impact on investors’ returns and, where this is the case, the prospectus should give meaningful disclosure. For example, in some circumstances it may be more appropriate to include a worked example or explain the practical effect of a fee, rather than just cite a complex formula. Where a performance fee formula means that investors’ returns are capped at 10%, it is not sufficient to disclose the formula. The prospectus must clearly and prominently disclose that investors’ returns will not exceed 10%.

Finally, listed investment company prospectuses often seek to include disclosure setting out the past performance of other entities managed by their manager. Concerns about these disclosures are commonly raised by ASIC.

UK PRA Sets Out How It Will Hold Senior Managers Accountable

The Prudential Regulation Authority (PRA) has today set out how it will hold senior managers in banks, building societies and designated investment firms to account if they do not take reasonable steps to prevent or stop breaches of regulatory requirements in their areas of responsibility.

In June 2013, the Parliamentary Commission for Banking Standards (PCBS) published its report “Changing Banking for Good” setting out recommendations for legislative and other action to improve professional standards and culture in the UK banking industry. This was followed by legislation in the Banking Reform Act 2013.

The Banking Reform Act introduced new powers which allow the PRA and Financial Conduct Authority (FCA) to impose regulatory sanctions on individual senior managers when a bank breaches a regulatory requirement if the senior manager responsible for the area where the breach occurred cannot demonstrate that they took reasonable steps to avoid or stop it.

The PRA has today published guidance for banks clarifying how it will exercise this new power; including examples of the kind of actions which may constitute reasonable preventive steps and how firms and individuals may evidence them.

The Banking Reform Act also creates a separate offence which could result in individual senior managers being held criminally liable for reckless decisions leading to the failure of a bank. This new criminal offence will, however, be subject to the usual standard of proof in criminal cases (‘beyond reasonable doubt’).

Andrew Bailey, Deputy Governor, Prudential Regulation, Bank of England and CEO of the PRA said

“Senior managers will be held individually accountable if the areas they are responsible for fail to meet our requirements. Our new accountability regime will hold all senior managers, including non-executive directors, to a clear standard of behaviour and we will take action where they fail to meet this.”

Insurers

In November 2014, the PRA consulted on a parallel accountability regime for the insurance sector. The Senior Insurance Managers’ Regime is aligned with the banking regime but it is not identical. The business model of insurers, the risks they pose to the PRA’s objectives and the legislative framework they operate under are different from banks.  Specifically, none of the potential criminal sanctions, nor the ‘presumption of responsibility’ in the banking regime, will apply to senior insurance managers.

The new regime also takes account of the need to introduce measures relating to governance and the fitness and propriety of individuals as part of Solvency II.

Non-executive directors (NEDs)

In November, the PRA indicated that it would issue a further consultation confirming how the PRA will apply the new Senior Managers’ Regime and Senior Insurance Managers’ Regime to NEDs in banks and insurers respectively.

The PRA has now confirmed that it will apply the Senior Managers’ Regime and Senior Insurance Managers’ Regime to the following NEDs:

  • Chairman;
  • Senior Independent Director;
  • Chair of the Risk Committee;
  • Chair of the Audit Committee; and
  • Chair of the Remuneration Committee.

The PRA’s Senior Managers’ Regime and Senior Insurance Managers’ Regime will therefore focus on those NEDs with specific responsibilities for areas or committees directly relevant to a firm’s safety and soundness. In addition to any collective responsibility they may have as members of the board, non-executives in scope of the Senior Managers’ Regime and Senior Insurance Managers’ Regime will be held individually accountable for their areas of responsibility. The PRA is also proposing to require firms to ensure that all board members are held to high standards of conduct.

The paper also includes details of the FCA’s approach to non-executive directors. Following the FCA’s decision to narrow the scope of its Senior Managers’ Regime to include a smaller group of NEDs, the PRA is also consulting on notification and assessment requirements for those NEDs who are not included in the regime. This will allow the UK to comply with its EU requirements to ensure the suitability of all members of a bank’s board.

Whistleblowing

The PCBS also recommended that banks put in place mechanisms to enable their employees to raise concerns internally, and that the PRA and FCA ensure these mechanisms are effective. The PRA and FCA have today set out a package of measures to formalise firms’ whistleblowing procedures. These proposals aim to ensure that all employees are encouraged to blow the whistle where they suspect misconduct, confident that their concerns will be considered and that there will be no personal repercussions.

Time To Fix Financial Planning Properly

There will, no doubt, be more calls for a Royal Commission into the impact of poor advice provided by financial planners, following the reports of mis-advice at the NAB, which follows on from CBA, and a long list of other firms.

It is clear that there has been significant poor advice provided by some, perhaps influenced by target chasing, commissions, personal gain or errors. Many who received such poor advice will probably be unaware, and simply observe their portfolios are not performing as they expected. On the other hand, poor performance does not necessarily mean poor advice, it could be simply market dynamics, because most investments are inherently risky. That said, it is therefore hard to get a good read on how many people are impacted, but my guess it is into the many thousands, many of these victims do not have deep pockets so cannot fight back.

The superannuation balances of Australians now stand at more than $1.93 trillion so more households will need advice going forward. Much of that could still be conflicted in the current industry structures. Conflicted advice is right in the middle of the current industry problems, and whilst there are many excellent advisors doing the right think by their clients, the reputation of the entire industry is being trashed.

Despite the FOFA reforms (which has been subject to various government attempted revisions) we think that there is still room for significant improvement in the regulatory framework, practice and culture relating to providing good financial advice in Australia, with a focus on doing the right thing for clients. The claim that “its just a few bad apples” becomes less credible as more organisations are implicated. Both ASIC and the recent FSI report highlighted significant structural problems.

We think that the concept of general advice should be removed, and advisors should not be able to receive any indirect financial benefit from the advice they provide.

Separately, financial products can be sold, provided all relevant facts, and costs are disclosed. The two – advice and product sales, should be separated completely. You can read my earlier discussions here. Any link between the two creates conflict and the risk of poor advice.

So, first we need to fix up the industry going forwards. Personally, I think the architecture of a solution is pretty clear, if unpopular from a market participants perspective. Next we need a mechanism to identify people who have received wrong advice, so it can be rectified. That of course is a complex process, and again will be resisted by the industry.

We do not need another couple of years of inactivity whilst yet more inquiries rake over the coals some more. Rather it is time for action.

How Does High-Frequency Trading Impact Market Efficiency?

The Bank of England just published a research paper examining how High-Frequency Trading impacts Market Efficiency. High-frequency trading (HFT), where automated computer traders interact at lightning-fast speed with electronic trading platforms, has become an important feature of many modern financial markets. The rapid growth, and increased prominence, of these ultrafast traders have given rise to concerns regarding their impact on market quality and market stability. These concerns have been fuelled by instances of severe and short-lived market crashes such as the 6 May 2010 ‘Flash Crash’ in the US markets. One concern about HFT is that owing to the high rate at which HFT firms submit orders and execute trades, the algorithms they use could interact with each other in unpredictable ways and, in particular, in ways that could momentarily cause price pressure and price dislocations in financial markets.

Interactions among high-frequency traders Evangelos Benos, James Brugler, Erik Hjalmarsson and Filip Zikes

Using a unique data set on the transactions of individual high-frequency traders (HFTs), we examine the interactions between different HFTs and the impact of such interactions on price discovery. Our main results show that for trading in a given stock, HFT firm order flows are positively correlated at high-frequencies. In contrast, when performing the same analysis on our control sample of investment banks, we find that their order flows are negatively correlated. Put differently, aggressive (market-“taking”) volume by an HFT will tend to lead to more aggressive volume, in the same direction of trade, by other HFTs over the next few minutes. For banks the opposite holds, and a bank’s aggressive volume will tend to lead to aggressive volume in the opposite direction by other banks. As far as activity across different stocks is concerned, HFTs also tend to trade in the same direction across different stocks to a significantly larger extent than banks.

We find that HFT order flow is more correlated over time than that of the investment banks, both within and across stocks. This means that HFT firms tend more than their peer investment banks to buy or sell aggressively the same stock at the same time. Also, a typical HFT firm tends to simultaneously aggressively buy and sell multiple stocks at the same time to a larger extent than a typical investment bank. What does that mean for market quality? A key element of a well-functioning market is price efficiency; this characterises the extent to which asset prices reflect fundamental values. Dislocations of market prices are clear violations of price efficiency as they happen in the absence of any news about fundamental values.

Given the apparent tendency to commonality in trading activity and trading direction among HFTs, we further examine whether periods of high HFT correlation are associated with price impacts that are subsequently reversed. Such reversals might be interpreted as evidence of high trade correlations leading to short-term price dislocations and excess volatility. However, we find that instances of correlated trading among HFTs are associated with a permanent price impact, whereas instances of correlated bank trad- ing are, in fact, associated with future price reversals. We view this as evidence that the commonality of order flows in the cross-section of HFTs is the result of HFTs’ trades being informed, and as such have the same sign at approximately the same time. In other words, HFTs appear to be collectively buying and selling at the “right” time. The results are also in agreement with the conclusions of Chaboud, Chiquoine, Hjalmarsson, and Vega (2014), who find evidence of commonality among the trading strategies of algorithmic trades in the foreign exchange market, but who also find no evidence that such commonality appears to be creating price pressures and excess volatility that would be detrimental to market quality.

A final caveat is in order. The time period we examine is one of relative calm in the UK equity market. This means that additional research on the behaviour of HFTs, particularly during times of severe stress in equity and other markets, would be necessary in order to fully understand their role and impact on price efficiency.

DFA’s perspective is a little different. The underlying assumption in the paper is that more transactions gives greater market efficiency, and therefore HFT is fine. We are not so sure, as first the market efficiency assumption should be questioned, second it appears those without HFT loose out, so are second class market participants – those with more money to invest in market systems can make differentially more profit. This actually undermines the concept of a fair and open market. We think HFC needs to be better controlled to avoid an HFC arms race in search of ever swifter transaction times. To an extent therefore, the paper missed the point.

 

How Does Macroprudential Impact Foreign Banks?

The Bank of England just released a paper which examines whether cross-border spillovers of macroprudential regulation depend on the organisational structure of banks’ foreign affiliates. On a tight leash: does bank organisational structure matter for macroprudential spillovers?  Piotr Danisewicz, Dennis Reinhardt and Rhiannon Sowerbutts.

Do multinational banks’ branches reduce their lending in foreign markets more than subsidiaries in response to changes in the regulatory environment in their domestic markets? And if so, how strong is this effect and how long does it last?

Studies show that multinational banks transmit negative shocks to their parent banks’ balance sheets – including changes in regulation – across national borders. In this paper we examine if the magnitude of the spillover effects depends on the organisation structure of banks’ foreign affiliates. We exploit cross-country cross-time variation in the implementation of macroprudential regulation to test if lending in the UK of foreign banks’ branches and subsidiaries respond differently to a tightening of capital requirements, lending standards or reserve requirements in foreign banks’ home countries.

Focusing on differences in lending responses of branches and subsidiaries which belong to the banking group allows us to control for all factors which might affect parent banks’ decisions regarding their foreign affiliates’ lending. Our results show that whether foreign branches or subsidiaries react differently to changes in regulation in their home countries depends on the type of regulation and the type of lending.

Multinational banks’ branches respond to tighter capital requirements in their home countries by contracting their lending more than subsidiaries. On average, branch interbank lending growth in the UK grows by 6.3 percentage point slower relative to subsidiaries following a tightening of capital requirements in the bank’s home country. This is in line with our hypothesis which predicts that branch lending will be affected due to higher degree of control which parent banks have over its foreign branches. But this heterogeneity in response to capital requirements is only observed in case of lending to other banks. We find that the response of lending to non-bank borrowers to a tightening in capital requirements does not depend on the organisational forms of foreign banks’ UK affiliates. Turning to the impact of a tightening in lending standards or reserve requirements, we find that there are no differential effects on interbank and non-bank lending.

Additional analysis suggests that the stronger contraction in the provision of interbank loans exhibited by branches is only contemporaneous – ie the differential effect fades out after one quarter. Our research provides some evidence that a branch structure is more likely than a subsidiary structure to transmit a tightening in capital requirements affecting the parent institution in the home country. However, the effects we find are short-lived which means that the potential negative effects associated with a higher number of foreign branches we find in this study may not necessarily outweigh any benefits.

NAB Financial Advisors Under The Microscope

According to the Sydney Morning Herald,

“The National Australia Bank has quietly paid millions of dollars in compensation to hundreds of clients given what it considers inappropriate financial planning advice since 2009.

The bank is the latest institution to face disturbing revelations of misconduct in its financial planning division, with a Fairfax Media investigation uncovering instances of forgery, “rogue advisers” and multiple sackings inside its financial advice arm.

A cache of confidential internal documents obtained by Fairfax Media reveals that, according to NAB, 31 of its financial planners were terminated, suspended or had their resignations “ensured” due to conflicts of interest, inappropriate advice, inappropriate practices or repeated compliance breaches

Disturbingly, the document states that these instances were not detected by the bank’s internal controls, but through client complaints or queries by authorities”.

This is further evidence that the financial advice sector is not up to scratch, and that despite the FOFA reforms (which has been subject to various government attempted revisions) we think that there is still room for significant improvement in the regulatory framework, practice and culture relating to providing good financial advice in Australia, with a focus on doing the right thing for clients. The claim that “its just a few bad apples” becomes less credible as more organisations are implicated. Both ASIC and the recent FSI report highlighted significant structural problems.  Remember the superannuation balances of Australians now stand at more than $1.93 trillion.

We think that the concept of general advice should be removed, and advisors should not be able to receive any indirect financial benefit from the advice they provide. Separately, financial products can be sold, provided all relevant facts, and costs are disclosed. The two – advice and product sales, should be separated completely. You can read my earlier discussions here.