Author: Martin North

Martin North is the Principal of Digital Finance Analytics

ASIC On Payday Lenders Again

ASIC crackdown stops another payday lender from overcharging consumers.

Fast Easy Loans Pty Ltd has agreed to refund more than 2,000 consumers a total of $477,900 following ASIC’s concerns that it charged consumers a brokerage fee where it was prohibited from doing so.

From September 2010 to June 2013, Fast Easy Loans Pty Ltd (Fast Easy) acted as the broker for a related lender, Easy Finance Loans Pty Ltd (Easy Finance), and unlawfully charged consumers a brokerage fee in excess of certain state and territory interest rate caps. In charging a brokerage fee, Fast Easy engaged in credit activities without a credit licence.

Fast Easy and Easy Finance operated under a previously commonly promoted business model where consumers dealt with both a broker and a payday lender at the same time, with the entities having the same directors and owners and operating out of the same premises. One reason for using this model was to provide a means (via the broker entity) to charge consumers an amount in excess of state and territory interest rate caps.

Commonwealth legislation introduced a cap on payday loans in July 2013 which supersedes the state and territory-based interest rate caps, and together with further Regulations in June 2014, make it clear that broker costs do not sit outside the small amount loan cap.

Deputy Chairman Peter Kell said, ‘ASIC will act to prevent payday lenders structuring their business to improperly impose fees and charges on consumers.

‘Our message to the industry and those who advise payday lenders is clear; if you set up business models to avoid the small amount loan cap, ASIC will take action’, Mr Kell said.

In response to ASIC’s concerns, Fast Easy has agreed to refund all affected consumers in Queensland, New South Wales and the Australian Capital Territory any amounts paid in brokerage fees above the state-based interest rate caps of 48% by November 2014.

Although the brokerage fee did not exceed any applicable interest rate caps in other states, Fast Easy has also put in place steps to notify consumers in Northern Territory, Western Australia, South Australia, Victoria and Tasmania (where the same 48% state interest rate cap law did not apply) that they can claim a refund for the brokerage fee that was charged.

Easy Finance has also engaged an external legal firm to conduct a compliance review on their current business model to ensure it meets the requirements of the National Consumer Credit Protection Act 2009.

ASIC’s action against Fast Easy means that since 2010, close to $2 million dollars has been paid in refunds to over 10,000 consumers who have been overcharged when taking out a payday loan. Further, payday lenders have been issued with just under $120,000  in fines in response to  ASIC concerns about their compliance with the credit laws.

Background

Under the National Consumer Credit Protection Act 2009 (National Credit Act), individuals or businesses who engage in credit activities are required to hold an Australian credit licence.

Any person who does engage in credit activities (such as acting as a broker) without the appropriate licence must not demand or receive any fees or charges from a consumer (s32 National Credit Act)

Prior to July 2013, some States and Territories held laws capping the cost of credit for small amount loans. These laws were superseded by the Commonwealth cap which was introduced in July last year.

A small amount loan, in general terms, is a loan where the amount borrowed is $2000 or less and the term is between 16 days and one year. From 1 July 2013, only the following fees can be charged on small amount loans:

  • a monthly fee of 4% of the amount lent
  • an establishment fee of 20% of the amount lent
  • Government fees or charges
  • enforcement expenses, and
  • default fees (the lender cannot recover more than 200% of the amount lent).

Are Large Banking Sectors A Problem?

In the light of the FSI report, and the emphasis on the need to secure the Australian economy from potential risks relating to banks which may be too big to fail (TBTF), there is a timely article in 2014 Q4 Quarterly Bulletin from the Bank of England on the consequences of  the UK’s large banking sector, which is estimated to be about 450% of GDP. Why is the UK banking system so big and is that a problem?

UKGDPBanking

The UK banking sector is big by any standard measure and, should global financial markets expand, it could become much bigger. Against that backdrop, this article has examined a number of issues related to the size and resilience of the UK banking system, including why it is so big and the relationship between banking system size and financial stability.

There are a number of potential reasons why the UK banking system has become so big. These include: benefits to clustering in financial hubs; having a comparative advantage in international banking services; and historical factors. It may also reflect past implicit government subsidies. Evidence from the recent global financial crisis suggests that bigger banking systems are not associated with lower output growth and that banking system size was not a good predictor of the crisis (after controlling for other factors). On the other hand, larger banking systems may impose higher direct fiscal costs on governments in crises. That said, there are aspects of banking sector size that were not considered in this paper but that might have a bearing on financial stability, such as the possibility that the banking system becomes more opaque and interconnected as it grows in size and the link between banking system size and the rest of the financial system.

Moreover, further work is needed to improve our understanding of the drivers of the n-shaped relationship between the ratio of credit to GDP and economic growth and on the quantitative importance of agglomeration externalities in banking. The importance of the resilience, rather than the size, of a banking system for financial stability is more clear-cut. For example, evidence from regressions and case studies suggests that less resilient banking systems are more likely to suffer a financial crisis. This is, in part, why the Bank of England, in conjunction with other organisations including the FSB, is pursuing a wide-ranging agenda to improve the resilience of the banking system. These policy initiatives will also mitigate some of the undesirable reasons why the UK banking system might be so big, for example, by eliminating banks’ TBTF status and implicit subsidy.

FSI – David Murray’s Speech

David Murray’s Speech to the Committee for Economic Development of Australia ‘Supporting Australia’s Economic Growth‘ coincided with the release of the Final Report of the Financial System Inquiry.

First let me thank CEDA for being our host, once again, as we release the Final Report of the Financial System Inquiry.

I’d also like to recognise some important people.

  • My fellow Committee members Kevin Davis, Craig Dunn, Carolyn Hewson and Brian McNamee, all of whom have put in an amazing effort to produce a set of expert judgements shared by us all.
  • The International Panel, Michael Hintze, David Morgan, Jennifer Nason and Andrew Sheng.
  • The Secretariat, as named in the Report, led very ably by John Lonsdale.
  • All of those who have made submissions or otherwise taken an interest in our work.

The Inquiry has been conducted in an open manner. We have consulted extensively with industry participants and end users.

The first round of consultation yielded more than 280 submissions and the second over 6,500. Our Interim Report provided a comprehensive review of Australia’s financial system.

The final report is a shorter and more focused document. It makes 44 recommendations to improve the efficiency, resilience and fairness of Australia’s financial system. It also sets out a blueprint to guide policy making over the next 10 to 20 years and makes 13 observations on taxation for reference to the Government’s Tax White Paper.

The Inquiry’s terms of reference required us to examine how Australia’s financial system can be positioned to support economic growth and meet the needs of end users. We were also asked to consider how the system has changed since the Wallis Inquiry, including the effects of the Global Financial Crisis.

This has not been an Inquiry established to deliver or prevent a particular outcome. Rather it has been conducted as a genuine exercise to assess the strengths and weaknesses of the Australian financial system.

We have considered the financial system in the context of Australia’s economy, particularly our status as a smaller, wealthy, open commodity exporter and described the features of a good financial system from Australia’s perspective.

In formulating our recommendations, we have focused on the national interest and the needs of end users. Our report is evidence-based and wherever possible presents cost/benefit trade-offs in support of our findings.

My purpose today is to explain how our recommendations will adapt the financial system to meet Australia’s special circumstances in the interests of its users and the nation as a whole.

I will first address recommendations that flow from two paradigm shifts since the Wallis Inquiry, namely those relating to resilience and consumer outcomes. Then I will deal with our unique and rapidly growing superannuation system. Lastly, I will talk about competition, efficiency, innovation and regulatory improvement.

While many of the Wallis Inquiry recommendations have stood the test of time, there are two areas where this Inquiry has formed a different view.

First, we believe external shocks can and will occur. As a result of the crisis, governments are now assumed to be the backstop the financial system. In contrast to Wallis, we cannot simply rule out the possibility that the Government will be required to backstop the banks in the event of a crisis. However we believe the system should be managed such that taxpayers are highly unlikely to lose money. We have to take practical steps to reduce moral hazard.

Second, we believe that effective disclosure and financial literacy are necessary but incomplete approaches for delivering satisfactory consumer outcomes. For this reason, we have highlighted the need for improved firm culture along with stronger obligations in some areas, especially in product manufacture and distribution.

The Inquiry makes six recommendations which directly address the issue of resilience, and two relating to competition and superannuation which also have consequences for system resilience.

I will discuss competition in the residential mortgage market later.

In relation to capital, the Inquiry believes the capital ratios of Australian banks should be ‘unquestionably strong’. Specifically, they should be ranked in the top 25 per cent of global banks. The major banks are currently somewhere between the global median and the 75th percentile. This means that they are not ‘unquestionably strong’. Accordingly, they should be required to increase their capital ratios so that they are in the top 25 per cent of global peers, and a process for more transparent reporting of comparative capital ratios should be developed.

Also in relation to capital, we recommend the Government should proceed to introduce a leverage ratio as a backstop to ADI’s risk weighted capital positions – in line with the unfinished Basel III agenda.

Proposals for the issuance of ‘bail-in’ debt securities should, however, not move ahead of developing international standards. If issued, this form of debt should conform to the principles relating to legal certainty outlined in our Report. We do not propose that depositors should be bailed-in.

The Report also endorses existing processes to improve pre-positioning, crisis management and resolution powers for regulators.

The Financial Claims Scheme should continue to be funded on an ex post basis, partly because our recommendations on resilience reduce the need for an ex ante levy.

To limit systemic risk and in the interests of fund members, we have recommended a general prohibition on direct borrowing for superannuation funds.

Generally, higher capital ratios and loss absorbency represent a form of insurance. They reduce both the likelihood and cost of failure. The Inquiry believes that the cost of this insurance is low and is significantly outweighed by the benefits of a more resilient system.

The Inquiry has been conducted against the backdrop of ongoing concerns about the quality of financial advice; a parliamentary inquiry into ASIC’s performance; and debate over amendments to the regulatory framework governing advice.

However, it would be a mistake to look at our recommendations in this area only through the narrow lens of the recent debate on FOFA.

Our six recommendations are based on a much broader assessment of the current framework, of which FOFA is only a small component.

We have identified three problems with the current arrangements.

First, firms do not take enough responsibility themselves for treating consumers fairly. This places pressure on the regulatory framework and the regulator.

Secondly, the current framework places too much reliance on disclosure and financial literacy. While these are important, they are not sufficient to deliver appropriate consumer outcomes.

Thirdly, we need a more pro-active regulator but, to be clear regulation cannot be expected to prevent all consumer losses. Our recommendations are not meant to absolve consumers of responsibility for their choices or insulate them from market risk; rather they are intended to reduce the risk of consumers being sold poor quality or unsuitable products.

Consistent with the approach in other industries where information imbalances can cause significant consumer detriment, product manufacturers should be required to consider the suitability of their products for different types of consumers as part of the design process.

Hence we have recommended the introduction of a targeted and principles-based product design and distribution obligation.

We also believe there needs to be a change in the approach of the regulator. ASIC should be a stronger and more proactive regulator that undertakes more intense industry surveillance and responds more strongly to misconduct once identified. Numerous submissions claimed it is under-resourced. We have recommended an industry funding model for ASIC.

We are putting the individual at the centre of the superannuation system and strengthening its focus on retirement incomes, because we believe the provision of income in retirement should be enshrined as the system’s primary objective.

The Inquiry has identified two major issues with the superannuation system.

Fees are too high in the accumulation stage given the substantial growth we have seen in fund size and member balances. And superannuation assets are not being converted into retirement incomes as efficiently as they could be.

The absence of strong consumer driven competition remains a significant problem in the accumulation phase. MySuper aims to improve efficiency and competition by mandating simple low cost default products and by encouraging funds to become larger. It has only been in place for around 18 months. However, we are not confident it will drive the efficiency improvements required. We have therefore laid down a challenge to the superannuation industry.

We have recommended a review of MySuper by 2020 to assess whether or not it has delivered sufficient improvements in competition and efficiency. If it has not been effective, we recommend the Government introduce a competitive mechanism under which only the best performing funds would be selected to receive default superannuation contributions. This would allow all default members to benefit from the type of purchasing power that currently delivers lower fees to employees of large firms that have negotiated bulk discounts for their employees.

The retirement phase of Australia’s superannuation system is under-developed.

Members need more efficient retirement products that better meet their needs and increase their capacity to manage longevity risk.

We therefore recommend that all fund members should be offered what we have called a Comprehensive Income Product for Retirement when they switch from accumulation to retirement. This would combine an account based pension with a pooled longevity risk product.

Retirees would benefit from these products because they would have higher incomes and would not be exposed to the risk of outliving their savings.

The trade-off would be that less money saved through superannuation would be available for bequests, reflecting our view that the system should be about retirement incomes.

Collectively, the Inquiry’s superannuation recommendations have the potential to increase retirement incomes for an average male wage earner by around 25 to 40 per cent, excluding the Age Pension.

Competition is the cornerstone of a well-functioning financial system, driving efficient outcomes for price, quality and innovation. Some parts of the system have experienced increased market concentration, especially in the wake of the financial crisis. Our aim has been to ensure there will be an adequate focus on competition in the future.

In the residential mortgage market we have recommended narrowing the gap between IRB and standardised model risk weights for housing loans by increasing the former to between 25 and 30 per cent. This corresponds with a small funding cost increase for the major banks. However, competition will limit the extent to which these costs are passed on to consumers.

In some industries, competition has not resulted in reasonable prices for card transactions. The largest number of submissions we received related to customer surcharging for credit card transactions. We have recommended the Reserve Bank should ban surcharging for low cost cards and cap surcharges in relation to credit cards. This should address concerns about excessive surcharging in some industries.

More than a quarter of our recommendations are designed to enhance competition. For example, we have recommended giving ASIC a competition mandate; three-yearly external reviews of competition in the financial sector; and regulation that is more technologically neutral to facilitate full on-line service delivery.

To facilitate continued innovation in the financial system, we have emphasised the need for regulatory frameworks to be more flexible and adaptable. Graduated frameworks are important to ensure that new entrants are not over-regulated and to provide scope for innovation.

We have made several recommendations to reduce structural impediments to SME access to credit and facilitate innovation in this area. Our focus has been on boosting competition, for example by encouraging the emergence of rival lenders and new techniques such as crowdfunding and peer-to-peer lending. Some of these recommendations will also assist development of the venture capital market. We have also identified issues with the fairness of SME loan contracts in relation to non-monetary default clauses.

Our emphasis on competition is designed to create a more efficient system. In considering allocative and dynamic efficiency, we have identified several aspects of Australia’s tax settings that distort the flow of funds, especially differential treatment of savings vehicles and barriers to cross-border capital flows. Because our terms of reference do not allow us to make recommendations on tax, these observations will flow into the Government’s Tax White Paper. The Report also addresses issues relating to the corporate bond market.

The regulatory architecture developed after the Wallis Inquiry is reasonably effective. Our recommendations aim to build on the current arrangements. We want regulators that are strong, independent and accountable. Our recommendation for a Financial Regulation Accountability Board will ensure our financial regulators are subject to regular systematic scrutiny and instil a culture of continuous improvement.

In approaching our task, the Committee has emphasised Australia’s need for a high quality financial system, setting out the roles and responsibilities of its participants.

The unique characteristics of Australia’s economy demand high quality in the eyes of the world because we want to continue to be successful at augmenting our own savings with foreigners’ savings to develop the economy.

We have a good track record at this and a generally reliable system of law and public administration. However, as a commodity driven economy we experience higher cyclical volatility in national income and we have very high net foreign liabilities at more than half our GDP. These factors cause the rest of the world to monitor closely the quality of our settings.

The Report assesses the potential costs of serious disruption to the financial system. The Basel Committee has estimated the average total cost of a financial crisis at around 63 per cent of a country’s annual GDP. For Australia, this is $950 billion, with 900,000 additional Australians out of work. The economic cost of a severe crisis is much higher – around 158 per cent of annual GDP. For Australia, this is around $2.4 trillion. And this is just the annual cost.

Our experience during the Global Financial Crisis makes it very difficult for Australians to empathise with the depth of the economic and social loss in other countries. Yet the circumstances that shielded Australia from the crisis will not recur.

We had very high terms of trade, negligible net government debt, a Budget surplus, a triple A credit rating, a record mining investment boom, and a major trading partner growing in real terms at an annual rate of around 10 per cent and able to throw immense resources at a stimulus program that favoured our exports.

For all these reasons we need to maintain credibility among foreign investors and have an unquestionably strong banking system. The marginal cost of achieving this is small relative to the economic and social cost to the country and to taxpayers when a crisis occurs in less favourable circumstances than the last one.

We also need to ensure the Government maintains a strong fiscal position. The crisis demonstrated how quickly government finances can deteriorate and how damaging this can be for the relevant country. Deterioration in the Government’s credit rating would have a direct effect on the cost of credit in the system.

We have designed our report and its recommendations to put Australia’s financial system in the very highest quality position. My colleagues and I simply ask that you embrace our recommendations in the national interest.

Reflections on FSI

The final report of the Financial Systems Inquiry was released on Sunday. We already provided a summary of the 44 recommendations and discussed some of the specific proposals. It is of course a report to Government, so still a political process will run before we see what translates into policy, though some recommendations – for example changed capital rules – are outside the political processes, being the responsibility of the regulators. However, DFA wanted to reflect on the overall 350 page report.

  1. We think this it is a fine, balanced and independent piece of work. Given the complex task, the various powerful lobbies involved, and the short time frame, this is a landmark study, and should provide direction for the financial services industry in Australia for the next few years.
  2. The underlying philosophy, that the markets should be allowed to work, with regulation used where necessary to balance the various stakeholder capabilities in appropriate. More regulation is not always better. The emphasis on consumers is welcome.
  3. The capital buffer recommendations are appropriate, and should be adopted by APRA. Capital levels need to be brought up to best global practice, and given the likely continued global push to lift capital higher, this process will continue for some time. Clearly there is a cost to do this, and the easy route will be for banks to trim deposit rates and lift loan rates to protect their margins and shareholders. The right course would be to expect the banks to drive greater efficiency to partly offset, at least, the costs of holding more capital. The bail-in bonds route will also provide additional buffers. The extra disclosure recommended is helpful.
  4. The move to lift the capital ratios of banks with advanced IRB capital calculations will help to make the playing field more level than it is, but it will not necessarily be sufficient to fundamentally change the competitive landscape. We will continue to have four large, vertically integrated players dominating the market.
  5. We believe the recommendation to rebalanced the regulatory focus towards competition is appropriate, as until now financial stability was the main game. As a result we have high industry concentration, and limited competition. This has led to super-profitable banks, which costs Australia Inc dear.
  6. The financial services regulatory environment in Australia is complex, with ASIC, APRA, ACCC and RBA all stakeholders. The FSI report has not recommended major changes, though ASIC’s role will be enhanced to focus on products, and enhanced consumer protection. Will this be adequately funded by charging industry participants more? A body to review the Regulators is proposed (another layer of cost?)
  7. The superannuation system was condemned as inefficient, and the proposals to drive fees lower, provide greater choice and have a default income structure on draw-down, are appropriate. We agree that the majority of directors in a super fund should be independent. Lets be clear, mandatory saving for retirement is a good policy, but the industry has been milking this for years, and changes need to be made. MySuper should be given a chance to work, but we like the idea of providers bidding for savings. The prospect of returns rising by 25% or more reflects the powerful impact the annual fees have on performance. Fees need to come down substantially.
  8. The support for SMSF is appropriate, as is the emphasis on saving for retirement, not generic wealth creation. The removal of leverage in SMSF’s makes sense, given the rise in property investment, but it is worth remembering the shares are issued by companies who are often  leveraged, so risk exists here too in a down turn!
  9. The changes to advice are appropriate. Advisers need to declare their alignment to product providers, be better trained, and the concept of general advice should be tuned.
  10. Card surcharging should be brought under control. There is no justification of consumers paying more than the cost of the transaction, yet some businesses are charging a percentage of transactions. We agree there is further work to do on interchange fees, and especially making the use of debit cards easier (thus avoiding card service fees).
  11. The Treasurer will find several ways to lift taxes, including potentially revising the tax treatment of superannuation, and negative gearing. In addition, the report comments on GST in relation to financial services products, leaving the door open for GST to be extended.
  12. The report recognises the impact of new technologies, and the comments on technology neutrality are appropriate. The report recommends a federated digital identity strategy that involves the Government setting up a framework under which private and public sectors compete to supply digital identities to consumers and businesses.  This is needed because of increasing consumer preference for online, fraud concerns and efficiency. We think it understates the importance of P2P.
  13. The main area of weakness relates to the SME sector, which is disadvantaged by the current banking environment. No significant recommendations were made in this important area.

FSI – Rebalance Regulatory Focus Towards Competition

The FSI report discussed the roles of APRA, RBA and ASIC, commenting that Australia’s institutional structure is relatively informal and decentralised.The most critical observation is implicitly that competitive tension has been traded away for in preference for financial stability. The acquisition of St George by Westpac, and Bank West by CBA would be two relative recent examples. Now there is an intent to redress the balance, with more focus on competitive aspects. This is important because thanks to lack of competitive tension our banks are amongst the most profitable in the world, whilst end users of banking services are effectively paying more than they should (as demonstrated by the higher margins in operation in Australia).

While the Inquiry does not recommend major changes to the overall regulatory system, it believes action should be taken in the following five areas to improve the current arrangements and ensure regulatory settings remain fit for purpose in the years ahead:

  • Improve the regulator accountability framework: Australia needs a better mechanism to allow Government to assess the performance of financial regulators. The Inquiry recommends establishing a new Financial Regulator Assessment Board (Assessment Board) to undertake annual ex post reviews of overall regulator performance against their mandates. It also recommends that Government should provide more clarity around its expectations of regulators, including its appetite for risk in the financial system, while regulators should develop better performance indicators. These new arrangements should ensure, among other things, regulators give stronger and more transparent consideration to competition and compliance cost issues.
  • Improve the effectiveness of our regulators: Australia’s regulatory system will continue to be challenged by the pace of technological change. Especially in payments and financial markets, new business models are challenging existing regulatory frameworks. The emergence of new technology is placing demands on regulators to be more flexible, and raising issues relating to identity, privacy and cyber security. Australia’s regulators need the funding and skills to meet these challenges into the future, including encouraging innovation through appropriately graduated approaches. The Inquiry recommends that ASIC and APRA should both be strengthened through increased budget stability built on periodic funding reviews, and greater operational flexibility. ASIC, APRA and the payment systems function of the RBA should also commit to six-yearly capability reviews. These exercises should ensure they have the required skills and culture to maintain effectiveness in an environment of rapid change, as will the recommendation in Chapter 3: Innovation that Government create a new public-private collaboration mechanism to facilitate regulatory change in response to innovation.
  • Strengthen ASIC: Instances of misconduct and consumer loss in the financial system have prompted questions about the effectiveness of consumer protection, as well as the adequacy of ASIC’s resources and the design of the regulatory framework in which it operates. The public expectation is that ASIC will act as a pro-active watchdog in supervising all financial services providers. However, in practice, ASIC has a very wide remit but limited powers and resources. The Senate Economics References Committee’s report on ASIC’s performance was released just before the publication of the Interim Report. The Interim Report indicated that the Inquiry would consider the Senate Committee’s recommendations in the lead-up to its Final Report. Several of the recommendations in this Final Report are consistent with those of the Senate Committee. The Inquiry has recommended some fundamental changes to the regulatory framework governing the financial services industry. These measures are part of a broad shift in Australia’s approach to consumer protection in the financial sector — away from primarily relying on disclosure and financial literacy. The Inquiry has also recommended changes in how ASIC approaches its consumer protection role. In particular, the Inquiry considers that ASIC should devote more attention to industry supervision, including more proactively identifying and weeding-out misconduct. It has also recommended several measures to strengthen ASIC, including better funding, enhanced regulatory tools, stronger licensing powers to address misconduct, and substantially higher criminal and civil penalties. In light of the significance of these changes, the Inquiry recommends that ASIC should be the first regulator to undergo a capability review, along with the funding review that would take place under the recommendation for increased budget stability. This would help to ensure ASIC has the appropriate skills and culture to adopt a flexible risk-based approach to its future role. Its overall performance would also be subject to annual review by the proposed new Assessment Board.
  • Rebalance the regulatory focus towards competition: Not surprisingly, regulators have increased their focus on resilience in the wake of the GFC. However, the Inquiry believes there is complacency about competition, and that the current framework does not systematically identify and address competition trade-offs in regulatory settings. Although the ACCC is responsible for competition policy in the financial sector, this is part of its broader economy-wide responsibilities. Furthermore, the ACCC is not responsible for reviewing how decisions by other regulators affect competition. It is not always clear how APRA and ASIC balance their core regulatory objectives against the need to maintain competition. Policy makers and regulators need to take increased account of competition when making regulatory decisions, while ASIC should be given an explicit competition mandate. Periodic external reviews of the state of competition should be conducted, including assessing whether Australia can reduce barriers to market entry for new domestic and international competitors.
  • Improve the process of implementing new financial regulations: Since the GFC, Australia’s financial system has been influenced by new global standards and the increasing scope and complexity of cross-border financial regulation. Substantial regulatory change has resulted from international developments and decisions made in major offshore financial centres, concurrent with a large number of domestically driven changes, especially in financial advice and superannuation.
    Although there is no evidence to suggest Australia’s compliance burden is substantially larger than in jurisdictions overseas, work commissioned by the Inquiry suggests that improved regulatory processes could reduce industry costs and lead to better outcomes. Specifically, the Inquiry recommends that Government and regulators adhere to minimum implementation lead times and monitor impacts more thoroughly post-implementation.

The Reserve Bank of Australia (RBA) and APRA each have responsibility for financial stability. However, most macro-prudential tools can only be deployed by APRA. This places a strong premium on cooperation between the two agencies. The RBA should continue to monitor risks in the non-prudentially regulated sector. The Inquiry believes the compulsory nature of superannuation justifies ongoing prudential regulation by APRA, including the availability of compensation in the event of fraud or theft. The Inquiry has not recommended giving the ACCC sole responsibility for consumer protection because these powers are an important part of ASIC’s enforcement toolkit. The Inquiry sees value in an integrated consumer regulator for financial services.

FSI – SMSFs Banned From Leveraged Property Investment

The FSI report recommends the removal of the exception to the general prohibition on direct borrowing for limited recourse borrowing arrangements by superannuation funds. This would stop property investments via SMSFs, a growing trend, or shares. Other than this, SMSF’s received an endorsement, as a legitimate savings vehicle for retirement (but not necessarily as a broader wealth generating mechanism).

Government should restore the general prohibition on direct borrowing by superannuation funds by removing Section 67A of the Superannuation Industry (Supervision) Act 1993 (SIS Act) on a prospective basis. This section allows superannuation funds to borrow directly using limited recourse borrowing arrangements (LRBAs). The exception of temporary borrowing by superannuation funds for short-term liquidity management purposes (contained in Section 67 of the SIS Act) should remain. Direct borrowing in this context refers to any arrangement that funds enter into where the borrowing is used to purchase assets directly for the fund.

The rationale for this recommendation is to prevent the unnecessary build-up of risk in the superannuation system and the financial system more broadly and fulfil the objective for superannuation to be a savings vehicle for retirement income, rather than a broader wealth management vehicle

Further growth in superannuation funds’ direct borrowing would, over time, increase risk in the financial system. As discussed in the Interim Report, the Inquiry notes an emerging trend of superannuation funds using LRBAs to purchase assets. Over the past five years, the amount of funds borrowed using LRBAs increased almost 18 times, from $497 million in June 2009 to $8.7 billion in June 2014. The limited recourse nature of these arrangements is intended to alleviate the risk of losses from assets purchased using a loan resulting in claims over other fund assets.

Borrowing, even with LRBAs, magnifies the gains and losses from fluctuations in the prices of assets held in funds and increases the probability of large losses within a fund. Because of the higher risks associated with limited recourse lending, lenders can charge higher interest rates and frequently require personal guarantees from trustees. In a scenario where there has been a significant reduction in the valuation of an asset that was purchased using a loan, trustees are likely to sell other assets of the fund to repay a lender, particularly if a personal guarantee is involved. As a result, LRBAs are generally unlikely to be effective in limiting losses on one asset from flowing through to other assets, either inside or outside the fund. In addition, borrowing by superannuation funds implicitly transfers some of the downside risk to taxpayers, who underwrite adverse outcomes in the superannuation system through the provision of the Age Pension.

Superannuation funds use diversification to reduce risk. Selling the fund’s other assets will concentrate the asset mix of the fund — small funds that borrow are already more likely to have a concentrated asset mix.79 This reduces the benefits of diversification and further increases the amount of risk in the fund’s portfolio of assets.

The GFC highlighted the benefits of Australia’s largely unleveraged superannuation system. The absence of leverage in superannuation funds meant that rapid falls in asset prices and losses in funds were neither amplified nor forced to be realised. The absence of borrowing benefited superannuation fund members and enabled the superannuation system to have a stabilising influence on the broader financial system and the economy during the GFC. Although the level of borrowing is currently relatively small, if direct borrowing by funds continues to grow at high rates, it could, over time, pose a risk to the financial system. The RBA states that “The Bank endorses the observation that leverage by superannuation funds may increase vulnerabilities in the financial system and supports the consideration of limiting leverage”. In addition, such direct borrowing could also compromise the retirement incomes of individuals. APRA was of the view that “… the risks associated with direct leverage are incompatible with the objectives of superannuation and cannot adequately be managed within the superannuation prudential framework”. Borrowing by superannuation funds also allows members to circumvent contribution caps and accrue larger assets in the superannuation system in the long run

Direct borrowing by superannuation funds could pose risks to the financial system if it is allowed to grow at high rates. It is also inconsistent with the objectives of superannuation to be a savings vehicle for retirement income. Restoring the original prohibition on direct borrowing by superannuation funds would preserve the strengths and benefits the superannuation system has delivered to individuals, the financial system and the economy, and limit the risks to taxpayers.

Many submissions support this recommendation. Some propose alternatives to address the risks surrounding borrowing, including imposing a maximum cap on fund assets that can be invested in a single asset other than cash or bonds. These alternatives would limit the risk associated with borrowing by superannuation funds, and provide funds with more flexibility to pursue alternative investment strategies. However, these options would also impose additional regulation, complexity and compliance costs on the superannuation system.

In implementing this recommendation, funds with existing borrowings should be permitted to maintain those borrowings. Funds disposing of assets purchased via direct borrowing would be required to extinguish the associated debt at the same time.

 

FSI – SME’s Little To Cheer About

Continuing our analysis of the FSI Report, we have been looking at comments and recommendations relating to SME’s. Australia’s SME’s are a critical though undervalued sector of the economy, accounting for some 3 million business, and 5 million jobs. We hoped there would be substantial focus on initiatives to kick-start this sector (given the growth mandate in the terms of reference), but we were largely disappointed. The Inquiry has noted that SMEs have few options for external financing outside the banking system compared with large corporations. In part, this reflects unnecessary distortions, such as information imbalances and regulatory barriers to market-based funding . But the key SME-related recommendations are collected in an appendix and are not really convincing.

A number of the Inquiry’s recommendations are designed to reduce structural impediments to SMEs’ access to finance. Such impediments include information imbalances between lenders and borrowers, and barriers to market-based funding. Other recommendations would help reduce costs for SMEs and support innovation.

The Inquiry encourages industry to expand data sharing under the new voluntary comprehensive credit reporting (CCR) regime. More comprehensive credit reporting would reduce information imbalances between lenders and borrowers, facilitate competition between lenders, and improve credit conditions for SMEs. Although CCR relates to individuals’ data, personal credit history is a major factor in credit providers’ decisions to lend to new business ventures and small firms.

The Inquiry supports a facilitative regulatory regime for crowdfunding, while recognising the risks involved.  A well-developed crowdfunding sector would give SMEs more funding options and increase competition in SME financing. The Inquiry supports Government’s current process to graduate fundraising regulation to facilitate securities-based crowdfunding. Government should use these policy settings as a basis to assess whether broader fundraising and lending regulation could be graduated to facilitate other forms of crowdfunding, including peer-to-peer lending.

Information imbalances, among other factors, have led to numerous and onerous non-monetary terms in some lending contracts. The Inquiry supports Government’s current process for extending consumer protections for unfair terms in standard contracts to small businesses. Although such protections would not prevent unfair terms in non-standard contracts, the Inquiry believes this approach may improve broader contracting practices. The Inquiry also encourages the banking industry to adjust its codes of practice, to require banks to give borrowers sufficient notice of an intention to enforce contract terms and give borrowers time to source alternative financing.

Recommendations to reform the payments system would benefit SMEs. The Inquiry’s proposals to lower interchange fee caps would reduce the fees paid by all businesses and reduce the difference in fees paid by small and large businesses. As technology evolves, greater access to data and innovations in data use are likely to benefit all businesses, particularly SMEs. For example, more extensive access to quality datasets would improve business decision making. Globally, payment providers are developing new ways to assess SMEs’ creditworthiness and extend credit to SMEs. The Inquiry recommends that the Productivity Commission review how data could be used more effectively, taking into account privacy considerations.

The Inquiry considers that financial system innovators which challenge the existing regulatory structure should have better access to Government, and that Government and regulators should have greater awareness and understanding of financial system innovation. This would enable timely and coordinated policy and regulatory responses to innovation. The Inquiry recommends that Government establish a permanent public–private sector collaborative committee, the ‘Innovation Collaboration’, consisting of senior industry, Government, regulatory, academic and consumer representatives.

Better targeted tax settings for start-ups and innovative firms would facilitate innovation. Simplifying the tax rules for Venture Capital Limited Partnerships, and streamlining Government administration of the regime, would reduce barriers to fundraising. More flexible access to research and development tax offsets could help reduce firms’ cash flow constraints, particularly for new ventures. These issues should be considered as part of the Tax White Paper process.

We are disappointing that there is no commentary on the relative capital buffers for mortgages compared with SME lending. There was an opportunity to recommend a tweak, so make SME lending more attractive relative to mortgage lending. Currently many SME’s have real issues getting funding, as highlighted in our recent SME report. The FSI acknowledges “particular sectors of the economy, such as small and medium-sized enterprises (SMEs) or rural businesses, do not have sufficient access to funding” but have not addressed this concern.

FSI – On Financial Advice

The FSI report discusses the alignment of consumer outcomes and financial advice firms, questions “general financial advice” and adviser qualification. The report recommends that the term “general advice” be changed to better reflect what is intended and that the financial adviser or mortgage broker should be required to clearly explain their association with the product issuer. In addition, advisers should be better qualified and cultural misalignment addressed.

The GFC brought to light significant numbers of Australian consumers holding financial products that did not suit their needs and circumstances — in some cases resulting in severe financial loss. Previous collapses involving poor advice, information imbalances and exploitation of consumer behavioural biases have affected more than 80,000 consumers, with losses totalling more than $5 billion, or $4 billion after compensation and liquidator recoveries. The changes outlined in this report should also significantly improve consumer confidence and trust in the financial system.The most significant problems related to shortcomings in disclosure and financial advice, and over-reliance on financial literacy. The changes introduced under the Future of Financial Advice (FOFA) reforms are likely to address some of these shortcomings; however, many products are directly distributed, and issues of adviser competency remain.

The current regulatory framework addresses advice on financial products. The framework makes an important distinction between personal and general advice:
• Personal advice takes account of a person’s needs, objectives or personal circumstances, whereas general advice does not.
• General advice includes guidance, advertising, and promotional and sales material highlighting the potential benefits of financial products. It comes with a disclaimer stating that it does not take a consumer’s personal circumstances into account.

However, consumers may misinterpret or excessively rely on guidance, advertising, and promotional and sales material when it is described as ‘general advice’. The use of the word ‘advice’ may cause consumers to believe the information is tailored to their needs. Behavioural economics literature and ASIC’s financial literacy and consumer research suggests that terminology affects consumer understanding and perceptions. Often consumers do not understand their financial adviser’s or mortgage broker’s association with product issuers. This association might limit the product range an adviser or broker can recommend from. Of recently surveyed consumers, 55 per cent of those receiving financial advice from an entity owned by a large financial institution (but operating under a different brand name) thought the entity was independent.

The Inquiry believes greater transparency regarding the nature of advice and the ownership of advisers would help to build confidence and trust in the financial advice sector. In particular, ‘general advice’ should be replaced with a more appropriate, consumer-tested term to help reduce consumer misinterpretation and excessive reliance on this type of information. Consumer testing will generate some costs for Government, and relabelling will generate transitional costs for industry — although these are expected to be small. The Inquiry believes the benefits to consumers from clearer distinction and the reduced need for warnings outweigh these costs.

Although stakeholders have provided little evidence of differences in the quality of advice from independent or aligned and vertically integrated firms, the Inquiry sees the value to consumers in making ownership and alignment more transparent. In particular, these disclosures should be broader than Financial Services Guide and Credit Guide rules currently require, and could include branded documents or materials. The Inquiry believes the benefits to consumers would outweigh the transitional costs to industry of effecting branding changes.

In addition, the report highlights the need to raise the competency of financial advice providers, and introduce a register of advisers. The register was announced recently but we argued it was not alone sufficient.

The Interim Report observed that affordable, quality financial advice can bring significant benefits for consumers. However, according to the Parliamentary Joint Committee on Corporations and Financial Services (PJCCFS), “the major criticism of the current system is that licensees’ minimum training standards for advisers are too low, particularly given the complexity of many financial products”. This affects confidence and trust in the sector and can prevent consumers from seeking financial advice.
A number of high-profile cases where consumers have suffered significant detriment through receiving poor advice, and a series of ASIC studies, have revealed issues with the quality of advice. For example, ASIC’s report on retirement advice found that only 3 per cent of Statements of Advice were labelled ‘good’, 39 per cent were ‘poor’ and the remaining 58 per cent ‘adequate’. Although these cases and many of these studies occurred before the FOFA reforms to improve remuneration structures, this is not the only issue. Adviser competence has also been a factor in poor consumer outcomes. ASIC’s review of advice on retail structured products found insufficient evidence of a reasonable basis for the advice in approximately half of the files.

Under the current framework, ASIC guidance sets out the minimum knowledge, skills and education for people who provide financial advice to comply with the Corporations Act 2001 and licence conditions. The training standards vary depending on whether the adviser is dealing with Tier 1 or Tier 2 financial products. As a minimum, current education standards are broadly equivalent to a Diploma under the Australian Qualifications Framework for Tier 1 products, and to a Certificate III for Tier 2 products.

Register of advisers
As the PJCCFS stated, “the licensing system does not currently provide a distinction between advisers on the basis of their qualifications, which is unhelpful for consumers when choosing a financial adviser”. ASIC currently has a public record of financial advice licensees and is notified of authorised representatives. However, ASIC has little visibility of employee advisers, or access to the type of information that an enhanced register could hold, such as length of experience and employment history. ASIC argues that transparency about advisers through an enhanced register is an important piece missing from the regulatory framework. Most stakeholders support introducing such an enhanced register.

Conclusion
The benefits of improving the quality of advice are significant. To achieve this, the Inquiry believes that minimum competency standards should be increased and the current Government process to review these standards should be prioritised.
In advance of the completion of the Government process, some adviser firms have recently announced they are increasing their own qualification requirements. However, low minimum competency standards have been a feature of the industry for a substantial length of time, and change is needed across the board. Many stakeholders are highly concerned about the low minimum education standards of financial advisers, with most supporting lifting education requirements to degree level.

Internationally, Singapore and the United Kingdom are seeking to raise minimum competency standards. The Inquiry is of the view that Australia should set high standards in comparison with peer jurisdictions. Although the Inquiry does not recommend a national exam for advisers, this could be considered if issues in adviser competency persist. For individual advisers and firms, the cost of undertaking further and ongoing education would be significant. However, this is a necessary transition to move towards higher standards of competence and would deliver long-term benefits for consumers. The cost would be mitigated by an appropriate transition period. Raising the minimum competency standards may increase the cost of advice for consumers. However, various cost effective market developments are emerging, such as scaled or limited advice and using technology to deliver advice.61 The Inquiry encourages advisers to develop new models for delivering advice more cost effectively to sit alongside existing comprehensive face-to-face advice models.

The requirement for higher education standards may cause some existing advisers to exit the industry and may deter some from entering, potentially causing an ‘advice gap’ for some consumers. Transitional arrangements to give advisers appropriate time to upgrade their qualifications would help manage this risk. Raising standards would also increase confidence and trust in the industry, encouraging more individuals to choose financial advisory services as a career path, and increasing the supply of financial advisers.

The Inquiry has not made a recommendation in relation to mortgage brokers. However, it considers that ASIC should continue to monitor consumer outcomes in this area and the performance of the industry in relation to its obligations under the National Consumer Credit Protection Act 2009. In relation to the register of advisers, the Inquiry supports the establishment of the enhanced register to facilitate consumer access to information about financial advisers’ experience and qualifications and improve transparency and competition. Further consideration could be given to adding other fields, such as determinations by the FOS.62 The register should be designed to take account of possible future developments in automated advice and record the entity responsible for providing such services.

At the heart of the matter is the question of aligning the interests of financial firms and consumers. This is a question of culture.

Recent cases of poor financial services provision raise serious concerns with the culture of firms and their apparent lack of customer focus. Research in 2009 suggested that financial firms may not be implementing systems and procedures within their organisations that promote ethical culture and integrate governance, risk management and compliance frameworks. In 2011–12, approximately 94 per cent of ASIC’s banning orders involved significant integrity issues, where the alleged conduct would breach professional and ethical standards and/or the conduct provisions in the Corporations Act 2001. The remaining 6 per cent of cases involved competency issues. The Inquiry considers that cases of consumer detriment and poor advice reflect organisational cultures that do not focus on consumer interests. Such cultures promote short-term commercial outcomes over longer-term customer relationships. This has contributed to a lack of consumer confidence and trust in the system. In research undertaken by Roy Morgan, only 28 per cent of participants gave financial planners ‘high’ or ‘very high’ ratings for ethics and honesty, and trust in bank managers was held by just 43 per cent of participants. In addition, ASIC found only 33 per cent of stakeholders agreed that financial firms operate with integrity.

Banning power
ASIC has observed phoenix activity in financial firms, where senior people from a financial firm with poor operating practices may establish a new business or move to an alternative firm. Currently, ASIC can prevent a person from providing financial services, but cannot prevent them from managing a financial firm. Nor can ASIC remove individuals involved in managing a firm that may have a culture of non-compliance.

Conclusion
To build confidence and trust in the financial system, financial firms need to be seen to act with greater integrity and accountability. The Inquiry believes changes are required not only to the regulatory regime and supervisory approach, but also to the culture and conduct of financial firms’ management, which needs to focus on consumer interests and outcomes. A change in culture in line with community expectations should promote confidence and trust in the financial system and limit the need for more significant regulation. Raising standards of conduct and levels of professionalism would require both a coordinated industry approach and focus of attention by individual firms. Industry associations could lead this initiative, with stakeholder input from ASIC and consumer organisations. Introducing or enhancing individual firm or industry codes of conduct is one way in which industry could set raised standards and hold themselves accountable. An enhanced banning power should improve professional behaviour, management accountability and the culture of firms, by removing certain individuals from the industry and preventing them from managing a financial firm. This should also include individuals who are licence holders or authorised representatives, or managers of a credit licensee. It should prevent those operating under an Australian Financial Services Licence from moving to operate under a credit licence and vice versa.

The Inquiry notes the FOFA ban on conflicted remuneration and associated measures are relatively new and should bring significant change to the industry and benefits for consumers. However, some incentive-based remuneration models remain, including grandfathered arrangements and other specific exclusions. The Inquiry believes that these instances of conflicted remuneration should be monitored, and Government should intervene if further significant issues are observed. Specific attention is required in the stockbroking sector in the immediate future. Unlike in the life insurance industry, a recent review of practices in stockbroking has not been undertaken. The Inquiry considers that ASIC should review current remuneration practices in stockbroking and advise Government on whether action is needed. The Inquiry believes that better aligning the interests of financial firms with consumer interests, combined with stronger and better resourced regulators with access to higher penalties, should lead to better consumer outcomes.

Given the current state of FOFA, there is an opportunity to get this reform on the right footing based on the recommendations. Most importantly, we believe product sales should be clearly separated from advice. Advice should separated from commissions and payments. Product sales can continue, but separate from advice. We agree that General Advice is not a helpful term.

 

FSI – Lift Capital Buffers

In today’s FSI report, there is a strong focus on the capital buffers which banks need to hold. We had expected this development.

  • Australia’s banking system is highly concentrated, with the four major banks using broadly similar business models and having large offshore funding exposures. This concentration exposes each individual bank to similar risks, such that all the major Australian banks may come under financial stress in similar economic and financial circumstances.
  • Australia’s banks are heavily exposed to developments in the housing market. Since 1997, banks have allocated a greater proportion of their loan books to mortgages, and households’ mortgage indebtedness has risen. A sharp fall in dwelling prices would damage household balance sheets and weigh on consumption and broader economic growth. It would also reduce the quality of the banking sector’s balance sheets and the capacity of banks to extend new credit, which would compromise the speed of a subsequent economic recovery.

A severe disruption via one of these channels would have broad economic and financial consequences for Australia. Indeed, interconnectedness within the financial system and the economy would be likely to propagate distress and heighten other risks and vulnerabilities. Even a modest banking crisis could cost 900,000 jobs.

Whilst Australian banks have strong capital structures, they are not in the top quartile of large internationally active banks. The report highlighted that the top quartile level was increasing as other banks “caught up” and on latest levels the average 9.1 per cent capital levels of the Australian banks was below the median of 10.5 per cent and below the 12.2 per cent required to get into the top quartile. Current global initiatives will raise this further. The FSI said any increases in capital should take the form of common equity capital.

This statement effectively rejects the claims of some submissions arguing the banks were already in top quartile position!  The Inquiry believes that top-quartile positioning is the right setting for Australian ADIs.

“ADIs should maintain sufficient loss absorbing and recapitalisation capacity to allow effective resolution while mitigating the risk to taxpayer funds — in line with emerging international practice”

This would require the raising of considerable extra capital, and impact bank profitability and product pricing. Drawing on multiple sources of evidence, the Inquiry calculates that raising capital ratios by one percentage point would, absent the benefits of competition, increase average loan interest rates by less than 10 basis points which could reduce GDP by 0.01-0.1 per cent.

In addition those banks who use the advanced IRB capital calculations should expect their ratios to be lifted higher, reducing the competitive advantage they have experienced recently. The major banks, using their “advanced” modelling systems, can set aside less capital against home loans by generating risk-weights of 18 per cent, compared to 39 per cent for small banks like Suncorp and Bank of Queensland. The recommendation is the major banks should increase their average risk weight to between 25 to 30 per cent. This translates to a one percentage point increase in major bank’s common equity Tier I levels from currency levels. The higher funding costs would be born by shareholders and consumers. As a result, as well as products costing more, we expect this to translate into a more level playing field, allowing players on standard capital ratios to compete more strongly.

A final point. The report recommended an additional ratio measure, banks are subject to a minimum of 3 per cent to 5 per cent “leverage ratio”. This ratio would be something like true value of their equity capital divided by the value of their assets. This ratio should never fall below this level. While the majors would currently not be compliant, if they adjusted their capital as recommended by 1-2 per cent, then they would be compliant with this leverage ratio. This approach nicely skirts around the “risk weighted assets” as calculated by Basel.

For background on capital, you can read my earlier posts.