ASIC To Investigate Interest-Only Loans

In a parallel announcement, ASIC will conduct a surveillance into the provision of interest-only loans as part of a broader review by regulators into home-lending standards. The probe will look at the conduct of banks, including the big four, and non-bank lenders and how they are complying with important consumer protection laws, including their responsible lending obligations. The review follows concerns by regulators about higher-risk lending, following strong house price growth in Sydney and Melbourne.

Through the Council of Financial Regulators, ASIC, APRA, the Reserve Bank of Australia (RBA) and the Treasury are working together to monitor, assess and respond to risks in the housing market. Interest-only loans as a percentage of new housing loan approvals by banks reached a new high of 42.5% in the September 2014 quarter (this includes owner-occupied and housing investment loans). ASIC Deputy Chairman Peter Kell said, ‘While house prices have been experiencing growth in many parts of Australia, it remains critical that lenders are not putting consumers into unsuitable loans that could see them end up with unsustainable levels of debt. ‘Compliance with responsible lending laws is a key focus for ASIC. If our review identifies lenders’ conduct has fallen short, we will take appropriate enforcement action.’

Background

The Australian Prudential Regulation Authority (APRA) announced today it has written to all authorised deposit-taking institutions (ADIs) to set out plans for a heightened level of supervisory oversight on mortgage lending in the period ahead. See the earlier DFA post in relation to this.

With interest-only loans, a borrower’s repayment amount will only cover the interest on the loan. The principal amount borrowed will not reduce unless the borrower chooses to make extra repayments. Paying interest-only means that a borrower will pay more interest over the term of the loan. Some borrowers choose interest-only loans to maximise the amount they can borrow, especially if it is for investment purposes. Loans are usually only interest-only for a set period of time, after which the borrower will either need to increase their repayments to start reducing the principal, or repay the loan in full.

Although interest-only loans can be appropriate in the right circumstances, interest-only loans can raise a number of risks, such as:

  • Whether the borrower can only afford a loan because it is interest-only
  • Whether the borrower can afford principal and interest repayments at the end of the interest-only period, and
  • Whether the borrower understands the impact of not making principal and interest repayments.

The responsible lending obligations require credit licensees to ensure that consumers are only placed in credit contracts that meet their requirements and objectives and that they can meet their repayment obligations without substantial hardship. In doing this, credit licensees must make reasonable inquiries into an individual consumer’s specific circumstances and take reasonable steps to verify the consumer’s financial situation.

In August 2014, the Federal Court handed down its first decision on the responsible lending obligations: ASIC v The Cash Store (in liquidation) [2014]. The Federal Court’s decision made it clear credit licensees must, at a minimum, inquire about the consumer’s current income and living expenses to comply with the responsible lending obligations. Further inquiries may be needed depending on the circumstances of the particular consumer.

In response, in November 2014 ASIC updated Regulatory Guide 209 Credit licensing: Responsible lending conduct to incorporate the general findings of the Federal Court on the responsible lending obligations for credit licensees. ASIC also updated RG 209 to make it clear that credit licensees cannot rely solely on benchmark living expense figures rather than taking separate steps to inquire into borrowers’ actual living expenses.

APRA Reinforces Sound Residential Mortgage Lending Practices

The Australian Prudential Regulation Authority (APRA) has today written to authorised deposit-taking institutions (ADIs) outlining further steps it plans to take to reinforce sound residential mortgage lending practices. These steps have been developed following discussions with other members of the Council of Financial Regulators.

In the context of historically low interest rates, high levels of household debt, strong competition in the housing market and accelerating credit growth, APRA has indicated it will be further increasing the level of supervisory oversight on mortgage lending in the period ahead.

At this point in time, APRA does not propose to introduce across-the-board increases in capital requirements, or caps on particular types of loans, to address current risks in the housing sector. However, APRA has flagged to ADIs that it will be paying particular attention to specific areas of prudential concern. These include:

  • higher risk mortgage lending — for example, high loan-to-income loans, high loan-to-valuation (LVR) loans, interest-only loans to owner occupiers, and loans with very long terms;
  • strong growth in lending to property investors — portfolio growth materially above a threshold of 10 per cent will be an important risk indicator for APRA supervisors in considering the need for further action;
  • loan affordability tests for new borrowers — in APRA’s view, these should incorporate an interest rate buffer of at least 2 per cent above the loan product rate, and a floor lending rate of at least 7 per cent, when assessing borrowers’ ability to service their loans. Good practice would be to maintain a buffer and floor rate comfortably above these levels.

In the first quarter of 2015, APRA supervisors will be reviewing ADIs’ lending practices and, where an ADI is not maintaining a prudent approach, may institute further supervisory action. This could include increases in the level of capital that those individual ADIs are required to hold.

APRA Chairman Wayne Byres noted that while in many cases ADIs already operate in line with these expectations, the steps announced today will help guard against a relaxation of lending standards and, where relevant, prompt some ADIs to adopt a more prudent approach in the current environment.

‘This is a measured and targeted response to emerging pressures in the housing market. These steps represent a dialling up in the intensity of APRA’s supervision, proportionate to the current level of risk and targeted at specific higher risk lending practices in individual ADIs’ he said.

‘There are other steps open to APRA, should risks intensify or lending standards weaken and, in conjunction with other members of the Council of Financial Regulators, we will continue to keep these under active review.’

The steps announced today build on the enhanced monitoring and supervisory oversight of residential mortgage lending risks that APRA has put in place over the past year, which has included a major stress test of the banking industry, targeted reviews of ADIs’ residential mortgage lending and the release of detailed guidance to ADIs on sound residential mortgage lending practices.

APRA’s heightened supervisory focus on lending standards will be conducted in conjunction with the review of interest-only lending announced today by the Australian Securities and Investments Commission (ASIC). APRA and other members of the Council of Financial Regulators will continue to work closely together to monitor, assess and respond to risks in the housing market as they develop.

Today’s letter to ADIs can be found on the APRA website here: www.apra.gov.au/adi/Publications/Pages/other-information-for-adis.aspx
BACKGROUND

Q: What impact does APRA expect this announcement to have?
A: The aim of this announcement is to further reinforce sound residential mortgage lending practices in the context of historically low interest rates, high levels of household debt, strong competition in the housing market and accelerating housing credit growth. We expect this announcement will help guard against any relaxation of lending standards, and also prompt some ADIs to reinforce their lending practices where there is scope for a more prudent approach in the current risk environment.

Q: What ‘higher risk lending’ practices will APRA be focussing on?
A: APRA will be focussing on the extent to which ADIs are lending at high multiples of borrower’s income, lending at high loan-to-valuation ratios, lending on an interest-only basis to owner-occupiers for lengthy periods and lending for very long terms.

Q: How was the 10 per cent threshold for investor lending determined?
A: The 10 per cent benchmark is not a hard limit, but is a key risk indicator for supervisors in the current environment. The benchmark has been established after advice from members of the Council of Financial Regulators, taking into account a range of factors including income growth and recent market trends.

Q: How was the 2 per cent buffer and 7 per cent floor lending rate determined?
A: The guidance on serviceability assessments was based on a number of considerations, including past increases in lending rates in Australia and other jurisdictions, market forecasts for interest rates, international benchmarks for serviceability buffers, and long-run average lending rates.

Q: Is the 10 per cent growth in investor lending, or the 2 per cent buffer, a hard limit?
A: No. These figures are intended to be trigger points for more intense supervisory action.  Where banks are achieving materially faster growth, utilising a lower buffer, and/or otherwise materially growing the other higher risk parts of their portfolio, it will be a trigger for supervisors to consider whether more intensive supervisory action, including higher capital requirements, may be warranted.

Q: What sort of supervisory action might be considered if banks exceed these thresholds?
A: There are a range of actions that APRA can take, depending on the circumstances. These could include some or all of increased reporting obligations, additional on-site reviews, mandated reviews by external parties, and higher capital requirements.

Q: How may this affect borrowers from obtaining home loans from ADIs?
A: APRA does not expect this to have any effect on the availability of credit for people borrowing within their means to purchase a home. ADIs already conduct affordability tests to ensure that new borrowers are not overstretching themselves to purchase property, or relying on expectations of future increases in house prices to afford to do so. This guidance will primarily guard against any further relaxation in standards.

Q. Why has APRA not introduced high LVR or serviceability limits, as in other countries?
A: In short, we do not see those sorts of limits as necessary or appropriate at this stage.  APRA’s response has been targeted on the specific areas of prudential concern in the current environment: these include risks around serviceability when interest rates are at historically low levels, strong investor loan growth and broader considerations of each ADI’s risk profile. The impact of any APRA actions will therefore be felt by those banks pursing higher risk lending strategies and/or using lower loan underwriting standards.

There is, of course, a range of further actions that could be taken in relation to residential mortgage lending practices if the risk outlook intensifies, and APRA  will continue to keep these under review as market conditions and lending standards evolve.

Q: What role did the Council of Financial Regulators play in the decision-making?
A: Given that these supervisory tools sit within APRA’s supervisory and regulatory framework, APRA is ultimately responsible for determining the appropriate supervisory response. However, we have taken advice from other members of the Council of Financial Regulators in developing our approach, and will continue to do so. ASIC has also today announced a review that it will be carrying out a review of interest-only lending, which will support APRA’s efforts to reinforce sound lending practices.

Q: Why is there a threshold for growth in investor lending, not total housing credit?
A: There is currently very strong growth in lending to property investors, as highlighted by the Reserve Bank in its most recent Financial Stability Review (FSR). This is leading to imbalances in the housing market; the RBA noted in the FSR that “the direct risks to financial institutions would increase if these high rates of lending growth persist, or increase further.” APRA’s approach has therefore sought to target the higher areas of risk.

Q: Does this relate to the recommendation on risk weights in the Financial System Inquiry report?
A: No. The recommendation on risk weights in the FSI report is focused on competitive issues with risk modelling, whereas the announcement today is in relation to further supervisory steps to address specific risks in residential mortgage lending.

The Australian Prudential Regulation Authority (APRA) is the prudential regulator of the Australian financial services industry. It oversees Australia’s banks, credit unions, building societies, life and general insurance companies and reinsurance companies, friendly societies and most of the superannuation industry. APRA is funded largely by the industries that it supervises. It was established on 1 July 1998. APRA currently supervises institutions holding $4.9 trillion in assets for Australian depositors, policyholders and superannuation fund members.

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.