Economics and Banking – Page 460 – Digital Finance Analytics (DFA) Blog

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.

FSI Report Out

The final FSI report is out, a 350 page document making 44 core recommendations. They received over 6.800 submissions and met more than 50 financial institutions as part of international consultations.

“Australia’s financial system has performed well since the Wallis Inquiry and has many strong characteristics. It also has a number of weaknesses: taxation and regulatory settings distort the flow of funding to the real economy; it remains susceptible to financial shocks; superannuation is not delivering retirement incomes efficiently; unfair consumer outcomes remain prevalent; and policy settings do not focus on the benefits of competition and innovation. As a result, the system is prone to calls for more regulation”.

The Inquiry has made recommendations on five specific themes:
• Strengthen the economy by making the financial system more resilient.
• Lift the value of the superannuation system and retirement incomes.
• Drive economic growth and productivity through settings that promote innovation.
• Enhance confidence and trust by creating an environment in which financial firms treat customers fairly.
• Enhance regulator independence and accountability, and minimise the need for future regulation.

Although the Inquiry considers competition is generally adequate, the high concentration and increasing vertical integration in some parts of the Australian financial system has the potential to limit the benefits of competition in the future and should be proactively monitored over time. The Inquiry’s approach to encouraging competition is to seek to remove impediments to its development. The Inquiry has made recommendations to amend the regulatory system, including: narrowing the differences in risk weights in mortgage lending; considering a competitive mechanism to allocate members to more efficient superannuation funds; and ensuring regulators are more sensitive to the effects of their decisions on competition, international competitiveness and the free flow of capital.

Here is the summary of recommendations by chapter. More commentary to follow, but much is in line with expectations. We are pleased to see comments on “Rename ‘general advice’ and require advisers and mortgage brokers to disclose ownership structures”.

Chapter 1 Resilience.

The Inquiry’s recommendations to improve resilience aim to: 1. Strengthen policy settings that lower the probability of failure, including setting Australian bank capital ratios such that they are unquestionably strong by being in the top quartile of internationally active banks. 2 Reduce the costs of failure, including by ensuring authorised deposit-taking institutions maintain sufficient loss absorbing and recapitalisation capacity to allow effective resolution with limited risk to taxpayer funds — in line with international practice.

Set capital standards such that Australian authorised deposit-taking institution capital ratios are unquestionably strong.
Raise the average internal ratings-based (IRB) mortgage risk weight to narrow the difference between average mortgage risk weights for authorised deposit-taking institutions using IRB risk-weight models and those using standardised risk weights.
Implement a framework for minimum loss absorbing and recapitalisation capacity in line with emerging international practice, sufficient to facilitate the orderly resolution of Australian authorised deposit-taking institutions and minimise taxpayer support.
Develop a reporting template for Australian authorised deposit-taking institution capital ratios that is transparent against the minimum Basel capital framework.
Complete the existing processes for strengthening crisis management powers that have been on hold pending the outcome of the Inquiry.
Maintain the ex post funding structure of the Financial Claims Scheme for authorised deposit-taking institutions.
Introduce a leverage ratio that acts as a backstop to authorised deposit-taking institutions’ risk-weighted capital positions.
Remove the exception to the general prohibition on direct borrowing for limited recourse borrowing arrangements by superannuation funds.

Chapter 2: Superannuation and retirement incomes

The Inquiry’s recommendations to strengthen the superannuation system aim to: 1. Set a clear objective for the superannuation system to provide income in retirement. 2. Improve long-term net returns for members by introducing a formal competitive process to allocate new workforce entrants to high-performing superannuation funds, unless the Stronger Super reforms prove effective. 3 Meet the needs of retirees better by requiring superannuation trustees to pre-select a comprehensive income product in retirement for members to receive their benefits, unless members choose to take their benefits in another way.

Seek broad political agreement for, and enshrine in legislation, the objectives of the superannuation system and report publicly on how policy proposals are consistent with achieving these objectives over the long term.
Introduce a formal competitive process to allocate new default fund members to MySuper products, unless a review by 2020 concludes that the Stronger Super reforms have been effective in significantly improving competition and efficiency in the superannuation system.
Require superannuation trustees to pre-select a comprehensive income product for members’ retirement. The product would commence on the member’s instruction, or the member may choose to take their benefits in another way. Impediments to product development should be removed.
Provide all employees with the ability to choose the fund into which their Superannuation Guarantee contributions are paid.
Mandate a majority of independent directors on the board of corporate trustees of public offer superannuation funds, including an independent chair; align the director penalty regime with managed investment schemes; and strengthen the conflict of interest requirements.

Chapter 3: Innovation

The Inquiry’s recommendations to facilitate innovation aim to: 1 Encourage industry and government to work together to identify innovation opportunities and emerging network benefits where government may need to facilitate industry coordination and action. 2. Strengthen Australia’s digital identity framework through the development of a national strategy for a federated-style model of trusted digital identities. 3. Remove unnecessary regulatory impediments to innovation, particularly in the payments system and in fundraising for small businesses. 4. Enable the development of data-driven business models through holding a Productivity Commission Inquiry into the costs and benefits of increasing access to and improving the use of private and public sector data.

Establish a permanent public–private sector collaborative committee, the ‘Innovation Collaboration’, to facilitate financial system innovation and enable timely and coordinated policy and regulatory responses.
Develop a national strategy for a federated-style model of trusted digital identities.
Enhance graduation of retail payments regulation by clarifying thresholds for regulation by the Australian Securities and Investments Commission and the Australian Prudential Regulation Authority.
Strengthen consumer protection by mandating the ePayments Code. Introduce a separate prudential regime with two tiers for purchased payment facilities.
Improve interchange fee regulation by clarifying thresholds for when they apply, broadening the range of fees and payments they apply to, and lowering interchange fees.
Improve surcharging regulation by expanding its application and ensuring customers using lower-cost payment methods cannot be over-surcharged by allowing more prescriptive limits on surcharging.
Graduate fundraising regulation to facilitate crowdfunding for both debt and equity and, over time, other forms of financing.
Review the costs and benefits of increasing access to and improving the use of data, taking into account community concerns about appropriate privacy protections.
Support industry efforts to expand credit data sharing under the new voluntary comprehensive credit reporting regime. If, over time, participation is inadequate, Government should consider legislating mandatory participation.

Chapter 4: Consumer outcomes

The Inquiry’s recommendations to improve consumer outcomes aim to: 1. Improve the design and distribution of financial products through strengthening product issuer and distributor accountability, and through implementing a new temporary product intervention power for the Australian Securities and Investments Commission (ASIC). 2. Further align the interests of firms and consumers, and improve standards of financial advice, by lifting competency and increasing transparency regarding financial advice. 3. Empower consumers by encouraging industry to harness technology and develop more innovative and useful forms of disclosure.

Introduce a targeted and principles-based product design and distribution obligation.
Introduce a proactive product intervention power that would enhance the regulatory toolkit available where there is risk of significant consumer detriment.
Remove regulatory impediments to innovative product disclosure and communication with consumers, and improve the way risk and fees are communicated to consumers.
Better align the interests of financial firms with those of consumers by raising industry standards, enhancing the power to ban individuals from management and ensuring remuneration structures in life insurance and stockbroking do not affect the quality of financial advice.
Raise the competency of financial advice providers and introduce an enhanced register of advisers.
Improve guidance (including tools and calculators) and disclosure for general insurance, especially in relation to home insurance.

Chapter 5: Regulatory system

The Inquiry’s recommendations to refine Australia’s regulatory system and keep it fit for purpose aim to: 1. Improve the accountability framework governing Australia’s financial sector regulators by establishing a new Financial Regulator Assessment Board to review their performance annually. 2. Ensure Australia’s regulators have the funding, skills and regulatory tools to deliver their mandates effectively. 3. Rebalance the regulatory focus towards competition by including an explicit requirement to consider competition in ASIC’s mandate and conduct three-yearly external reviews of the state of competition. 4. Improve the process for implementing new financial regulations.

Create a new Financial Regulator Assessment Board to advise Government annually on how financial regulators have implemented their mandates. Provide clearer guidance to regulators in Statements of Expectation and increase the use of performance indicators for regulator performance.
Provide regulators with more stable funding by adopting a three-year funding model based on periodic funding reviews, increase their capacity to pay competitive remuneration, boost flexibility in respect of staffing and funding, and require them to undertake periodic capability reviews.
Introduce an industry funding model for the Australian Securities and Investments Commission (ASIC) and provide ASIC with stronger regulatory tools.
Review the state of competition in the sector every three years, improve reporting of how regulators balance competition against their core objectives, identify barriers to cross-border provision of financial services and include consideration of competition in the Australian Securities and Investments Commission’s mandate.
Increase the time available for industry to implement complex regulatory change.
Conduct post-implementation reviews of major regulatory changes more frequently.

Appendix 1: Significant matters

Explore ways to facilitate development of the impact investment market and encourage innovation in funding social service delivery. Provide guidance to superannuation trustees on the appropriateness of impact investment. Support law reform to classify a private ancillary fund as a ‘sophisticated’ or ‘professional’ investor, where the founder of the fund meets those definitions.
Reduce disclosure requirements for large listed corporates issuing ‘simple’ bonds and encourage industry to develop standard terms for ‘simple’ bonds.
Support Government’s process to extend unfair contract term protections to small businesses. Encourage industry to develop standards on the use of non-monetary default covenants.
Clearly differentiate the investment products that finance companies and similar entities offer retail consumers from authorised deposit-taking institution deposits.
Consult on possible amendments to the external administration regime to provide additional flexibility for businesses in financial difficulty.
Publish retirement income projections on member statements from defined contribution superannuation schemes using Australian Securities and Investments Commission (ASIC) regulatory guidance. Facilitate access to consolidated superannuation information from the Australian Taxation Office to use with ASIC’s and superannuation funds’ retirement income projection calculators.
Update the 2009 Cyber Security Strategy to reflect changes in the threat environment, improve cohesion in policy implementation, and progress public–private sector and cross-industry collaboration. Establish a formal framework for cyber security information sharing and response to cyber threats.
Identify, in consultation with the financial sector, and amend priority areas of regulation to be technology neutral. Embed consideration of the principle of technology neutrality into development processes for future regulation. Ensure regulation allows individuals to select alternative methods to access services to maintain fair treatment for all consumer segments.
Rename ‘general advice’ and require advisers and mortgage brokers to disclose ownership structures.
Define bank accounts and life insurance policies as unclaimed monies only if they are inactive for seven years.
Support Government’s review of the Corporations and Markets Advisory Committee’s recommendations on managed investment schemes, giving priority to matters relating to:
• Consumer detriment, including illiquid schemes and freezing of funds.
• Regulatory architecture impeding cross-border transactions and mutual recognition arrangements.
Introduce a mechanism to facilitate the rationalisation of legacy products in the life insurance and managed investments sectors.
Remove market ownership restrictions from the Corporations Act 2001 once the current reforms to cross-border regulation of financial market infrastructure are complete.

The Treasurer was at pains to point out this is a report to Government, for their consideration, not a Government report, allowing substantial wiggle room if required.

FSI Countdown

Sunday is D-day for the FSI inquiry. The Financial System Inquiry will establish a direction for the future of Australia’s financial system. The Inquiry will lay out a ‘blueprint’ for the financial system over the next decade. So in preparation, its worth reflecting on how we got to this point. The earlier Campbell inquiry in 1981 was all about the entry of foreign banks into Australia, deregulation of the financial system and the floating of the Australian dollar. In 1997, the Wallis Inquiry, changed the regulatory environment with APRA looking after prudential regulation and ASIC for consumer protection and business conduct.

Since then the world has changed, with significant industry consolidation, globalisation, the growth of superannuation, new payment systems, and a massive swing towards mortgage lending. In addition the regulatory focus has been on financial system stability, which stood Australia in good stead through the GFC. However, banks are holding less capital today than before the GFC and internationally there is a focus on banks being too big to fail leading to a requirement for new more onerous capital requirements. In Australia we have a cadre of very profitable banks at a competitive advantage to the rest of the market. As a result, it could be argued that consumers and small business customers are not getting the products and services they should, and whilst the banks have inflated their balance sheets with mortgage lending, its not economically productive.

In additional the fast emerging digital landscape has to potential to disrupt products and services across a wide spectrum.

So, the current review was tasked with considering a wide range of issues, including how Australia should funds its growth, local and international competitiveness and the availability of financial services products and capital for users at the right price, quality and safety.

A review panel oversaw the inquiry. It was chaired by the former Commonwealth Bank of Australia chief executive David Murray. He was the inaugural chairman of the Australian government Future Fund board of guardians between 2006 and 2012. Other members include Professor Kevin Davis, Craig Dunn, Carolyn Hewson and Dr Brian McNamee.

There were a vast number of submissions to the inquiry. Many incumbents argued for little change, the regulators pointed to the financial stability exhibited through the GFC (and argued for more regulatory funding), whilst others were more critical, and advocated significant structural change. There is a complex set of interactions in the financial services sector, and many opinions.

In the interim report a number of key issues surfaced. For example, the major banks exposures to the mortgage market could create risks in terms of financial stability in a housing downturn. The recent APRA stress tests made the same point. The big four have significant advantages over smaller players. There were important discussions about the question of banks being too big to fail (meaning they would require public money to bail them out in a down turn). The report also looked at the payments system and the role of emerging technology and superannuation and financial advice were also discussed.

So what might be on the agenda of the final report? Here is my shortlist (against which I will be checking the released documents later).

Capital buffers to be raised to reduce the competitive gradient between larger and small banks, and adjusted also for investment housing lending
Competition rules to be tweaked to reduce the too big to fail problem (probably too hard to break up the existing large integrated financial services players) and to encourage new players
Reduction or removal of credit card surcharging
Changes to financial advice regulation
Leverage rules for Self Managed Super Funds to be trimmed back
Opening up of the payments systems
Use of superannuation funds to more directly power growth
Incentives for lending to SME’s
Changes to the regulatory environment, with a stronger emphasis on consumer protection, to balance financial stability

It is likely that the recommendations contained in the report will go through further iteration before they are implemented. We shall see.

Local P2P On The Up

SocietyOne, Australia’s first and largest Peer-to-Peer (P2P) lender has announced the successful completion of a Series B capital raise with a consortium of eminent Australian investors, made up of Consolidated Press Holdings (CPH), News Corp Australia and Australian Capital Equity. The consortium will acquire 25 per cent of the business initially.

Matt Symons, Chief Executive Officer and co-founder with Greg Symons of SocietyOne said: “This investment marks a new and exciting chapter for SocietyOne and for the acceleration of P2P Lending in Australia. We are thrilled to partner with investors of this calibre with their unparalleled track record for building successful businesses in Australia and overseas”.

Regarded by some as the future of banking, P2P lending or marketplace lending as it is also known, is growing rapidly worldwide with considerable success in markets such as the United States and Europe. Investors have been particularly excited by the significantly increased returns from removing the intermediary from the lending markets. The largest P2P lender in the US, Lending Club, is now originating over USD$1 billion in personal loans per quarter and is expected to launch its much-anticipated public offering before year-end. The listing will create a global benchmark for the new industry.

Speaking on behalf of the consortium of CPH, News Corp Australia and Australian Capital Equity, Mr James Packer said: “We have seen first-hand the power of technology in reshaping the media industry and I am excited about the potential of technology, led by the team at SocietyOne, to help reshape the financial services industry in Australia. We see enormous potential in delivering significant savings to borrowers as well as providing new innovative products that will also be attractive to the investor market. Peer-to-Peer lending is one of the global forces leading the transformation of banking by putting people, not intermediaries, at the centre of the borrowing and lending experience.”

The Westpac Group-backed venture capital fund Reinventure has also agreed to participate in the latest capital raising following its initial investment in February 2014 as part of an earlier $8.5m raising.

“We continue to be impressed by the growth of the model and the execution of this team. This new round of investment brings together the best group of strategic investors in the country,” said Simon Cant, Co-founder and Managing Director of Reinventure. “This is consistent with our approach of backing experienced entrepreneurs, proven models and driving value to ensure they win their market.”

SocietyOne uses a risk-based pricing approach and its proprietary ClearMatch technology platform to offer creditworthy borrowers a better deal and investors direct access to an attractive new fixed income investment option. Borrowers with good credit histories benefit from personalised rates that are generally much lower than standard credit cards and up to 5% lower than personal loans from the major banks.

P2P Goes Main Street

Peer To Peer Lending is going main stream as San Francisco-based Lending Club, the biggest p2p lender in the world with more than $6.2bn worth of loans made through its platform (this is three times the amount of its closest rival, Prosper) seeks to raise at least $650m by IPO at $10 to $12 per share. This would translate into a mid value at about $4bn for the company.

Trading for more than eight years now, Lending Club’s business model is based on using advanced computer algorithms to match those seeking money with those willing to provide it. High-quality credit customers, with FICO scores starting at about 660, can borrow up to $35,000 at interest rates averaging 14 percent. The IPO roadshow is targeting the big end of town, including the investment arms of some of the very banks which might find their lunch being eaten.

Setting the right price is of course a problem as it is the first cab off the rank, but if successful, it would mark an important step in the evolution of P2P, and competitors like Prosper Marketplace and the small business specialist On Deck Capital, could follow suite.

At a time when the traditional banks are finding it hard to lend to some small borrowers, thanks to capital pressure, and legacy infrastructure, P2P may look an attractive alternative to borrowers and investors a like. Whilst the company began with personal loans, targeting borrowers looking to refinance credit card debt with high interest rates, it has moved into other offerings. Small businesses can now borrow up to $100,000 through the platform and recently, the lending platform unveiled a new two-year “super prime” loan enabling customers to borrow up to $10,000.

Lending Club already has the backing of some of the biggest names on Wall Street and in Silicon Valley. Its board includes Lawrence H. Summers, the former Treasury secretary; John J. Mack, the former chief executive of Morgan Stanley; and Mary Meeker, the venture capitalist and onetime star Internet analyst. Its existing investors range from Google, the venture capital firm Kleiner Perkins Caufield & Byers and the mutual fund giants T. Rowe Price and Black Rock. According to the prospectus, only three of the company’s existing investors plan to sell in the initial offering. Lending Club will list on the New York Stock Exchange.

According to the FT:

The p2p sector’s growing partnership with Wall Street has been a sensitive topic for the industry, with some keen to downplay the role of professional investors in their growth. Lending Club recently changed the way it hands out data on its platform as it seeks to level the playing field between professional and retail investors.

Prosper and Lending Club have also installed electronic “speed bumps” in an attempt to stop sophisticated investors from snapping up the most attractive loans.

RBA Rate Unchanged

At its meeting today, the Board decided to leave the cash rate unchanged at 2.5 per cent.

Growth in the global economy is continuing at a moderate pace. China’s growth has generally been in line with policymakers’ objectives. While weakening property markets present a challenge in the near term, economic policies have been responding in a way that should support growth. The US economy continues to strengthen, but the euro area and Japan have both seen weakness recently. Some key commodity prices have declined significantly in recent months, reflecting somewhat softer demand and, more importantly, increased supply.

Global financial conditions remain very accommodative and long-term interest rates and risk spreads remain very low. Differences in monetary policies across the large jurisdictions are affecting markets, particularly exchange rates.

In Australia, most data are consistent with moderate growth in the economy. Resources sector investment spending is starting to decline significantly, while some other areas of private demand are seeing expansion, at varying rates. Public spending is scheduled to be subdued. Overall, the Bank still expects growth to be a little below trend for the next several quarters.

Inflation is running between 2 and 3 per cent, as expected, with recent data confirming subdued rises in labour costs. Although some forward indicators of employment have been firming this year, the unemployment rate has edged higher. The labour market has a degree of spare capacity and it will probably be some time yet before unemployment declines consistently. Hence, growth in wages is expected to remain relatively modest over the period ahead, which should keep inflation consistent with the target even with lower levels of the exchange rate.

Monetary policy remains accommodative. Interest rates are very low and have continued to edge lower over the past year or so as competition to lend has increased. Investors continue to look for higher returns in response to low rates on safe instruments. Credit growth is moderate overall, but with a further pick-up in recent months in lending to investors in housing assets. Dwelling prices have continued to rise.

The exchange rate has traded at lower levels recently, in large part reflecting the strengthening US dollar. But the Australian dollar remains above most estimates of its fundamental value, particularly given the significant declines in key commodity prices in recent months. A lower exchange rate is likely to be needed to achieve balanced growth in the economy.

Looking ahead, continued accommodative monetary policy should provide support to demand and help growth to strengthen over time. Inflation is expected to be consistent with the 2–3 per cent target over the next two years.

In the Board’s judgement, monetary policy is appropriately configured to foster sustainable growth in demand and inflation outcomes consistent with the target. On present indications, the most prudent course is likely to be a period of stability in interest rates.

G20 On Financial Reform

The G20 Brisbane communique included a paragraph on financial stability reform, and refers specifically to the Financial Stability Review proposals to strengthen capital requirements for globally significantly banks.

Strengthening the resilience of the global economy and stability of the financial system are crucial to sustaining growth and development. We have delivered key aspects of the core commitments we made in response to the financial crisis. Our reforms to improve banks’ capital and liquidity positions and to make derivatives markets safer will reduce risks in the financial system. We welcome the Financial Stability Board (FSB) proposal as set out in the Annex requiring global systemically important banks to hold additional loss absorbing capacity that would further protect taxpayers if these banks fail. Progress has been made in delivering the shadow banking framework and we endorse an updated roadmap for further work. We have agreed to measures to dampen risk channels between banks and non – banks. But critical work remains to build a stronger, more resilient financial system. The task now is to finalise remaining elements of our policy framework and fully implement agreed financial regulatory reforms, while remaining alert to new risks. We call on regulatory authorities to make further concrete progress in swiftly implementing the agreed G20 derivatives reforms. We encourage jurisdictions to defer to each other when it is justified, in line with the St Petersburg Declaration. We welcome the FSB’s plans to report on the implementation and effects of these reforms, and the FSB’s future priorities. We welcome the progress made to strengthen the orderliness and predictability of the sovereign debt restructuring process.

It is sometimes hard to read the meaning behind the words, but Mark Carney, Governor of the Bank of England made some important comments in a speech in Singapore on his way home from Brisbane.

Banks are now much more resilient. They have more capital, more liquidity and are less susceptible to procyclical spirals. Capital requirements for banks are much higher, as are risk weights and the quality of bank capital. In all, new capital requirements are at least seven times the pre-crisis standards for most banks. For globally systemic banks, they are more than ten times. Large internationally active banks are on course to meet the new requirements 4 years ahead of the 2019 deadline. Despite the scale of the changes, the aggregate shortfall of those banks that still have shortfalls was €15bn at end 2013, having been €115bn two years ago.

It is just as clear that banks’ liquidity positions before the crisis were precarious. Now, for the first time, global standards have been agreed to place requirements on the liquid asset buffers banks must hold and on the extent of maturity transformation in which they can engage. The rapid contagion during the crisis showed how the system magnified shocks. Two particular fault lines made the system procyclical.

First, banks were heavily exposed to movements in market prices and volatility around them, creating a cycle in which falls in prices caused banks to retrench and reduce their positions, leading to further falls in asset prices. That issue has been addressed through strengthening regulatory requirements on trading books – a move that has contributed to the share of banks’ assets accounted for by trading assets almost halving.

Second, banks and shadow banks were entwined in a dangerous funding spiral. Incredibly low initial margins on repo transactions facilitated the build-up of excessive leverage and maturity mismatches in shadow banks. The first wave of losses led banks to tighten margin requirements, effectively reducing financing available to the non-bank financial system, causing those institutions to deleverage through asset sales, driving a death spiral of falling asset prices and rising margin requirements.

Such dynamics have now been mitigated through agreed minimum haircuts for securities financing transactions and the net stable funding ratio for banks.

As the memory of the crisis fades, it will be ever more important to explain the benefits of reform to counter the fatalism. So let me take this opportunity to take stock of the benefits of reforms, both of those already agreed and of the next phase of reform I have outlined. While we all recognise that future crises can never be ruled out, the steps taken to make banks safer and simpler have certainly reduced the likely frequency and severity of future financial crises. In doing so, they have reduced the exorbitant costs of instability. The Basel Committee assessed in 2010 that the economic cost of the median financial crisis amounted, over time, to 60% of national income. With a 5% probability of a crisis each year, that is equivalent to annual costs of 3% of GDP. For the G20 as a whole that is $2trn. By eroding these costs, financial reform alone can therefore more than deliver the G20 commitment to raise GDP by more than 2%. The Basel Committee found these costs to be minimised only if risk-weighted bank capital ratios were raised above 15%. The Basel III requirements did not go this far, in part because they anticipated the additional requirements for loss absorbing capacity that G20 Leaders have just endorsed.

Once implemented, the combined effects of the reforms will take the system much closer to the degree of safety needed to minimise the costs of financial crises. That authorities have reached this point in a measured way – allowing both equity and forms of debt to qualify as loss absorbing capacity – shows our sensitivity to the potential costs of greater safety. What are those costs? Three points are worth emphasising.

First, the Basel Committee study judged that each 1% increase in capital ratios could reduce output by just 0.1% as higher bank funding costs were passed through to borrowers. However, even that small number seems an upper bound. It fails to take account of the fact that monetary policy can offset the impact of higher lending spreads on effective borrowing rates.In fact, the need to offset the impact of higher lending spreads is one reason why some advanced economy central banks, such as the Bank of England, are so clear now that interest rate increases, when they come,will be gradual and limited.

Second, the transitional costs of moving to higher capital requirements were found to be a little higher than the long-run costs. But that result depends on the starting position. Outside of financial booms, under capitalised banking systems do not provide the credit needed for economic growth, regardless of capital requirements.Where banking systems have raised capital and restored trust in their creditworthiness, access to credit has returned. This central lesson from the US and the UK recoveries could not be clearer. The evidence internationally suggests much the same. With the possible exception of parts of the euro area, lending spreads have fallen and credit volumes have increased at the same time as capital has gone up. In other words, if anything, regulators may have significantly overestimated the transitional costs, or even possibly got the sign wrong.

Third, although tighter regulatory requirements have caused bank balance sheets to shrink, that does not translate fully into reduced access to credit for real economy borrowers. As I said, some of the reduction in bank-based intermediation has been substituted with market-based finance for the real economy. Moreover,as bank balance sheets have shrunk, and as they have rebalanced more towards traditional banking than trading, they have become more focussed on the real economy.

In short, any serious look at the experience of post-crisis reform shows that reform and regulation support –not damage – long-term prosperity.Furthermore, the reforms have also brought benefits in terms of the distribution of the costs and benefits of finance. The removal of the implicit taxpayer subsidy transfers the costs of excessive risk taking to private creditors and away from the taxpayer.And by making resolution of failing institutions a real possibility and facilitating smooth exit, the reforms willalso promote competition. Before the crisis, the largest and most systemic firms enjoyed the largest subsidies. Now, over time, the absence of that subsidy will create a level playing field, transferring the benefits of finance to customers and clients.These benefits will accrue slowly over time. Indeed, they may never be obvious to many who don’t recall a different world. That is why it is vital that our sons and daughters are taught not that financial crises are inevitable, but that they are both avoidable and tremendously costly for jobs, growth and prosperity. The lessons of the crisis need to be learned and handed down to future generations in order that the next phase of reform is sustained.Those reforms have the potential to make finance more effective in serving the real economy

Savers Are Going To Get Crunched

There is bad news for those households with bank deposits. We have already seem a range of deposit repricing initiates by the banks, as they trim their deposit rates. But it is likely to get worst, as international sources of funding get cheaper, and changes to capital requirements are likely to translate to further rate cuts for savers down the track.

Rates have been coming down for those with bank deposits in recent months, and the rate of fall has accelerated recently. The chart below shows the movements of discounted mortgages, 3 month and 6 month deposits, and also the 3m swap rate, using RBA datsets.

Whilst there is selective deeper discounting on the mortgage side, for some, savers are finding their returns falling. This is show most clearly by comparing the margins between the RBA rate, and loans and deposits. Despite the static RBA rate, deposit rates are falling.

We know that overseas funding continues to improve, and as a result banks will be seeking to source funds through these channels. They are also discounting hard to get mortgage business. So to square the circle they are quietly trimming the rates to savers. We highlighted last week that bank deposits fell by 0.06% last month, to a value of $1.76 trillion, whereas lending grew.

Looking ahead, with banks likely to have their wings clipped by the FSI report, due soon, and changes to capital following on which are likely to lift the costs of lending, the net result will be further pressure on saving rates, and more households looking for higher risk alternatives, as the RBA often mentions in their monthly statements. This continued fall of deposit returns hits older household segments the hardest, especially those banking on deposits to fund their retirements. Returns will be below inflation, so capital is effectively being eroded.

As a comparison, in the UK they have had 6 years of low deposits, and recently savers have found their rates being cut further. Many households are in financial stress as a result. In Australia, savers will either wear the losses, seek higher risk alternatives, or spend the money. Perhaps this latter course may assist an otherwise sluggish consumer sector. But it is not looking pretty.

Higher Capital for Big 4 Australian Banks Credit Positive – Fitch

According to Fitch Ratings, the Australian Banks will be able to handle any potential increase in capital requirements, and would be credit positive for the banks.

Australia’s Financial System Inquiry (FSI), due to report by end-2014, is likely to recommend higher capital requirements for the large banks, says Fitch Ratings. A higher capital charge and/or a rise to the mortgage risk-weighting floor for the four domestic systemically important banks (D-SIBs) are the most likely ways in which this will be implemented. In either case, Fitch maintains that Australia’s banks are well positioned to meet the additional buffers though internal capital generation.

Australia’s bank capital profiles have strengthened since 2008, though they are about average relative to their international peers. Fitch maintains that additional capital requirements for the four D-SIBs – ANZ, CBA, NAB and Westpac – would be credit positive.

The FSI, led by Chairman David Murray, is expected to push for regulatory changes that would reinforce the improvements in recent years. The gap between Australia’s banks and global peers in terms of capital strength has closed, though an objective of the FSI is to bring the largest banks back into the upper quartile. Increasing the D-SIB capital buffer requirement from the current 1ppt, as well as implementing a mortgage risk-weight floor for banks using advanced models to calculate regulatory capital, are likely to be two areas of focus for the Murray report.

A number of global initiatives are addressing the wide discrepancy in risk weights based on banks’ internal models, including a Basel Committee project. Risk-weights for residential mortgages have been a particular focus because they can be very low. In Sweden, the risk-weight floor for residential mortgages was raised to 25% from 15% this year, while Norway is raising its floor to 20%-25% from 10%-20%. In Switzerland, the authorities are reviewing the differences between risk-weights based on banks’ internal models and those based on the standard approach used by domestic and regional banks.

Taking the global context into account, there is the potential for the FSI to recommend raising Australia’s mortgage risk-weight floor to 25%, which would result in capital shortfalls for each of the four major banks – AUD2.9bn for ANZ (the lowest) to in excess of AUD4.6bn for Westpac, based on FY14 numbers and assuming the banks maintain an internal buffer of 1ppt over the fully loaded regulatory requirements. Under a more aggressive scenario, where the risk-weight floor is increased to 30%, the D-SIB charge also raised 2ppt to 3ppt, and a 1ppt internal buffer maintained, the capital shortfalls would be between AUD12bn-15bn for each of the Big 4, and total around AUD53bn. With combined profits for the four banks of around AUD29bn in FY14, the capital shortfall under this scenario would be just less than twice annual profit before dividend.

The Basel Committee’s framework for D-SIBs is more flexible and less prescriptive than the G-SIB framework that applies to the world’s largest banks, but the phase-in for both starts in 2016. Few jurisdictions have yet finalised their D-SIB implementation, but the current 1ppt requirement in Australia appears low compared with Sweden, where a systemic risk buffer of 3ppt is required from 1 January 2015, with a further 2ppt within Pillar 2. Hong Kong, Singapore and India are considering D-SIB buffers of up to 2.5ppt, 2.0ppt and 0.8ppt, respectively, although these have not necessarily been finalised.

Fitch expects that the Australian authorities would set implementation timetables so that the banks would be able to generate the bulk of capital internally, even under the latter scenario.

Increasing the capital of the Big 4 would continue the trend for credit profile strengthening that has occurred since 2008 at a time when there are concerns about risks from rising property prices and exposure to a slowing China and commodity cycle. However, competitively, the higher D-SIB charges and risk-weight floors for the Big 4 could erode some of their substantial scale advantages relative to smaller competitors.

It is important to note that if the measures to address the problems of ‘too big to fail’ banks went beyond higher capital requirements and included measures such as ‘bail-in’ of senior creditors, this would be likely to result in downgrades of Fitch’s Support Ratings and Support Rating Floors – the agency currently factors in a very high likelihood of government support for the major banks, given their strong market position in the domestic banking system. The Issuer Default Ratings, however, would be unaffected, as no Australian bank is currently at its Support Rating Floor.