financial system inquiry – Digital Finance Analytics (DFA) Blog

NAB Financial Advisors Under The Microscope

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

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

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

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

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

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

RBA Reinforces Current Policy Settings

The RBA has made a supplementary submission to the Financial System Inquiry. Of note, they want to limit the extent to which SMSF’s can borrow, especially for property purchase; acknowledges the potential systemic risk from more housing lending, and the potential impact on business lending; and continues to be skeptical about the potential benefits of macroprudential tools. A couple of contextual charts may help – $1.85 billion in superannuation, 30% in SMSF, and the property sector is worth $5.2 trillion, with borrowing of $1.375 trillion, and a greater proportion for investment purposes, with a rise in interest only loans.

SUPERANNUATION

Assets should be managed in the best interests of members. Measures to lower costs and fees, optimise liquidity management and limit leverage should be considered”. The Bank endorses the observation that leverage by superannuation funds may increase vulnerabilities in the financial system and supports the consideration of limiting leverage. The general absence of leverage in superannuation was a key source of resilience in the Australian financial system during the financial crisis. Furthermore, the compulsory and essential character of retirement savings implies that it should remain largely unlevered. While still in its infancy, the use of leverage by superannuation funds to enhance returns appears to have been mainly taken up by self-managed superannuation funds (SMSFs). The Bank has previously commented on the risks that may arise from geared property investment through SMSFs, which may act as an additional source of demand that exacerbates property price cycles. Nonetheless, some limited leverage for liquidity management purposes may be appropriate.

HOUSING MARKET

The Interim Report finds little evidence of a shortage of mortgage finance in Australia, a view that the Bank shares. Even so, the Interim Report raises a number of options in the context of competition in the mortgage market that, if implemented, could result in relatively more finance being directed towards housing. These options should be assessed in terms of the end benefits and risks for consumers and the broader economy. Relevant considerations include whether the policy change might accelerate household borrowing, and the associated implications for systemic risk and the available funding for Australian businesses. As noted in the Bank’s initial submission, housing is generally not a particularly risky asset, but because of its size, importance to the real economy and interconnectedness with the financial system it poses systemic risk. With regards to Capital Requirements, the Interim Report highlighted several options for aiding competition through Australia’s capital framework, including changes to mortgage risk weights and providing capital inducements for ADIs that use Lenders’ Mortgage Insurance. Because of the cyclical nature of risk-taking and the large social and economic costs of instability in financial systems, it is crucial that institutions’ capital be allocated according to risk. Hence, changes to the capital framework on competitive grounds should not come at the expense of greater risk, and should not amount to a weakening relative to global regulatory minima.

MACROPRUDENTIAL

The Bank concurs with the Interim Report’s caution regarding unproven macroprudential tools. The Bank and the other CFR agencies view macroprudential policy as being subsumed within the broader financial stability policy framework in Australia. The Interim Report notes the existing framework where APRA, in consultation with the Bank and other CFR agencies, is responsible for administering prudential regulation. Consistent with its existing mandate to promote financial stability, APRA has adapted its prudential intensity in light of developments in systemic risk. For example, following signs of increased risk appetite in the mortgage market, APRA recently surveyed mortgage underwriting standards, released guidance on managing mortgage risk, and asked the major banks to specify how they are monitoring lending standards and the ensuing risks to the economy. Tools like loan-to-valuation ratio and debt-servicing ratio limits on mortgages have only recently begun to be used in developed countries. It is still too early to judge their effectiveness with the available evidence so far mixed; the effects of particular initiatives are not easily disentangled from those of other policy settings, including changes in monetary policy. APRA already has the powers to implement these tools if it was decided they would be beneficial. The Bank is not attracted to arrangements whereby prudential policy setting is spread across multiple agencies or groups of agencies. Australian agencies will continue to closely monitor how these tools perform overseas.

If The Worm Turns, What Happens To Household Mortgage Stress?

The wind appears to be changing. First the new head of APRA warned at a CEDA event they were watching the mortgage lending of the banks closely, “The Australian banking system clearly has a concentration of risk in housing. If anything was to go wrong in the housing market it would have very severe impact on the viability and health of the banking system, so it’s naturally something we watch very carefully.” Meantime in London, Treasury Secretary Martin Parkinson spoke to Chatham House where he mused on the low interest rate strategies being adopted by many countries, the limits of monetary policy and the potential for macroprudential measures. Locally, whilst fixed rate mortgages are being offered at record lows below 5%, the consensus appears to be shifting towards a lift in rates in Australia, partly as a result of rising inflation, although timing is not certain. So, what is the potential impact of a rate rise on Australian mortgage holders, bearing in mind that the average loan to income is stretched? How far would rates rise? Where would the pain be felt most?

To answer these questions, we have examined interest rate trends, and incorporated a rising rate scenario into our mortgage stress models. First, let’s look at rate trends. This is a plot of the RBA target rate since 1990. If we take a linear average, we see that currently we are well below the “neutral” range. An RBA rate of 4-4.5% would on this basis be a neutral rate. This is the first assumption I have made in my stress modelling.

Then we have to estimate the spread above the target rate the variable rate mortgage will be coming in at. We still have most households on a floating rate, although 15% are locking in fixed at the moment. This plot shows the target cash rate, against the spread between a CMT deposit account and a standard variable mortgage. Lets assume an average uplift of 300 basis points. That would put the mortgage rate at about 7%.

Now, we will assume rates will be lifted to this level in the next 12-15 months. We will also assume that income rises at the level it has in the past 2 years, and that unemployment stays at 6% (to isolate the effect of the rate movement). We then calculate for the 26,000 households in our survey the impact on their income/expenditure if their mortgages do rise. The impact is of course immediate, unless households are on a fixed loan. This is incorporated in the modelling. Now, we calculate the proportion of households which will be in mortgage stress in 18 months time (see the definitions we use here). Lets take Sydney as an example. This geo-mapping shows where the main movements are in terms of increases in mortgage stress. The blue postcodes are worst hit. Many of these households are in the western suburbs, and are typically younger, and on lower incomes. Many are first time buyers.

Mortgage stress does not mean an immediate crisis, but households hunker down short term, and it is a warning of trouble ahead because many households who get into difficulty are ultimately forced to sell. My read on this modelling is that if rates rise, the impact on the property market could be quite profound. This in turn does indeed lay potential bear traps for the banks, because of their high leverage into property. There is a strong case to lift the currently relatively low capital rules for the big four, to provide a buttress against rising rates, and to avoid financial stability issues. The recent FSI interim report touched on this. If rates do indeed start to rise, we will need to be alert to the issues. Actually, the regulators should have been acting sooner, as the genie is now out of the bottle. We will publish data on this scenario for other states another day.

The Payments Revolution Around The Corner

The FSI Interim report, released earlier in the week, includes a section on how technology may disrupt payments, a critical domain in financial services.

The report says ” Advances in technology have reduced traditional barriers to market entry in payments, such as the need to construct a dedicated network. New entrants can leverage high levels of internet connectivity, penetration of smart devices and pre-existing networks to connect users to payments services more easily and cheaply than incumbents. The payment hub, being developed by eftpos Payments Australia Limited, and the New Payments Platform (NPP), an industry project being developed as a result of the Reserve Bank of Australia’s (RBA’s) strategic innovation review, may further reduce barriers to entry and drive competition. Incumbents in the Australian payments industry are facing competitive challenges from new market entrants, such as PayPal, POLi, PayMate and Stripe. Closed-loop pre-paid systems operated by companies outside the financial sector, such as Apple, Skype and Starbucks, are holding growing amounts of customers’ funds. Apple has also recently signalled its interest in mobile payments more broadly and recently developed fingerprint biometric authentication for its phones. Advances in cryptography and computer processing power have facilitated the development of virtual or crypto-currencies.

Today we look at the potential convergence of new payment mechanism, overlaid on smart devices, and in the context of customer centric thinking. Consider this, the ubiquitous smart mobile device is essentially a mobile wallet plus a payment instrument, a centre of interaction and potentially can provide secure identification.

You walk down a high street and receive a personalised messages from a retailer, based on your profile, as you pass. The offer is triggered by your proximity to the store. It is a deep discount on that item you were goggling last night, available for just 10 minutes. You decide to accept the offer, pay direct from your phone using your secure wallet, and the deal is done. Rather than collect it, you choose to have it delivered to your home, later in the day. No human interaction, simply a combination of technologies to fundamentally change the customer experience.

Consider the disruptive impact of this, on the retail trade, the payments system, and human behaviour.

Is this far fetched? Not at all. For example, Apple has been working on iBeacon, which is “a new technology that extends Location Services in iOS. Your iOS device can alert apps when you approach or leave a location with an iBeacon. In addition to monitoring location, an app can estimate your proximity to an iBeacon (for example, a display or checkout counter in a retail store). Instead of using latitude and longitude to define the location, iBeacon uses a Bluetooth low energy signal, which iOS devices detect”. It is still early, but Apple has been testing it since December last year in its US retail stores. In the UK, Virgin Atlantic is also conducting trial of iBeacon at Heathrow airport, so that passengers heading towards the security checkpoint will find their phone automatically pulling up their mobile boarding pass ready for inspection. Paypay is experimenting with its own version of beacon – “hands Free shopping – the future in here”, they say.

In May, St. George revealed that is trialling iBeacon at three Sydney branches. When a customer walks into the bank, the iBeacon senses the person’s entrance and sends a welcome message and personalised information directly to the iPhone or iPad, according to Computerworld. George Frazis, CEO of St. George Banking Group, said in a statement the launch of the new technology forms part of an increased focus on delivering an innovative and customer-centric in-branch experience. “The future of business will be in the ability to anticipate customer’s needs, understand what matters to them and act on that knowledge to surprise and delight them,” he said. “Our investment in iBeacon will help us to achieve that — and it has the potential to dramatically change the service experience in Australian banking.”

The question is, what is the right regulatory settings to, on one hand allow innovations like this to flourish, whilst on the other hand, ensure that adequate protections are in place. That is the question posed, but not yet answered in the FSI interim report.

“Some submissions argue that firms performing similar functions should be regulated in the same way. This position is often made by large incumbent players concerned about the capacity of new players to operate around the edge of the regulatory perimeter. Failure to apply equivalent regulation may result in an uneven playing field and regulatory arbitrage. It may also incentivise those within the current regulatory perimeter to lower their own standards of compliance to compete. However, applying the full weight of prudential or conduct regulation to small players and new start-ups, regardless of the materiality of the risk they represent, may stifle valuable innovation unnecessarily.”

What is clear to me, based on our survey of households and their use of mobile devices, there is potentially a revolution round the corner, which will disrupt traditional payment mechanisms, retail behaviour and customer expectations. Actually many people are ahead of many of the incumbents, and are expecting to do ever more with their ubiquitous mobile devices. The real power is wedding the multiple technologies contained in the device, to create a seamless consumer experience, with smart analytics and segment data. The marketeers dream of one to one targetting is here. Unless people to select to opt out – if they can find the right tab. That may not be easy.

Reflections On The FSI Interim Report – Part 1

Having summarised the main observations from the 460 page Financial System Inquiry (FSI) interim report yesterday, today we start to delve more deeply into some of most important issues raised. In a number of areas, we believe the work to date could be sharpened.
Lender’s Mortgage Insurance. The report rightly highlights that for banks with advanced capital models, there is now no benefit to underwriting risks to an LMI entity, as they already receive a 20% weighting, whether or not they are LMI insured. Therefore, LMI may become sidelined, and be used by smaller banks only, reducing volumes and increasing underlying portfolio risks.
However, whilst the report recognises that about 25% of new loans are underwritten by LMI, and the borrower pays, it does not reflect on the fact that the insurance is not portable, so consumers forfeit the premium they pay if they move later; that consumers are confused by the cover provided (protects the banks, not the household) and LMI encourages higher LVR lending. We think the role of LMI should be considered more broadly.
Industry Concentration. The report comments “Some submissions argue that the increasing concentration and integration of the major banks is harming competition. They submit the major banks can cross-subsidise products to drive out competitors in some markets. Submissions also argue that the major banks’ market power has led to oligopolistic competition and higher prices for consumers. The major banks have market power across a range of markets. However, it is not clear they are abusing this power. The ACCC has taken relatively little action against the major banks in recent years. The Inquiry would welcome views on the level and exercise of market power across the various markets in which the major banks operate.”
The major banks have become financial services conglomerates, extending their reach across retail, business and commercial banks, as well as wealth management, wealth management platforms and insurance. In addition, they have become more vertically integrated, with the accumulation of mortgage brokers, financial planners and other advisors businesses, and are extending services into online channels as well as branch networks. There are important implications, first consumers often find the brand they transact with does not clearly indicate its relationship with the parent bank. Second, as players control more of the value chain there is more opportunity for price control and reduced competition. For example, a mortgage broker working for one of the large players may recommend an in-house mortgage, so long as it is not unsuitable.
The report says “Vertical integration of mortgage broking may create conflicts of interest, which could hamper competition. Mortgage brokers can improve competition by enabling smaller players to access a broader range of consumers than their standard distribution networks would allow. However, vertical integration may have the potential to distort the way in which mortgage brokers direct borrowers to lenders. The extent of this issue is not clear. The Inquiry welcomes views on this issue.”
More broadly there is a case for greater transparency in the proportion of industry segments which players occupy. No consolidated data is provided by the regulators, across business streams. In addition, ACCC tends to look at specific transactions, not necessarily setting them in the broader cross segment context. We need an overall industry concentration metric, and regular reporting.
The Implications of Four Pillars. The report noted that “The ‘four pillars’ policy, which prevents mergers between the big four banks, has been in place, with some modifications, since 1990. Allowing a merger between the large banks would likely reduce competition, and this may offset any advantages that flow from larger scale. No submissions supported removing this policy.”
“The Inquiry views this as appropriate and does not plan to recommend changes. The banking sector is already concentrated; further significant concentration has the potential to limit competitive pressure in the market and reduce the choices available to Australian individuals and firms. Although general competition law may prevent a merger between the major banks, the Inquiry sees merit in retaining the four pillars policy.”
Now, I agree that further consolidation in the industry amongst the major banks should be resisted, however, the unintended consequence of this policy is that the banks can complete quite happily on the basis of inefficient processes and systems. This in turn flows on to higher fees and charges. So, with competition dampened by four pillars, what mechanisms should be established to ensure that Australia Inc. does not pay more than it should for banking and financial services products? At very least, we need an objective cost benchmark, against players in analogous markets overseas, to ensure that the four pillars does not artificially support higher margins and fees.
Innovation in Financial Services. The report recognises that innovation, often enabled by new technology is significant and important. “Government and regulators face challenges from the expected pace of change in technological developments. By its nature, regulation lags market developments. Consequently, Government and regulators need effective mechanisms for monitoring emerging trends, a flexible approach, and the ability to adapt and design regulation in a changing environment. Where new, technology-enabled business models, products and delivery mechanisms emerge, regulators need to consider whether and how to regulate such developments. They may also need to be flexible in how they apply existing frameworks.”
The latency between developing new business models, and regulation needs to be reduced. For example, Peer-To-Peer lending, is now on ASIC’s radar, and regulatory mechanisms are being developed.
So the report is considering “Developing a comprehensive Government strategy, in consultation with industry, to ensure the regulatory framework supports technological innovation, while managing risks.” One option mooted is to “Establish a central mechanism or body for monitoring and advising Government on technology and innovation. Consider, for example, a public–private sector collaborative body or changing the mandate of an existing body to include technology and innovation”.
Our recent experience is that the currently constituted bodies are populated predominantly with people who live within the current mode of operation in financial services. There is the need to break the mould, and inject innovation into the heart of the financial services environment. This would indeed require a different model of engagement. In addition, the pace of change, as individuals adopt new devices, and smart mobile becomes the norm, this is important, and urgent.
Next time, we will look at some of the other important area.

Financial System Inquiry – Interim Report

The draft report was released today. In a layered document, it sets out a series of 28 observations, and possible options for ongoing consideration. The main observations are set out below:

• The banking sector is competitive, albeit concentrated. The application of capital requirements is not competitively neutral. Banks that use internal ratings-based (IRB) risk weights have lower risk weights for mortgage lending than smaller authorised deposit-taking institutions (ADIs) that use standardised risk weights, giving the IRB banks a cost advantage.
• Regulation of credit card and debit card payment schemes is required for competition to lead to more efficient outcomes. However, differences in the structure of payment systems have resulted in systems that perform similar functions being regulated differently, which may not be competitively neutral.
• Ongoing access to foreign funding has enabled Australia to sustain higher growth than otherwise would have been the case. The risks associated with Australia’s use of foreign funding can be mitigated by having a prudent supervisory and regulatory regime and sound public sector finances.
• There are structural impediments for small- and medium-sized enterprises to access finance. These impediments include information asymmetries, regulation and taxation.
• Australia has an established domestic bond market, although a range of regulatory and tax factors have limited its development.
• There is little evidence of strong fee-based competition in the superannuation sector, and operating costs and fees appear high by international standards. This indicates there is scope for greater efficiencies in the superannuation system.
• If allowed to continue, growth in direct leverage by superannuation funds, although embryonic, may create vulnerabilities for the superannuation and financial systems.
• Superannuation policy settings lack stability, which adds to costs and reduces long-term confidence and trust in the system.
• During the GFC, significant government actions in a number of countries, including Australia, entrenched perceptions that some institutions are too-big-to-fail. These perceptions can be reduced in Australia by making it more credible to resolve these institutions without Government support.
• A number of jurisdictions have implemented new macroprudential toolkits to assist with managing systemic risks. The effectiveness of these for a country like Australia is not yet well established, and there are significant practical difficulties in using such tools.
• Australia has implemented some aspects of global prudential frameworks earlier than a number of jurisdictions. It has also used national discretion in defining capital ratios. When combined with other aspects of the prudential framework and calculated on a consistent basis, Australian banks’ capital ratios (common equity tier 1) are around the middle of the range relative to other countries. However, differences such as those in definitions of capital do limit international comparability.
• To contribute to the effectiveness of the financial system, sound corporate governance requires clarity of the responsibilities and authority of boards and management. There are differences in the duties and requirements of governing bodies for different types of financial institutions and, within institutions, substantial regulator focus on boards has confused the delineation between the role of the board and that of management.
• The current disclosure regime produces complex and lengthy documents that often do not enhance consumer understanding of financial products and services, and impose significant costs on industry participants.

• Affordable, quality financial advice can bring significant benefits for consumers. Improving standards of adviser competence and removing the impact of conflicted remuneration can improve the quality of advice. Comprehensive financial advice can be costly, and there is consumer demand for lower-cost scaled advice.
• Technological developments have the potential to reduce insurance pooling. This will reduce premiums for some consumers; however, others will face increased premiums, or be excluded from access to insurance. Underinsurance may occur for a number of reasons, including: personal choice, behavioural biases, affordability, and lack of adequate information or advice on the level of insurance needed.
• The regulatory perimeters could be re-examined in a number of areas to ensure each is targeted appropriately and can capture emerging risks.
• Australia generally has strong, well-regarded regulators, but some areas of possible improvement have been identified to increase independence and accountability.
• During the GFC and beyond, Australia’s regulatory coordination mechanisms have been strong, although there may be room to enhance transparency.
• Regulators’ mandates and powers are generally well defined and clear; however, more could be done to emphasise competition matters. In addition, ASIC has a broad mandate, and the civil and administrative penalties available to it are comparatively low in relation to comparable peers internationally.
• To be able to perform their roles effectively in accordance with their legislative mandate, regulators need to be able to attract and retain suitably skilled and experienced staff.
• The retirement phase of superannuation is underdeveloped and does not meet the risk management needs of many retirees.
• There are regulatory and other policy impediments to developing income products with risk management features that could benefit retirees.
• Technological innovation is a major driver of efficiency in the financial system and can benefit consumers. Government and regulators need to balance these benefits against the risks, as they seek to manage the flexibility of regulatory frameworks and the regulatory perimeter. Government is also well-positioned to facilitate innovation through coordinated action, regulatory flexibility and forward-looking mechanisms.
• Access to growing amounts of customer information and new ways of using it have the potential to improve efficiency and competition, and present opportunities to empower consumers. However, evidence indicates these trends heighten privacy and data security risks.
• The financial system’s shift to an increasingly online environment heightens cyber security risks and the need to improve digital identity solutions. Government has the ability to facilitate industry coordination and innovation in these areas.
• Although elements of Australia’s financial system are internationally integrated, a number of potential impediments have been identified. Financial system developments in the region will require continuing Government engagement to facilitate integration with Asia.
• Government efforts to promote Australia’s policy interests on international standard setting bodies have been successful. Domestic regulatory processes could be improved to better consider international standards and foreign regulation, including processes for collaboration and consultation about international standard implementation, and mutual recognition and equivalence assessment processes.
• Coordination of Australia’s international financial integration could be improved.

A number of important areas are highlighted, but at this stage its too early to read the potential impact. We are pleased to note that macroprudential measures and lending to smaller businesses are highlighted, as well as the impact of technology. Further consultation is to follow. According to the media release, the closing date for second round submissions is 26 August 2014.