Tag: The Conversation

Hayne fails to tackle banks’ structure

From The Conversation.

Every 10 to 15 years it’s the same.

Ever since financial deregulation in the 1980s we’ve had a finance industry scandal followed by an inquiry, a quick fix, and a declaration that it shouldn’t happen again.

In the early 1990s there were royal commissions into the A$1.7 billion Tri-continental/ State Bank Victoria collapse, the A$3.1 billion State Bank of South Australia collapse and the WA Inc collapse which explored the interrelated activities at Rothwells bank, the A$1.8 billion collapse of Bond Corporation and the A$1.2 billion siphoned from Bell Resources.

A decade later in 2003 Justice Owen reported on the A$5.3 billion collapse of Australia’s largest insurer HIH.

And now, bang on schedule, we have Kenneth Hayne delivering the final report of a royal commission into systemic misconduct in banking, superannuation and financial services industry to a government that voted 26 times against holding it.

There are two particularly striking things about the 10-15 year cycle.

One is the rhythm of public inquiries followed by reports, then (sometimes) trials, then books, then almost everyone forgetting (except for those personally scarred) only for problems to resurface later.

The other is that the times between have been punctuated by government-commissioned banking and financial system reviews: the 1991 Campbell Inauiry, the 1996 Wallis Inquiry, the 2010 Cooper superannuation review and the 2012 Murray Review . Each either missed or downplayed the links between poor governance, industry structure, systemic misconduct and prudential risk.

Has Kenneth got the frequency right this time?

Commissioner Kenneth Hayne’s 1000-page final report hasn’t gone far enough to end this cycle.

While his referral of 24 misdeeds for possible criminal and civil prosecution will help in righting past wrongs and perhaps focus the minds of directors and executives, the impact will be generational rather than permanent.

The flurry of prosecutions and actions will again reveal problems with the law – gaps in coverage, inadequate penalties and cases the law won’t allow to stand up.

Taken together the recommendations are a patchwork of measures that if implemented will over time be eaten away – and at some point will be dismantled – because the rationale for their adoption will be forgotten.

Even before they are implemented they will have to run the gauntlet of a massive subterranean lobbying effort from industry to water them down, something Hayne indicated he expected.

The deepest flaw lies unaddressed…

Even though Hayne emphasises the link between systemic misconduct, governance, structure and prudential (system-wide) risk, something that Treasury, the RBA and Australia’s three business regulator amigos, APRA, ASIC and the ACCC, have long rejected, he makes no concrete suggestions to tackle it.

As we have written previously, research tells us big systemically important shareholder-focused universal for-profit banks that cross-sell products are more profitable than smaller banks in the good times but are more prone to misconduct and to failure in the worse times.

Australia’s big four fit the bill – they’re big, they have been vertically integrated one-stop shops, they are very, very profitable and they are very focused on shareholder returns.

While the banks, apart from Westpac, have divested themselves of wealth management and insurance arms for now there is nothing stopping them reacquiring them in the future.

This means we are once again 10 or 15 years away from systemic misconduct resurfacing as big banks seek to become more profitable.

…and putting the onus on directors won’t much help

While heads might roll in yet another round of internal investigations to fix bank culture, it is wise to remember that as Adele Ferguson observed ANZ’s internal investigation of the Opes Prime collapse left the bigger governance lessons “unlearned”.

Directors and senior executives of failed companies continue to live charmed lives.

The directors of Babcock and Brown were cheered as they left the building, while friends and family of the disgraced One.Tel director Jodee Rich have resurfaced at Hayne and other public inquiries.

Some of the One.Tel directors have had long corporate careers. The former chair at of the collapsed Allco Finance Group Bob Mansfield went on to review the ABC.

As Adam Schwab bluntly put it, “corporate Australia is nothing if not forgiving”.

It’ll chase horses rather than close doors

Hayne is persisting with a chasing bolting horses approach to misconduct that relies on detection and enforcement.

We have argued this approach is just not as a effective as other alternatives such as two-tier boards and employee directors which have a better track record of keeping stable doors closed and horses tethered.

Without them we could very easily have another crisis and another royal commission in 15 to 15 years time.

Ireland has taken a been prepared to change corporate structures. After the meltdown of its financial system triggered by the end of a “classic vanilla property boom” its parliament legislated to appoint public interest directors to the boards of its failed banks.

These changes were designed to ensure banks directors put the public interest first, ahead of shareholders interests and even customers interests.

It’s beyond time we did it here.

Authors: Andrew Linden, Sessional Lecturer, PhD (Management) Candidate, School of Management, RMIT University; Warren Staples,

Warren Staples

Senior Lecturer in Management, RMIT University

It’s Time For A Broader Review Of Super

From The Conversation.

There’s a lot in the Productivity Commission’s landmark 722-page table-thumper of a report into Australia’s superannuation system, completed after nearly three years of invesigation. For now, I’ll make three comments.

The Commission gets the industry

First, it’s a very valuable report. The Productivity Commission (PC) has undertaken a deep analysis of the superannuation industry and collected a range of information that was previously unavailable. The research has been conducted with considerable care and diligence, backed by insight. I am confident the PC understands the industry. The report is a great resource that will probably be cited for years to come.

Yet sets itself against the industry…

My second comment relates to the gusto by which the PC has called out shortcomings of the system, and advocated for key changes. While the PC is aiming to be constructive, the report reads as quite critical.

It seems guilty of overstatement for dramatic effect, which I fear may inhibit moving forward. Many report headings read as if they are brickbats. It headlined two of its diagrams: “the character of member harm”. It sets the tone on page five:

The system delivers good outcomes for many members, but not all. The industry’s peak body submitted that “the Australian superannuation system is not broken, and is in fact a world class private pension system”. The evidence suggests otherwise.

In my view, the system is better described as being very good with room for improvement.

The PC has raised the ire of the industry, which will create a barrier to change as the advocacy ramps up.

While most of its recommendations are sensible, the idea of a panel selecting a “best-in-show” shortlist of 10 default funds is controversial.

The recommendation is being attacked on its potential shortcomings, when the debate ought to be around whether it is the best option among a set of imperfect alternatives. The simpler question of whether the PC’s recommendation is better than the current system is not being debated.

We are travelling down an adversarial path unlikely to build consensus around what needs to happen.

…and raises more important questions

Third, the PC has recommended further investigations going beyond its terms of reference. I will finish by focusing on Recommendation 30: an independent public inquiry into the role of compulsory superannuation in the broader retirement incomes system, including the net impact of compulsory super on private and public savings.

Surprising, there is no established position on how effective superannuation has been in working toward Australians supporting themselves in retirement. It is an open question whether the costly tax concessions attached to super provide an overall benefit to Australian society.

The Commission also wants the inquiry to examine who is hurt and who is helped by compulsory superannuation, both over time and at any point in time.

Recommendation 30. Superannuation: Assessing Efficiency and Competitiveness. Productivity Commission, December 2018

The PC is calling for an examination into the amounts being contributed into super, given that it called for the inquiry to be completed ahead of the the next scheduled increase in the compulsory contribution rate from 9.5% of salary to 10% in June 2021.

The PC was limited to examining the efficiency of the system under current policy settings. But the settings themselves are arguably the greatest barrier to the efficiency of the system, and its ability to serve the public. An inquiry into super’s place within the broader retirement income system would be an opportunity to work out how it can serve us best.

Too often the discussion is framed as if superannuation is the only resource supporting members through retirement. The call to lift the compulsory levy from 9.5% to 12% – some have argued for 15% or even 20% – epitomises this myopic perspective.

The reaction to a recent Grattan Institute report (Money in retirement: more than enough, November 2018) addressing various aspects of system design and questioning the need to increase the levy was revealing.

Grattan was lambasted for their stance, unfairly in my opinion. Much of the criticism came from those with a stake in seeing the levy increased, and mostly danced around the fringes of the argument. All this is indicative of an inability to have a thoughtful discussion over important policy issues.

Superannuation interacts with many other aspects of retirement support, including the social security system (specifically the aged pension), the tax system, other assets held by individuals, in particular whether they own a home, and personal circumstances.

Money siphoned off into super to support spending in retirement comes at the cost of lower spending power during the working years.

Placing more in superannuation might be entirely right for some, but might come at a cost for others.

They are good questions

The first interrelation between super and other features of the system needs to be better understood. There are various flags pointing to inconsistencies.

Claims that people are not saving enough for retirement do not gel with many retirees taking money out of super at the minimum rates.

Meanwhile the social safety net is substantial. The (single) aged pension of A$24,824 is 86% of the Association of Superannuation Funds “modest” living standard up to age 85, and 91% of it after age 91. And Australians have access to affordable health care.

Home ownership is a key determinant of capacity to support oneself through retirement, and it is only heightened by it being excluded from the pension means test. There can be a huge gap between retirees who own their home and those who do not.

Many low income earners struggle to establish themselves in life, yet are forced to invest in super, on which they may be taxed at greater rate than their current income tax rate.

The super system is designed around individuals, yet most people operate within households.

The PC is right to call for an inquiry into the entire system design. It would be an opportunity to examine the interaction of super with everything else, whether it is doing what it should, and whether it is treating different types of Australians in the way we would want.

Author: Geoff Warren, Associate Professor, College of Business and Economics, Australian National University

Productivity Commission finds super a bad deal

From The Conversation.

… And yes, it comes out of wages. 

Want more to retire on?

In its long-awaited final report on the efficiency and competitiveness of Australia’s leaky superannuation system, Australia’s Productivity Commission provides a roadmap.

Weeding out scores of persistently underperforming funds, clamping down on unwanted multiple accounts and insurance policies, and letting workers choose funds from a simple list of top performers would give the typical worker entering the workforce today an extra A$533,000 in retirement.

Even Australians at present in their mid fifties would gain an extra A$79,000.

If this government or the next cares about the welfare of Australians rather than looking after the superannuation industry it’ll use the recommendations to drive retirement incomes higher.

So why the continued talk (from Labor) about lifting compulsory super contributions from the present 9.5% of salary to 12%, and then perhaps an unprecedented 15%?

It’s probably because (and Paul Keating, the former treasurer and prime minister who is the father of Australia’s compulsory superannuation system says this) they think the contributions don’t come from workers, but from employers.

To date, they’ve been dead wrong. And with workers’ bargaining power arguably weaker than in the past, there’s no reason whatsoever to think they’ll be right from here on.

Past super increases have come out of wages

Australia’s superannuation system requires employers to make the compulsory contributions on behalf of their workers. Right now that contribution is set at 9.5% of wages and is scheduled to increase incrementally to 12% by July 2025.

So, for workers, what’s not to like?

It’s that while employers hand over the cheque, workers pay for almost all of it via lower wages. Bill Shorten, then assistant treasurer, made this point in a speech in 2010:

Because it’s wages, not profits, that will fund super increases in the next few years. Wages are the seedbed of the whole operation. An increase in super is not, absolutely not, a tax on business. Essentially, both employers and employees would consider the Superannuation Guarantee increases to be a different way of receiving a wage increase.

The Henry Tax Review and other investigations have found this is exactly what happens. Increases in the compulsory super contributions have led to wages being lower than they otherwise would have been.

Even Paul Keating, speaking in 2007, made this point. Compulsory super contributions come out of wages, not from the pockets of employers:

The cost of superannuation was never borne by employers. It was absorbed into the overall wage cost […] In other words, had employers not paid nine percentage points of wages, as superannuation contributions, they would have paid it in cash as wages.

This is more than mere theory. Compulsory super was designed to forestall wage rises. Concerned about a wages breakout in 1985, then Treasurer Paul Keating and ACTU President Bill Kelty struck a deal to defer wage rises in exchange for super contributions.

When the Super Guarantee climbed from 9% to 9.25% in 2013, the Fair Work Commission stated in its minimum wage decision of that year that the increase was “lower than it otherwise would have been in the absence of the super guarantee increase”.

The pay of 40% of Australian workers is based on an award or the National Minimum Wage and is therefore affected by the Commission’s decisions. For these people, there is no question: their wages are lower than they would’ve been if super hadn’t increased.

Where’s the evidence employers pay for super?

If wage rises came from the pockets of employers then we should see a spike in wages plus super when compulsory super was introduced, and again when it was increased. But there wasn’t one when compulsory super was introduced – a point Bill Shorten has made in the past.

When compulsory super was introduced via awards in 1986, workers’ total remuneration (excluding super) made up 63.3% of national income. By 2002, when the phase-in was complete, it made up 60.1%.

Out of the 26 countries for which the Organisation for Economic Co-operation and Development has data, Australia recorded the tenth largest slide in the labour share of national income during the period compulsory super contributions were ramped up.

Of course, changes in super aren’t the only thing that affects workers’ share of national income.

But the size of the fall in the labour share in Australia over the period when the super guarantee was increasing isn’t consistent with the idea that employers picked up the tab for super.

Would it be different this time?

Paul Keating argues that while in the past lifting compulsory super to 9.5% was paid for from wages, a future increase to 12% today would not be:

Workers are not getting real wage increases anywhere, and can’t get them. The Reserve Bank governor makes the point every week. So the award of an extra 2.5% of super to employees via the super guarantee will give them a share of productivity they will not get in the market – without any loss to their cash wages.

But such claims are difficult to square with concerns that workers’ weak bargaining power is one of the reasons current wage growth is so weak.. If employers don’t feel pressed to give wage rises, why would they feel pressed to absorb an increase in the compulsory Super Guarantee?

And while real wages (wages adjusted for inflation) haven’t grown particularly quickly, the dollar value of wages continues to grow: by 2.2% a year over the past five years. It would be easy for employers to simply reduce those increases to offset any increase in compulsory super – as they have in the past.

And no, more contributions won’t help workers

The Grattan Institute’s recent report, Money in Retirement, showed increasing the compulsory super would primarily benefit the top 20% of Australians. It would hurt the bottom half during working life a lot more than it helps them once retired.

Their higher super contributions would not improve their retirement outcomes: their extra super income would be largely offset by lower part-pensions. What’s more, the age pension is indexed to wages. If wages grew by less (as they would as compulsory super contributions were increased) pensions would grow by less too.

Lifting compulsory super would also cost the budget A$2 billion a year in extra tax breaks, largely for high-income earners, because it is lightly taxed.

That would mean higher taxes elsewhere, or fewer services.

For low-income Australians, increasing compulsory super contributions would be a thoroughly bad deal. It means giving up wage increases in return for no boost in their retirement incomes.

A government that wanted to boost the living standards of working Australians both now and in retirement would consider carefully all of the Productivity Commission’s suggestions including this one: an independent inquiry into the whole idea and effectiveness of Australia’s regime of compulsory contributions, to be completed ahead of any increase in the Superannuation Guarantee rate .

Author: Brendan Coates, Fellow, Grattan Institute

Opal Tower Lessons

The Conversation discusses the lessons from the Opal Tower, and it goes way beyond building certification.

The reasons for the cracked concrete that triggered the evacuation – twice – of residents from Sydney’s Opal Tower over Christmas and the New Year are unknown and will take time to properly establish. Many commentators are jumping to the conclusion (yes that includes you, Senator Carr) that the problem is the result of the privatisation of building certification. Instead of being done by government or council inspectors, certification is now done by private contractors engaged by the developer.

It might well be a contributing factor, but what went wrong at Opal Tower is is much more complex than that. Making certification a government responsibility again won’t solve it.

Opal is unusual. Very few residential buildings in Australia have ever been evacuated due to construction defects, and fewer still because of structural cracking. The vast majority of construction defects in multi-unit residential buildings are waterproofing failures. Rather than creating short-term alarm, they create long-term misery. Because misery does not generate headlines, the problem of quality in multi-unit housing continues to be ignored by governments.

Most strata buildings are defective

Strata title allows each resident to own the space in which they live as well as a share of the common property including pipes and walls. It’s the way apartments are usually sold after they are developed.

We don’t have definitive, current data on the extent of defects in strata title buildings. Researchers from UNSW’s City Futures Research Centre have begun collecting the information for Sydney. But there are clear indications that defects are significant and widespread.

A 2012 study by City Futures surveyed 1,020 strata owners across NSW, and found 72% of all respondents (85% in buildings built since 2000) knew of at least one significant defect in their complex.

In 2017 a City of Sydney survey identified defects and maintenance as the top concern of owner occupiers of apartments, along with short-term letting through organisations such as Airbnb.

Unfortunately for those keen to leap to conclusions about certification, studies showed the same thing back in the early 1990s when certification was largely in the hands of local governments. In fact, studies have found the same thing ever since speculative housing became common in Australia, from the end of World War One.

In fact, ever since speculative housing development and investment has become common (after World War I in Australia), residential construction defects have been a concern both here and overseas.

The market for residential buildings is extremely competitive, and controlling the cost of construction is one of the key factors in making a profit. Sometimes, the urge to maximise profit dominates to the extent that both short and long-term construction failures are inevitable.

It’s the consequence of cost control

There are, of course, reputable developers and builders, but reputation usually finishes last, undercut by less-reputable players who produce buildings that are slightly cheaper.

Defects in single-storey speculative houses with pitched roofs are probably just as common as defects in multi-unit dwellings with flat roofs, but they are much easier to fix because the houses are close to the ground and no strata committee is involved.

They are also much easier to find; a competent building inspection initiated by a purchaser is normally enough to protect the buyer. On the other hand, a building inspection of a single unit in a multi-unit development is highly unlikely to find defects which are located elsewhere in the common property of a building.

There are 653 apartments in the Meriton-developed Regis Towers, for example, which was the subject of a long-running legal action for defects.

Intervening at certification is too late

The only practical way to make multi-unit dwellings a good investment for the residents and a decent place to live is for government to take a pro-active role in driving quality throughout the design and construction process, not just at the end when the building is certified for occupation, or at the beginning when it gets a development approval.

It is a simple reality that no other actor in the construction process has the capacity to take this role. It is also simpler and cheaper to build in quality than to rectify defects.

Often, a $1 detail realised for fifty cents will cause endless grief and cost thousands of dollars to fix.

Reducing the amount of rectification required will improve sustainability outcomes by containing the amount of embodied carbon incorporated in the building.

If the building performs well, it will have a longer life and that will reduce the need to eventually replace it with a new building; again saving materials and improving the outcome for embodied carbon. It is worth remembering that 20 million tonnes of construction and demolition waste are produced in Australia each year.

Governments have been reluctant to intervene early

Governments have as good as ignored the problem of defects in multi-unit residential construction even though they have been aware of it for years.

This is particularly concerning because the state governments in NSW and Victoria have been busy spruiking this type of accommodation as the solution to the pressures of rising populations in Sydney and Melbourne. Given this, the protections for apartment owners under existing legislation are ludicrously slight.

Unfortunately, compliance with the National Construction Code (NCC) in its current form is no guarantee. There are so many ambiguities and grey areas in the NCC and in the way that it is applied that it is a guarantee of almost nothing, particularly when it comes to waterproofing.

A simple example is the construction of balconies with flat slabs, which is perfectly acceptable under the NCC. The floor slab is constructed as a single plane from the interior to the exterior of the building with the waterproof barrier at the balcony being provided by a masonry wall or a concrete ridge on top of the slab.

This design almost always leaks within a few years. The reliable solution is to cast the slab with a step, but this is more expensive and as a consequence is rare. Cut-price membranes under tiled terraces are also common, causing leaks, mould and misery, despite arguably complying with the provisions of the NCC.

Fortunately, there is plenty that government could do to improve quality of multi-unit construction without affecting prices much.

Five stars. Information could drive standards

One clear way forward is to make the construction quality of a building more transparent to buyers.

This could be achieved by introducing a similar sort of quality assurance scheme to the one government runs to improve safety in cars; a five-star rating.

People are free to buy a two-star car, but for obvious reasons, not many do, even if they are cheap. Similarly, it is unlikely that many people would buy a two-star unit.

It would be perfectly possible to star rate multi-unit housing for construction quality using an independent assessment body against a transparent set of criteria.

It’s been tried before

Such a quality assurance scheme was introduced by the now defunct Building and Construction Council (BACC) in NSW during the 1990s, but unfortunately foundered due to a lack of funding and will from Bob Carr’s government. This was a pity, as the scheme was designed to drive quality through the whole of the building process, from design to completion.

It still provides a perfectly valid model for a policy that would actually do something to improve multi-unit construction quality at a cost which is minimal in relation to the value of the benefits produced. If a building is built correctly in the first place, then owners will not need to rely on shonky fly-by-night builders and developers for rectification works nor need to claim against complex insurance policies.

If the NSW and Victorian governments are serious about having a greater proportion of people live in multi-unit developments, they have a responsibility to do something about their quality before we are left with a overhang of misery, leaks and failures. Just ask the residents and owners of Opal Tower.

Author Geoff Hanmer: Adjunct Lecturer in Architecture, Univeristy of NSW, UNSW

MYEFO: More mirage than good management

From The Conversation.

The Morrison government wants next year’s election to be about economic management.

So understandably, it’s using the improved bottom line in the Mid Year Economic and Fiscal Outlook (MYEFO) to talk up its economic credentials.

But the numbers in MYEFO show it has failed to hit many of its own targets.

Target 1: Surpluses on average over the cycle

The government’s overarching fiscal objective is to deliver budget surpluses: not just in one year but on average over the economic cycle.

MYEFO indicates the government is expecting a $5.2 billion deficit in 2018-19 (0.3% of GDP).

It will be the 11th consecutive deficit for the Commonwealth budget.

Deficits have averaged $33.2 billion (2.1% of GDP) over those 11 years.

Yes, a $4.1 billion surplus is forecast for next year, with surpluses projected to reach $19 billion (0.9% of GDP) by 2021-22.

But so big have the recent deficits been, that even if everything goes well and the fiscal position continues to improve, the budget would need to be in surplus for decades to produce a surplus on average over each year, far longer than what most economists consider a typical economic cycle.

A related fiscal target is that budget surpluses will build to at least 1% of GDP as soon as possible.

Despite revenue windfalls from income and company taxes (discussed below), the government is still forecasting it won’t reach that 1% of GDP surplus target until 2025-26.

Policy decisions in this year’s budget and MYEFO – including income and company tax cuts, additional funding for independent and Catholic schools, and changes to the GST formula to placate Western Australia – have weakened the bottom line in 2021-22 by $10.5 billion.

Hardly the actions of a government in a hurry to deliver a sizeable surplus.

Verdict: Fail.

Target 2: Reduce the payments-to-GDP ratio

The government’s policy is also to maintain strong fiscal discipline by controlling expenditure, with a falling payments-to-GDP ratio its measure of success.

Whether it has met the target depends on the starting year. Governments payments are forecast to reach 24.9% of GDP in 2018-19, up from 23.9% in 2012-13 before the Coalition took office.

The government prefers the starting point of its first year in office 2013-14 where payments were 25.5% of GDP.

Either way, payments in 2018-19 remain above the 30-year historical average of 24.7% of GDP.

While the government projects that spending will fall slightly further to 24.6% of GDP by 2021-22, this relies on spending growth across the government’s major programs falling substantially compared to the previous four years – without major policy changes to help facilitate the fall.

Verdict: Debateable pass.

Target 3: Tax-to-GDP ratio below 23.9% of GDP

In last year’s budget, the government introduced a new target of capping tax collections at 23.9% of GDP.

Why 23.9%? That was the average level of tax during the final two terms of the Howard/Costello government.

While the Coalition is understandably keen to follow the lead of one of its most electorally successful governments, that was also a period where tax collections were historically high.

Tax collections are projected to reach 23.8% of GDP in 2022, on the back of stronger than forecast personal income tax and company tax receipts.

Verdict: Pass.

MYEFO Chart.

Target 4: New spending measures more than offset by reductions in spending elsewhere

Since becoming prime minister, Scott Morrison has sent mixed signals about whether his government will adhere to the longstanding budget rule that all new spending proposals be matched with budget savings.

At the MYEFO press conference, Finance Minister Matthias Cormann said it was a “matter of balancing competition priorities”.

Here’s the straight answer – the net effect of policy changes announced in MYEFO are an additional $12.2 billion in spending over four years.

In other words, the government has not offset new spending with cuts to other spending programs. The Turnbull government similarly failed to offset its new spending in 2017-18 (although it succeeded in prior years).

There have been some reductions in spending because of improvements in the economy. The government claims these reductions offset its recent spending announcements. But genuine offsets come from policy changes, not economic good luck.

Verdict: Fail.

Target 5: Shifts due to changes in the economy banked as an improvement in budget bottom line

This objective is key to the government’s fiscal conservative credentials.

If it has some economic good luck, it commits to use the proceeds for budget repair rather than new spending or tax cuts.

This rule has been irrelevant for most of the past decade, because almost every budget had revenue collections falling short of forecast.

But the Morrison government is in the middle of a mini revenue boom – revenue collections were higher than forecast in both the 2018-19 budget and MYEFO.

Company tax collections are higher largely due to strong commodity prices. Income tax collections are up and government spending is down because of improvements in the economy.

So has the government used this chance to show off its fiscal prudence?

Not exactly. It will spend around $11.8 billion of this windfall, give away another $19.3 billion in tax cuts and bank just over half of it ($35.2 billion) to the bottom line.

And in the shadow of an election, we can almost certainly expect further spending. The $9 billion in decisions taken but not announced – potentially a pre-election warchest – suggests that more tax cuts could also be on the way.

Verdict: Fail.

Our final verdict

The challenge in assessing budget management is separating good luck from good management. Governments will always seek to take credit for economic upswings that boost the bottom line.

Fiscal targets are there to keep them on the straight and narrow.

An objective assessment of the government’s performance against its own key targets suggests its good news budget is more mirage than magnificent management.

Authors: Danielle Wood, Program Director, Budget Policy and Institutional Reform, Grattan Institute; Kate Griffiths Senior Associate, Grattan Institute

Monday’s MYEFO will look good, but…

From The Conversation

An appallingly perfect storm is brewing for the federal budget:

  • a government with much more income than expected
  • a federal election due within months
  • a government well behind in the polls

With the election all but announced for May, next Monday’s Mid Year Economic and Fiscal Outlook (MYEFO) will be the effective start of the campaign.

The latest figures put the government’s budget position about A$10 billion better than was expected when it was delivered last May.

The budget has been gifted much higher revenues from corporate income taxes, almost entirely driven by mining companies selling more than they expected (at higher prices than they expected) to China.

A stronger than expected domestic economy has also helped, producing small upside surprises in various other taxes and cutting the need for government spending.

In the past six months the stars have aligned to hand the government a virtual war chest with which to fight the election.

A full MYEFO, then an election budget

Prime Minister Scott Morrison has laid out the timetable.

MYEFO is due on Monday December 17 and an early Budget will be handed down on Tuesday April 2, days before the government is expected to call the May election.

In announcing it, he promised to deliver a budget surplus in 2019/20.

This tells us two things, firstly, that he has zero interest in bringing that surplus forecast forward to the current financial year, 2018-19; and second, that that surplus is unlikely to be materially different from what Morrison previously forecast (as treasurer) in May.

That will give him room to make some very expensive announcements.

With as much as (or more than) an extra A$10 billion per year to play with, Morrison’s ministers will be rubbing their hands together working out how to get the most electoral bang for the bucks.

Endangering the budget long term

This does not bode well for government finances beyond the next few years.

Highly targeted spending measures aimed at improving election prospects are rarely the best use of public funds.

New spending commitments in the just past few months are set to cost the budget just under A$500 million this year, rising to almost A$1.5 billion next year.

Spending all or most of the extra money that’s pouring into the Treasury coffers risks creating a budget black hole if the sources of that revenue prove to be temporary.

A slowdown in Australia or a drop in China’s demand for raw materials could take a big chunk out of the budget.

The damage to the government’s finances after the global financial crisis was only partly the result of spending aimed at averting a recession.

We now know a big part of the surge in revenues in the years before the crisis were temporary.

The increased spending and repeated lower taxes they funded were permanent, creating a structural budget deficit that has taken a decade to repair.

As mentioned, the latest upside surprises on revenue are largely due to strong commodity prices and a rising tax take from mining companies.

They might vanish as quickly as they appeared.

Commodity prices are notoriously volatile and almost entirely dependent on what is happening in China.

Problem: China

Perversely, China is buying more of our commodities because it has upped spending on infrastructure to boost a slowing economy under threat of trade war.

The boost in infrastructure spending won’t last.

Eventually we will see a shift in the drivers of Chinese growth towards domestic consumption and business investment and away from metal-intensive infrastructure spending.

It will curtail the growth of our exports and weaken our corporate income tax take.

Dark clouds are forming at home as well.

Problem: Australia

Bank profitability has stopped growing, and the indications from the Hayne Royal Commission are that bank profits will be challenged over the next few years as remediation costs rise and lending slows.

And then there is housing.

While not a direct source of revenue for the federal government, the fall in house prices could start to bite into economic activity as early as next year.

While consumers have so far looked past the lower house values, that is likely to change in 2019 if prices continue to fall.

It’d be wise to hang on to the extra billions

The best economic approach would be for this government to save money and leave it for the next government to use them prudently as needed.

It’s certainly not going to happen.

Centre right governments tend to characterise unexpected bumps in revenue as belonging to the citizenry and to be given back.

They usually do it in the form of income tax cuts. We should prepare for substantial fresh income tax cuts, from as soon as July 1, 2019.

Control of the Treasury is one of the most important weapons available to a political party contesting an election.

Having a prime minister who spent several years as treasurer only enhances the weapon.

The government’s timeline for MYEFO and the April budget suggests they fully intend to use it.

Author: Warren Hogan , Industry Professor, University of Technology Sydney


How low will Bitcoin now go?

From The Conversation.

Nearly 170 years before the invention of Bitcoin, the journalist Charles Mackay noted the way whole communities could “fix their minds upon one object and go mad in its pursuit”. Millions of people, he wrote, “become simultaneously impressed with one delusion, and run after it, till their attention is caught by some new folly more captivating than the first”.

His book Extraordinary Popular Delusions and the Madness of Crowds, published in 1841, identifies a series of speculative bubbles – where people bought and sold objects for increasingly steep prices until suddenly they didn’t. The best-known example he cites is the tulip mania that gripped the Netherlands in the early 17th century. Tulip bulbs soared in value to sell for up to 25,000 florins each (close to A$45,000 in today’s money) before their price collapsed.

The Bitcoin bubble surpasses this and all other cases identified by Mackay. It is perhaps the most extreme bubble since the late 19th century. In four years its price surged almost 2,800%, reaching a peak of US$19,783 in December 2017. It has since fallen by 80%. A month ago it was trading at more than US$6,000; it is now down to US$3,500.

That’s still a fantastic gain for anyone who bought Bitcoin before May 2017, when it was worth less than US$2,000, or before May 2016, when it was worth less than $500.

But will it simply keep dropping? What makes Bitcoin worth anything?

To begin to answer this question, we need to understand what creates the values that drive speculative price bubbles, and then what causes prices to plunge.

The above chart shows the magnitude of the Bitcoin bubble compared with the price movement of Japanese property and dot-com bubble from four years prior to their peak until four years after.

When asset values diverge

We typically think about bubbles in financial assets such as stocks or bonds, but they can also occur with physical assets (such as property) or commodities (like tulip bulbs).

A bubble begins when the price people are willing to pay for something deviates significantly from its “intrinsic value”.

The intrinsic value of an asset is theoretical, based its “fundamental” value. Fundamental value includes: the ability to generate cash flow (e.g. interest or rental income); scarcity or rarity value (e.g. gold or diamonds); and potential use (e.g. silver and platinum are used in both jewellery and industrial operations).

A house may have fundamental value owing to the scarcity of land, its use as a home, or its ability to generate rental income. A tulip (or Bitcoin) has none of those things; even the presumed scarcity does not exist when you consider all of the alternative flowers (or cryptocurrencies) available.

Flemish painter Jan Brueghel the Younger portrayed tulip speculators as monkey in his ‘Satire on Tulip Mania’ dated to circa 1840. Jan Brueghel the Younger / Wikimedia Commons, CC BY

Price bubble preconditions

A bubble tends to occur after a sustained period of economic growth, when investors’ get used to the price an asset always increasing and credit is easily accessible.

To these conditions something more must be added for a bubble to form. That is typically a major disruption or innovation, such as the development of a new technology. Think of railways in the 19th century, electricity in the early 20th century, and the internet at the end of the 20th century.

Initially most investors tend to be cautious and “rational” about a new technology. For instance, early investment in railways took advantage of limited competition and focusing on profitable routes only. It was gradual and commercially successful.

This creates higher growth and profitability, leading to positive feedbacks (from greater investment, higher dividend payouts, and increased consumer spending), which raises confidence further.

If conditions allow, this develops into a period the economic historian Charles Kindleberger described as “euphoric”: investors become fixated on the ability to make a profit by selling the asset to a “greater fool” at an even higher price.

South Cryptocurrency values are displayed in the Seoul shopfront of Bithumb, South Korea’s leading cryptocurrency exchange, in January 2018. Jeon Heon-Kyun/EPA

That is, they are attracted not by “fundamental” motives – the benefits from potential cash-flows such as dividend or rental income – but by “speculative” motives – the pursuit of short-term capital gains.

Higher prices attract a greater number of speculators, pushing prices higher still. Uncertainty around the significance of the new technology allows extreme valuations to be rationalised, although the justifications seem weaker as prices rise further.

The virtuous cycle of ever-rising prices continues, often fuelled by credit, until there is an event that leads to a pause in price rises. Kindleberger suggests this can be a change in government policy or an unexplained failure of a firm.

When asset prices stop rising, investors who have borrowed to finance their purchases realise the cost of interest payments on their debt will not be offset by the capital gain to be made by holding onto the asset. So they cut their losses and start to sell the asset. Once the price starts falling, more investors decide to sell.

Bitcoin’s bubble

The possible triggers for a pause in Bitcoin price rises included concerns about increased government regulation of crypto-assets and the possibile introduction of central bank digital currencies, as well as the large theft of assets and collapse of exchanges that have dogged Bitcoin’s short history.

Going down

In liquid markets such as stocks (where it is inexpensive to buy and sell assets in large values) the price decline can be steep. In illiquid markets, where assets cannot easily be sold for cash, the fall can be brutal. Examples include the mortgage-backed securities (MBS) and collateralised debt obligations (CDOs) that led to the Global Financial Crisis.

Bitcoin is particularly illiquid. This is due to a large number of different Bitcoin exchanges competing; often substantial transaction costs, and constraints on the capacity of the Blockchain to record transactions.

A Bitcoin ‘mine’ in China. Miners are rewarded with new currency for solving the complex math problems required to validate and record Bitcoin transactions. It requires a massive amount of computer-processing power. Liu Xingzhe/Chinafile/EPA

The aftermath

The aftermath of a bursting bubble can be brutal. The stock market crash of 1929 was a prelude to the Great Depression of the 1930s. The collapse in Japanese asset values after 1989 heralded a decade of low growth and deflation. The dot-com crash of 2000-01 destroyed US$8 trillion of wealth.

The effect of a crash depends the size, ownership and importance of the asset involved. The effect of the tulip crash was limited because tulip speculations involved a relatively small number of people. But sharp declines in property values during 2007 led to the worst financial crisis since the Great Depression.

Bitcoin is more like tulips. The entire market valuation was about US$300 billion at the peak. To put this into context, the US stock and housing markets are currently valued more than US$30 trillion each (the equivalent Australian markets are valued at A$2 trillion and A$6.9 trillion respectively). Relatively few investors own the majority – it is estimated that 97% of all Bitcoin are owned by just 4% of users. This suggests the effects on the wider economy of the Bitcoin crash should be contained.

Estimating Bitcoin’s intrinsic value

Obtaining a realistic estimate of Bitcoin’s intrinsic value is tricky because it is not an asset that generates a periodic cash flow, such as interest or rental income.

This does not provide a positive story for Bitcoin. Though the total number of Bitcoins is limited, there are many competing, virtually indistinguishable cryptocurrencies (such as Ehtereum and Ripple).

Bitcoin also fails to meet the criteria of a currency. Its the price movements are too volatile to be a unit of account. The transaction capacity of the Blockchain is too limited for it to be a medium of exchange. Nor does it appear to be a good store of value.

For such an asset, value ultimately depends on what others are willing to pay for it. This often relates to scarcity.

Since it produces no income, has limited scarcity value, and few people are willing to use Bitcoin as currency, it is even possible that Bitcoin has no intrinsic value.

Author: Lee Smale,  Associate Professor, Finance, University of Western Australia


We’ll wait an eternity for the banks to fix themselves

From The Conversation.

Asked at the banking royal commission how long it might take to embed the right culture in the National Australia Bank, its chairman Ken Henry replied: ten years.

As head of the Commonwealth Treasury before he left to join the NAB board in 2011, Dr Henry was regarded as a good, if cautious, forecaster. So ten years might be about the right answer.

He said there were “cultural inhibitors” at the bank, and he is right.

Deeply embedded within the workings of many financial institutions is a corrupt ethos of client exploitation.

These words might seem harsh, a kneejerk reaction to outrageous and possibly transient circumstances.

But they are neither my words, nor new ones.

Commissions corrupt, inevitably

Way back in 1826, when life insurance was in its infancy, it was already apparent that many policies were being mis-sold.

Charles Babbage, better known as the inventor of the first programmable computer, but also actuary of the Protector Life Assurance Society of London, identified the fundamental problem with commission-based selling of financial products, which he likened to “the acceptance of a bribe”.

It is a system, said Babbage, that will inevitably “corrupt and debase those through whom it is carried on”.

What Babbage described is what economists have subsequently called the “agency problem”, and it is endemic to commission-based remuneration where the agent is supposed to be working in the best interest of the client, but will gain greatest personal benefit by selling the product that offers the largest commission.

It is present whether the product is insurance, or financial advice, or a mortgage.

Bankers’ codes of ethics don’t work

The Royal Commission has shown that insurance companies, banks, brokers and advisers are prepared to trample on the trust placed in them by millions of Australians by putting their own income and interests ahead of their clients’.

The way professions have typically addressed the agency problem is by constructing a set of moral codes and formal regulations to prevent (or at least limit) bad behaviour.

Medics have their Hippocratic Oath; lawyers have their Code of Ethical Conduct, and in large measure they seem to work.

Insurers, bankers, brokers and financial planners have less formal codes of conduct, but it is now clear that they don’t work – they are little more than smokescreens to conceal self-interested avarice.

As Babbage noted almost two centuries ago, wherever financial products are sold on commission, the payment received by the agent or broker has all the characteristics of a bribe.

What will work is removing temptation

These habits of rapacity are so deeply ingrained in the culture and operation of financial institutions that no amount of self regulation, no elaboration or reinforcement of voluntary codes of conduct, has been able to spare the sector from the corruption and debasement that Babbage foresaw.

More self regulation won’t help.

Here’s what would.

First, ban commissions of all types

The government should impose an outright ban on the payment of any commission of any kind with respect to any consumer financial transaction.

The cost of the work should be transparently priced, and should be paid for at the point of delivery.

It would, at a stroke, end high-pressure selling and would reward financial advisers and brokers for the service they actually deliver to clients.

Those who deliver good advice would prosper. The rest would go out of business.

The idea lies at the heart of the banning of commissions in Labor’s Future of Financial Advice Act, which unfortunately did not extend its ban on commissions to those for insurance.

Then report fees as dollar amounts

Second, where clients buy a financial product that charges an annual management fee, such as a superannuation account, the fee should be reported to the client in dollar terms rather than the percentage of funds under management.

Each year the client should be given the option of a “free transfer” of their funds to an alternative provider that can offer the same product for a lower fee.

It would open up the opaque structure of management fees to critical review by clients, and would impose competitive pressure to drive down fees, which in Australia’s bloated superannuation sector are more than double the OECD average.

Such reforms would be greeted with howls of protest from super funds (and banks, where banks still control them) but as Babbage foresaw and the Royal Commission has demonstrated, the industry has become so beholden to its own self-interest that it has forfeited the right to control its future.

Author: Paul Johnson Warden, Forrest Research Foundation, University of Western Australia

Why The Big Four Banks Soon Mightn’t Exist

It will be worth watching the final round of hearings at the banking royal commission, which begins today. The chief executives of each of the big four will be recalled for reexaminations, via The Conversation.

 

It might be the final time they appear in the same room. It might even be the last time there’s even such a thing as the big four.

Not only are the so-called four pillars under attack from the Commissioner Kenneth Hayne, but there are also enormous economic and technological pressures that are already beginning to undermine their special status.

Together, these pressures have the potential to radically change the banking landscape over the coming decades and bring an end to the Four Pillars policy under which Westpac, the Commonwealth, the ANZ and the National Australia Bank have been effectively protected from takeover and prevented from merging.

Although never a formal law, the understanding that none of the big four can merge has been an accepted rule in Australian business since the late 1980s, when the then treasurer Paul Keating made it clear he would block takeovers.

Eggs in one basket

Since then the big four banks have changed in two important, but related, ways.

Over the past few years they have retreated from their overseas banking ventures, largely divesting themselves of their sometimes ill-judged foreign acquisitions.

And they have recently sold off most of their local wealth management (insurance and investment) subsidiaries.

These divestments mean we are left with four enormous retail-oriented banks that dominate both the banking system (with almost 80% of banking assets) and the stock market (four of the top six companies on the S&P/ASX 200).

Their profitability is heavily dependent on lending for housing, which in turn is heavily dependent on the housing market.

That market is already beginning to contract, meaning the big four are going to find it increasingly hard to maintain their stellar profits.

No longer unique

What’s more, the near monopoly they have had on processing payments is under threat.

In Britain around 1,000 bank branches are closing per year in the wake of a technologicial revolution that makes it possible to process payments away from branches and away from banks. The rate of these closures is climbing.

Mobile banking means that many basic transactions that used to require a visit to a branch can be done online. Australia’s New Payments Platform means that payments to people such as tradies can be made anywhere, any time, in real time and at minimal cost. Use of the platform isn’t limited to the big four.

The Reserve Bank reports that after only eight months of operation the number of payments on the platform already exceeds the number of cheques.

Too many branches

Compared with other countries, we have a lot of bank branches.

Australian banks operate more than 5,000 branches, most of them owned by the big four, as well as 30,000 automatic teller machines, and more than 900,000 EFTPOS terminals at supermarkets and Post Offices.

In the United States, just one bank, the Bank of America, has 67 million customers.

Here more than 140 banks (technically, authorised deposit-taking institutions compete to serve a population of just 25 million.

Inevitably at least one of the big four will come under pressure to fold, be taken over, or merge with one of the others.

Vanishing support

The four pillars policy is “aimed at ensuring that whatever other consolidations occur in retail banking, the four major banks will remain separate”.

In 1997, the Wallis Financial Systems Inquiry recommended it be scrapped.

On the other hand, the 2014 Murray Inquiry into financial services recommended that the policy be retained.

But the Murray inquiry, probably due to its narrow terms of reference, found little of the egregious misconduct that has been uncovered by the royal commission. This calls into question the inquiry’s conclusion that there is adequate competition in the banking system.

Indeed, this conclusion was rejected in a recent Productivity Commission report, which stated bluntly that “the Four Pillars policy is a redundant convention”.

An end in sight

The end of the four pillars policy needn’t mean the end of competition. Smaller, cheaper competitors will be doing more of what the big four did.

A shakeout of bank branches is long overdue, however painful that may be in many small towns, where despite the serious problems raised at the royal commission, a bank branch is still an important part of the community.

Undoubtedly, such a major disruption, unless managed carefully, will be harrowing for many customers and staff.

But for the long-term stability of the economy, it is incumbent on governments to address the inevitability of a smaller, more technologically driven banking system – one that hopefully, after the royal commission, will operate ethically for the benefit of customers.

Author: Pat McConnell, Visiting Fellow, Macquarie University Applied Finance Centre, Macquarie University

A tip for bankers ahead of the royal commission

An interesting piece in the The Conversation.  suggesting that regulation of banking will not deliver the outcomes we need:

The financial services royal commission resumes for its final round of hearings on Monday, and reappearing before Justice Hayne will be the chief executives each of the big six institutions he has in his sights: the Commonwealth Bank, Westpac, AMP, Macquarie, ANZ, and the National Australia Bank.

At issue are shocking abuses of trust, and when the government responds after receiving the report in February it will be under pressure to introduce tighter rules that more closely regulate bankers’ behaviour.

There’s another, better, path it could follow. It could loosen the rules and treat bankers more like doctors.

Crude attempts to regulate behaviour fail

We trust doctors, not because their behaviour is tightly regulated but because it is self-regulated. As professionals they strive to be trustworthy, in the same way as citizens who don’t cheat on their social security claims, or restaurant customers who don’t eat without paying.

A regulation imposed on top of a relationship of trust can ruin it.

In a famous study titled A Fine Is A Price, economists Uri Gneezy and Aldo Rustichini examined what happened when an Israeli daycare centre attempted to impose fines on parents who picked up their children late.

 

Surprisingly, the trial of the fine resulted in more, rather than fewer, late pickups.

In the eyes of the late parents, the fine changed late pickups from bad behaviour into an acceptable outcome of cost-benefit analysis. They simply interpreted the fine as a babysitting cost, and weighed it against the benefit of arriving when it suited them. Moral motivations were crowded out.

Doctors take vows

Professionals with ethics take vows to honour their duty to their clients, even where the costs of doing so are greater than the benefits of not doing so.

Service providers who don’t take ethics seriously weigh the costs and benefits of acting in the interests of their clients versus acting in their own interests. This ‘moral optimization’ may take account of ethics, but only if it pays.

Many financial services workers don’t take ethics seriously partly because they have been trained in economics or finance – disciplines which teach that cost-benefit analysis applies to everything.

A start would be to train them better. Their teachers could listen to the words of the creator of much of the theory used to justify performance pay, Michael Jensen of Harvard:

We teach our students the importance of conducting a cost-benefit analysis in everything they do. In most cases, this is useful – but not when it comes to behaving with integrity.

When integrity is at stake it is better to replace moral optimization with moral prioritization, by giving priority to moral principles like telling the truth or looking after vulnerable clients.

Money changes things

Recent research on the psychological power of money suggests that financial market participants are at risk of negative ethical tendencies when money is used as an incentive, or even when they are just reminded of its importance, so-called money priming.

Money is used as an incentive to in order overcome the so-called principal-agent problem in which agents, (workers or chief executives) are tempted to put they own interests ahead of those of the firm they work for.

It can work, but if high-powered financial incentives communicate that the recipient’s only goal should be to maximise profit, then a culture of material self-interest takes hold, constrained at best by the letter of the law. And this crowds out other interests, such as those of their customers.

This means high-powered financial incentives can solve one kind of untrustworthiness, but only by creating another.

Professionals such as doctors and teachers solve the principal agent problem in another way: through ethics.

Banking could be a profession

Rather than further regulation, we propose a greater focus on ethics through a program of professionalisation, including:

  1. Establishing an interim professional body run by outsiders who come with a proven ethic of serving the public in fields such as education or health. After five years the finance industry can apply to the government to staff and run the body itself, subject to performance.
  2. A winding back of regulation in order to signal that “you are professionals who have to take responsibility for ethical judgements”. The professional body could stand down senior managers deemed to be showing commitment to the new culture.
  3. A fundamental change of bonuses so that they become incentives for ethical behaviour. We suggest an automatic bonus payment of 10-20% of total pay. It could be withheld for two reasons: either poor financial performance of the firm, or an ethical breach. In effect, it would be a negative bonus. Multiple ethical breaches would result in the loss of professional status and employment.

Regulation hasn’t worked

Automatic bonuses remove the extreme money priming of the finance industry, and they can be helpful in maintaining employment in the event of a downturn. They can simply be reduced instead of laying off staff, as happened during the global financial crisis.

Boosting regulation and boosting the capability of regulators, as many say they want, could work against developing the ethics and the trust that makes other professions work.

Authors: Warren Hogan Industry Professor, University of Technology Sydney; Gordon Menzies Associate Professor of Economics, University of Technology Sydney