ACFS-Finsia Conference to highlight key issues for Australia’s financial institutions in transition

Posted on September 29, 2010
Filed Under Banking, Financial Institutions and Markets, Event News, Media Release | Leave a Comment

Professor Deborah Ralston, Director, Australian Centre for Financial Studies, stated today that the ACFS-Finsia Banking and Finance Conference running Thursday and Friday this week in Melbourne is “a must attend for finance practitioners and academics to swap experiences and share knowledge, and to develop contacts across their disciplines.” She noted that the prac-academic conference, now in its 15th year, serves as “a rare interface between academics and professionals in the banking and financial services industry”.

Professor Kevin Davis, Research Director, Australian Centre for Financial Studies, added that “in an environment where financial markets are undergoing marked change, understanding recent developments in both theory and practice, and the results of applied research are crucial.”

There are many highlights of the event including:

1. Conference Dinner – with keynote speaker Steven Münchenberg, CEO, Australian Bankers’ Association speaking on Banking, for fun and profit on Thursday 30th September 2010 at the RACV Club 501 Bourke Street Melbourne.

2. Eight Morning Plenary Financial Services speakers over the 2 days, cover a breadth of industry critical issues:

1. Ben Gray, Head, TPG Capital Aust: Private equity investing during & post GFC
2. Prof Stephen Gray, University of Qld: How to use economic models in practice
3. Mark Joiner, Executive Director Finance, NAB: Australian Bank Management in the wake of the Global Financial Crisis
4. Greg Medcraft, Commissioner ASIC: Financial Services: What is on the Forward Agenda for ASIC?
5. Colin Nicol, Partner, McGrathNicol: Current issues in Corporate Restructuring & Insolvency
6. Dr Don Russell, Chairperson, State Super: Post-Cooper review, do super funds need to reconsider their investment strategies?
7. Justin Wood, former Barclays Global Investors Australia: Retirement system development and implications for financial market participants
8. Prof Kevin Davis, ACFS – on the Recommendations from Australia-New Zealand Shadow Financial Regulatory Committee meeting on Repairing Retailing Finance

3. Each afternoon there are 3 concurrent sessions of peer reviewed research, ACFS Research Grant papers and Finsia PD workshops. Research topics covered include:

• Bank Credit Rating
• High Frequency Trades
• Hedge Fund fees
• Contrarian Investment Strategies
• Networks in Financial Markets
• Rating Triggers in Loan Contracts
• Islamic Banks
• Consumer behaviour and Margin Lending
• Basel capital adequacy and Australian bank risk

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Deborah Ralston
Director

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Message from the Director – September 2010

Posted on September 23, 2010
Filed Under ACFS eNewsletter, Message from the Director | Leave a Comment

The Australian Centre for Financial Studies works across the spectrum of financial services activity. Over the past twelve months, we have established three Research Reference Groups consisting of industry, academe and regulators across Banking, Funds Management and Insurance. Each group has produced a research agenda for academic staff and students. We look forward to seeing the first research outputs in the form of honours student theses at the end of this year.

My ACFS colleagues and I have benefited from exposure to thinking across the three sectors and have felt validated in spreading our focus across financial services rather than specialising too much in one areas or another.

The Australian Superannuation System Review chaired by ACFS Industry Advisory Comittee member Jeremy Cooper presages major change in Australia’s retirement incomes arena. If Cooper’s recommendations are adopted, for instance MySuper, it will likely see smaller funds struggle to differentiate themselves in a busy market with pressure to consolidate. The next stage of our Melbourne Mercer Global Pension Index will be released on Wednesday October 20^th and it will be interesting to see if Australia’s retirement incomes system has retained its high rating of 2009.

However, Cooper’s work is also likely to have an impact on insurance if commissions are phased out. ACFS’s own work highlights the fact that despite near compulsory superannuation around half of Australians will be dependent upon the Age pension at some stage of their retirement. (Refer the report Financial Wellbeing in Retirement authored by myself and ACFS Research Director Prof Kevin Davis.) Just as longevity and annuity product design are growing issues in superannuation so too are they in insurance, and particularly in the area of disability services funding where it appears that insurance might have a larger role to play than previously considered. (see our submission to the Productivity Commission.)

In banking, reforms to liquidity and capital rules coming out of Basel in Switzerland suggest that bank capital will be more expensive – at least at the margin. Our Research Director, and author of the Davis Report into Financial Guarantees, Prof Kevin Davis suggests that the banks should be alert but not yet alarmed. Our International Distinguished Lecturer BIS chief Jaime Caruana dropped a few hints in his address to us in February.

I hope you find interest in our newsletter. My colleagues and I look forward to hearing from those of you who wish to share ideas and work with us.

Deborah Ralston
Director

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Why be Afraid of Higher Bank Capital Requirements?

Posted on September 13, 2010
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Policy | 2 Comments

FRDP – 2010-04

September 13, 2010

There is much debate, and resistance from the banking sector, about the merits of higher required bank capital ratios. Both in theory and in practice there is little reason to justify such concern.

Under the Basel Accord, banks in most countries are subject to minimum regulatory capital requirements, generally expressed as a proportion of risk weighted assets. Currently there is discussion about increasing the minimum capital requirements (as well as making changes to the way it is calculated, what counts as eligible capital etc.)

While there was general support for higher capital ratios in the immediate aftermath of the Global Financial Crisis, the passage of time is seeing strong pushback from banks on the case for imposing higher capital ratios. Many of the arguments are unfounded and it should be asked whether the costs of higher capital ratios are significant and would outweigh the benefits.

In addressing this question, the first point to note is that the risks inherent in bank asset portfolios must be borne by stakeholders (shareholders, debt-holders, depositors and government – as an explicit or implicit guarantor) in the banks. In providing funds to the bank, they will (or should) demand a risk premium for bearing that risk. In this regard, all that higher capital ratios do is to change the mix of bank funding (and risk bearing) towards more equity and less deposits or debt.

In theory (absent tax distortions and financial “safety net” effects) this would not change the overall (average) cost of funding to banks. Indeed, to the extent that potential financial distress costs are reflected in the cost of funding, a lower risk of bank failure should in principle reduce the average cost of funding.

While reality differs from that world of theory, some of the conclusions highlight real world implications. In particular, lower bank leverage won’t necessarily lead bank depositors and debt holders to accept lower promised interest returns – because perceptions of government support for banks mean that they disregard or discount bank risk of failure.

If that is a cause of increased bank cost of funding due to higher capital requirements, they should not necessarily be seen as involving a social cost. Rather, they involve a “corrective” mechanism which limits bank access to this implicit subsidy and partially redresses competitive imbalance with non-bank financing which the subsidy induces.

An alternative cause of increased bank funding cost could be the tax effects. In a classical tax system the “double taxation of dividends” makes high leverage attractive. And while Australia’s dividend imputation tax system reduces that effect, it may still have some relevance.

But again, it should be asked how much leverage should be permitted in pursuit of such tax benefits. Australian (and international) banks have leverage ratios (assets/equity) in the order of 20, compared to non-financial companies for which the average is around 2.

Non-financial companies can’t lever up to that extent because shareholders and creditors get nervous and demand much higher rates of return. Banks escape that market discipline, perhaps partly because they have less risky activities – the GFC notwithstanding, but because of perceptions of government support and oversight (prudential supervision). If market discipline inadequately constrains excessive leverage for these reasons, explicit constraints can be justified.

For these types of reasons, it may be argued that a consequence of higher bank capital requirements will be a higher cost of bank funding, which will have adverse effects upon economic activity through consequently higher loan interest rates. But how significant is this claimed effect. Consider the case where a bank currently funds its assets with 5 per cent equity capital with a required rate of return of 15 per cent, and 95 per cent by deposits with an interest cost of 5 per cent. With no change in these rates of return, increasing the equity funding to 6 per cent means that the average cost of funding increases from 5.50 per cent to 5.60 per cent, ie 10 basis points (or an increase in funding costs of around 2 per cent).

Of course, banks may not be able to pass on the higher funding costs to borrowers, such that the return payable to shareholders is reduced. And because of the high leverage, that would be significant – at the new leverage ratio an average cost of funds of 5.50 per cent means that the compatible return on equity drops to around 13.5 per cent.

Ultimately, whether banks would be able to pass on the higher cost of funding in loan rates, or whether the cost of deposit funds would decline and offset the effect, depends upon how the Reserve Bank adjusted monetary policy. But even if there were no change in monetary policy, the effect upon real activity is unlikely to be substantial, given the relative interest inelasticity of demand , and thus not a strong argument for opposing (at least modest) increases in required bank capital ratios.

This FRDP was prepared by Kevin Davis, Professor of Finance, University of Melbourne, and Research Director, Australian Centre for Financial Studies.

kevin.davis@australiancentre.com.au

(1. )For example, the IMF recently estimated that a 100 basis point increase in interest rates would reduce residential housing investment in Australia by around 2.5 per cent. World Economic Outlook (April 2008, Chapter 3),   http://www.imf.org/external/pubs/ft/weo/2008/01/pdf/text.pdf

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The Financial Regulation Discussion Paper Series provides independent analysis and commentary on current issues in Financial Regulation with the objective of promoting constructive dialogue among academics, industry practitioners, policymakers and regulators and contributing to excellence in Australian financial system regulation. More in this series…

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Long-term Disability Care & Support Scheme – Involve private providers

Posted on September 8, 2010
Filed Under Financial Roundtable Report Series, Inquiry Submissions, Insurance, Media Release, Policy, Publications | 2 Comments

ACFS releases submission to Productivity Commission

A national insurance scheme for long-term disability care and support is a laudable concept but the devil is in detail of design and implementation. While an ill-designed scheme may be costly, having no scheme may prove more costly in the long term.

Much can be learned from existing schemes and useful mechanisms imported from existing products. Disability is a hidden cost of life for a large minority, and at some stage in retirement a major cost for many. Insurance products and schemes can help.

A priority of the new Government will be to address the economic and social costs of disability. An aging population, longer work hours and consequent pressures on carer families and community networks are likely to mean growing pressure for action. While Australia’s social security and health care systems provides universal services based on need, there is currently no similar entitlement to disability care and support services.

The Productivity Commission has been requested by Assistant Treasurer Senator Nick Sherry to undertake an inquiry into a National Disability Long-term Care and Support Scheme. The Inquiry assesses the costs, cost effectiveness, benefits, and feasibility of such a scheme.

Australian Centre for Financial Studies (ACFS) stated its broad support for the objectives of the Inquiry.  ACFS Director Prof Deborah Ralston noted that “disability care and support services are a vital part of our social fabric” and that “disability insurance is a key component of society’s approach to dealing in a just fashion with the economic and social costs that disability creates”. ACFS assesses that the current role of insurance-based compensation for disability is under-estimated by both the community at large, and also the financial sector.

ACFS has established a Research Reference Group of academics, practitioners and regulators for Insurance. It has a key objective of building a dynamic insurance research agenda for academic staff and students to be of direct relevance to industry and government. Impetus for this ACFS submission came out of that group.

ACFS focused its submission upon existing and potential insurance schemes and addressed the following specific questions:

1. What is the range of current disability insurance schemes in Australia and what lessons can be learnt from the experiences of those schemes (including underinsurance, claims experience)?
2. What impediments are there to insurance schemes for dealing with particular types of disability claims?
3. What relationships between insurers as payers of claims and providers of disability support services are appropriate? Fault vs. No fault; Equity issues – outcomes vs. causes; Ongoing care costs; Compensation amounts; and Insurer Solvency
4. What is the appropriate role for Government funding versus private insurance in dealing with disability coverage? Common Law Settlements vs. Insurer payouts; Structured settlements; Special Disability Trusts; Pension Age
5. What innovations in privately provided disability insurance schemes should be promoted/supported by Government and how?

More questions than answers remain. Some conclusions can be drawn.

• A lesson from failed schemes is that it is better to fail fast and fail small. There may be value in any national scheme being developed and refined in proto-type on a smaller scale e.g. in one state or region or product area.
• Specific insurance schemes provide protection for producers and service providers, and compensation for victims, for disabilities arising from specific events. These include medical indemnity schemes, public and private liability schemes, sporting injury schemes, crime victims’ compensation schemes.
• For the individual, insurance against particular life events such as total and permanent disability (TPD) could have greater encouragement from government. For instance, tax neutrality for friendly society products.
• Aspects of each of the pooled schemes, and individual products, may be appropriate to import into a National Disability Scheme.
• It would appear that lump sum payments increase the risk of eventual depletion of funds while there is still a need for care, forcing beneficiaries into reliance upon social welfare arrangements.
• Annuity-type products may be a solution. What scope is there for modification of taxation arrangements to allow for common-law court-determined settlements to be paid as structured settlements in the form of an annuity?
• In assessing the cost of a national scheme, it is important to take into account the scope for reduction in other social security costs. For instance, a well designed disability care and support system may reduce the number of families on welfare by making available more professional carers.
• Concerning compensation it appears that no current approaches allow sufficiently for the inflation rate of medical and care costs relative to general inflation. And normal discount rates may understate the appropriate risk based rate of return, with both factors creating a downward bias to compensation amounts.

ACFS Research Director Prof Kevin Davis noted that “issues of adverse selection and moral hazard are prevalent and unavoidable when insuring against the costs of disability. They may be mitigated but at cost.” For instance, testing for genetic predispositions to various chronic diseases is now possible but Government must decide whether broad use of these techniques, which would lead to differential charging, is consistent with broader societal objectives. Similarly, technology may be applied to determine risk profiles based on behaviour e.g. the tendency of vehicle drivers to speed can be tracked. Arguably the use of the technology may compromise civil liberties.

Disability insurance is a “long tailed” risk business. Any proposal for mandating the involvement of commercial providers in any scheme must consider the solvency of insurers. Prof Ralston commented that “the greater involvement of non-statutory bodies would support innovation over time, and would spread the risk, but there must be opportunity for profit”.

A key issue is scheme coverage. Prof Davis asked

“Should there be a national scheme for inherited or genetically based disabilities, should such a scheme also cover accident induced cases? This might reduce the potential role for insurance schemes and would likely leave the taxpayer carrying more of the burden.”

View Submission to Productivity Commission

The Disability Insurance Roundtable Report included in the submission is part of the ACFS Financial Roundtable Report Series. The Series assembles the expertise and thoughts of leading financial services individuals on relevant topics. Through the use of roundtables, ACFS enhances its thought leadership role by facilitating discussion among academics, industry practitioners, policymakers and regulators.  This discussion contributes to the public policy debate and identifies further research areas. More in this series…

Media contact details:

Professor Kevin Davis
Research Director, Australian Centre for Financial Studies and
Professor of Finance, University of Melbourne
W: +61 3 9666 1050
Mob: +61 409 970 559
kevin.davis@australiancentre.com.au

Professor Deborah Ralston
Director, Australian Centre for Financial Studies and
Professor of Finance, Monash University
W: +61 3 9666 1010
Mob: +61 419 650 318
deborah.ralston@australiancentre.com.au

www.australiancentre.com.au

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