The Vickers Report – Implications for Australia

Posted on September 30, 2011
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Publications | Leave a Comment

FRDP 2011-04
September 27, 2011

In this Australian Centre for Financial Studies Financial Regulation Discussion Paper, Professor Kevin Davis outlines key recommendations of the recently released UK Independent Commission on Banking, and considers their relevance to Australia.

The final report of the UK Independent Commission on Banking (Vickers Report, 2011) was released on September 12, 2011, and recommends a number of significant changes in the structure and regulation of banking in Britain. While some are driven by issues specific to Britain, the question arises of how other countries, such as Australia, should react to the Report’s more general proposals.

At the risk of oversimplifying (and more detail is given in the Appendix), the proposals can be grouped into three main types.

• Banking sector structure – involving operational and legal separation via “retail ring-fencing” of what are sometimes referred to as “utility” and “casino” banking activities.
• Increased capital requirements for larger more systemically important banks
• Greater failure management powers for regulators and protection of depositors.

Retail Ring-fencing

The structural separation proposal reflects a long-standing idea that “narrow banking” has merit – by virtue of limiting risk-spillovers from other activities typically undertaken within a bank with a broader range of activities[1].  The Vickers report argues that benefits of retail ring-fencing include: insulating vital retail banking services from global shocks; making resolution of troubled banks easier; and facilitating banking competition by allowing different regulatory approaches to domestic retail banking and global wholesale/investment banking approaches. Within the “broad bank”, only the ring-fenced bank would be able to provide basic retail banking services, it would be separately capitalized, and have independent directors. While it would be able to share operational services with, and access financial services from, other parts of the broad bank it would be precluded from a range of “non-basic” financial activities.

Can such a separation be done without imposing excessive social costs? Would it have the benefits claimed? Australian experience is potentially relevant here.

Not too many years ago (until changes to the Banking Act in 1989), the major Australian banks operated as structurally separate – but operationally integrated[2]  – Savings and Trading Banks with the former historically having been effectively limited to taking deposits from individuals and making housing loans. The State Government owned (and Trustee) Savings Banks were the only Savings Banks allowed to provide payments (checking) services until legislative changes in 1984. While a return to the (very) heavy regulation of those days (which prompted growth of alternative non-bank institutions) needs to be avoided, the historical record does suggest that structural separation is feasible, and not necessarily excessively costly. The continued profitable operation of specialist retail ADIs (credit unions and building societies) also suggests that retail ring-fencing is a viable option.

The history also suggests that limiting the activities of ring-fenced institutions has merit – if it prevents them moving into areas outside their particular expertise and without adequate governance and risk management capabilities. The demise of the State Banks of Victoria and of South Australia at the start of the 1990s, arising from expansion into investment banking type activities are good examples.

But retail ring-fencing in the modern financial sector can create complications. A major growth area for banks is wealth management, involving provision of financial advice to individuals and creation of financial products such as managed funds, margin loans etc for use by those individuals. Where these activities would fit is unclear.

More relevant is the issue of dealing with imbalances in the demand for and supply of funds from the “ring-fenced” retail clientele. While the nationwide branch networks of banks create a form of internal capital market able to smooth out geographical liquidity imbalances, it is far from clear that in aggregate there is a “natural” balance between household loan demand and deposit supply. Indeed, retail loan demand generally far outstrips deposit supply, such that ring-fenced banks would need to obtain funds from other sources, such as via securitizations or loans from their parents or affiliates – thereby indirectly creating counterparty exposures to their “casino” banking activities.

These issues do not seem insoluble, but would require careful regulatory consideration. Such a separation would, most likely, involve limitation of the Financial Claims Scheme deposit insurance to the retail-ring-fenced bank.

It is also worth noting that, some fifteen years ago, the Australian Financial System Inquiry (Wallis, 1997) considered the issue of financial conglomerates. While their focus was more upon entities combining banking, insurance, funds management and securities activities, rather than different types of banking activities, their preference (p346) was for use of a Non-Operating Holding Company structure as the best method for effecting prudentially desired separation. Their Recommendation 49 to permit such a structure was subsequently facilitated by legislation in 2007 and Macquarie Bank converted to such a structure in that year.

Capital Requirements and Loss Absorbency

The Vickers report proposes higher capital requirements for large retail ring-fenced banks, and particularly for non-ring-fenced systemically important banks. An important consideration arises here of whether this is a matter best dealt with via regulation (such as implied under the Basel III proposals for SIFIs) or via supervision. In Australia, APRA operates a graduated approach to supervisory intensity of individual institutions based upon its PAIRS and SOARS framework. In principle, assessments of the severity of micro and macro – prudential risks arising from that framework can lead to imposition of higher, and tailored, capital requirements for SIFIs, rather than a specified regulatory requirement of “x” per cent.

Compliance with international standards suggests that there is limited scope for not adopting the Basel III regulatory proposals for large banks. However, the Vickers structural separation proposal would, arguably, enable a supervisory approach towards the retail ring-fenced entity while applying Basel III regulatory requirements to the non-ring-fenced entities.

Failure Management Powers

The Vickers report proposes the implementation of “depositor preference” arrangements for the ring-fenced bank whereby depositors are senior to all other claimants in the event of bank liquidation. Australia is one of a relatively small number of countries where depositor preference already exists – although it is in the process of being slightly weakened to enable issuance of “covered bonds”, and its rationale somewhat reduced since the introduction of deposit insurance via the Financial Claims Scheme.

Depositor preference arguably increases the cost of other (wholesale market) funding for banks – because of its subordinated status in bank liquidation. In this regard, the Vickers proposals of structural separation and limitation of depositor preference to the retail-ring-fenced bank would provide the opportunity for Australia to remove depositor preference from the non-ring-fenced banks.

Another of the Vickers proposals is to provide the authorities with “bail-in” powers, such that long-term unsecured debt (“bail-in” debt) of a bank requiring resolution could be subject to some degree of write down by the authorities[3].  Such powers may enable an open resolution to take place rather than having to place the bank into liquidation. The dilemma with such a power is the uncertainty it may create unless potential bail-in arrangements are clearly specified, and thus the consequences for the costs of debt.

While “bail-in” debt seems unlikely to garner much support in Australia, it is worth noting that New Zealand, having decided against continuation of explicit deposit insurance after the end of 2011, is considering such arrangements as part of the Open Bank Resolution proposals on which the Reserve Bank of New Zealand is currently consulting. A particularly noteworthy feature of those proposals is that “bailing-in” or “haircuts” would also apply to depositors. (Deposits would be written down to some level consistent with the solvency of the bank, and the remaining balances government guaranteed to prevent outflows while the open resolution (eg by takeover by another bank) was effected). Since New Zealanders can place funds in the parent Australian banks (in AUD) and get the protection of the Financial Claims Scheme, any preference for doing so, rather than maintaining deposits at risk in the New Zealand banks in any future period of uncertainty, may create additional liquidity problems for the NZ banks.

[1]In the USA, a variant of this view has been incorporated into the Dodd-Frank Act passed in July 2010 through incorporation of the Volcker Rule (requiring prohibition of proprietary trading and sponsorship of hedge and private equity funds by banks).
[2]For example, cash deposits would be conducted through the same teller and go into the same till regardless of whether the account to be credited was at the Savings or Trading Bank!
[3]“Bail-in” debt is different to contingent capital (which has also been proposed as a regulatory requirement) in that the latter involves specific defined trigger events at which the debt converts to equity according to pre-specified arrangements.

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

Download extended version of paper

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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Financial Preparedness for Life Events: Looking Beyond Superannuation

Posted on September 21, 2011
Filed Under Banking, Financial Institutions and Markets, Contracted Research and Consulting, Funds Management & Superannuation, Insurance, Media Release, Policy, Publications | Leave a Comment

Abacus, the industry body for the Australian mutual financial services sector, and the Australian Centre for Financial Studies (ACFS) have released the research report, “Private Saving: The Role of Life Event Products” on behalf of the Friendly Societies of Australia.

Households often have inadequate savings and insurance to cover even the most common and predictable of possible life events such as education, health, housing, and retirement each of which may have a major financial impact and for which they have not adequately provisioned. The ACFS report notes that this lack of financial preparedness is not merely income-based but reflects inadequate information and behavioural biases which are sometimes reinforced by well-meaning Government regulation.

“In recent times we in Australia have had a laudable focus on superannuation, which is a great way to save for retirement, but there are other life cycle events which we also need to prepare for, such as ill health and the education of children” said ACFS Director and report co-author Professor Deborah Ralston.

“A mix of other products – some of which do not currently enjoy the same sort of tax incentives as superannuation – are worthy inclusions in a robust and sustainable portfolio” said Professor Ralston.

The report notes that “the tax incentives given for superannuation may have impeded the development and growth of other financial products well suited for non-retirement life event preparation.” Long-established life cycle savings products offered by Australian Friendly Societies do not enjoy the same tax-incentives as superannuation. According to the report, these existing “products have the potential to raise private savings levels and assist individuals to prepare for life cycle events without the need for complex and on-going financial advice.”

Louise Petschler, CEO of Abacus Australian Mutuals, commended the research and encouraged individuals and their financial advisors to look at the various forms of friendly society insurance bonds as a straight-forward way of saving for expected future events such as children’s education, aged-care accommodation and funerals as well as for supplementing other savings.
“Friendly society bonds are a great tool to help secure your financial future,” said Ms Petschler.

“Encouraging short to medium-term savings is the good way to build a savings culture in Australia, and will have positive flow on effects to longer term financial goals.

“Friendly society products can help households save for the practical life challenges of most Australians – educating your kids, safeguarding your family’s health and boosting housing affordability for first home buyers,” said Ms Petschler.

The report authors encourage Government to strengthen incentives to use insurance bonds for delivery of targeted social benefits and to encourage financial literacy and personal financial responsibility. “Australian policy makers have failed to appreciate the opportunity that life event savings schemes offer, … as a consequence, such products receive far less favourable tax treatment in Australia”, than in other leading markets, said the report.

Report co-author and ACFS Research Director Prof Kevin Davis stated that “with insurance bonds tax concessions, or government co-contributions, can be provided effectively and without complexity”. He noted that the sector was prudentially supervised by the Australian Prudential Regulatory Authority (APRA) and that the long-term nature of the modern insurance bond contract enables risk reduction benefits from “time diversification”.

About Abacus – Australian Mutuals
Abacus – Australian Mutuals is the industry body for the Australian mutual financial services sector, a strong alliance of mutual building societies, credit unions and friendly societies.
The mutual sector has combined assets of some $83 billion, offering Australians a competitive alternative to banks and access to a range of savings, investment, loan and insurance products. Unlike banks, profits are not paid to external shareholders, but put back into better products and services for the over 5.5 million members (customers) and their communities.

As the official industry body, Abacus delivers a strong, united and clear voice for the mutual financial services sector as it brings together the strength and professionalism of its 128 member institutions. All are united in that they are all mutual organisations and have closely aligned values, including: cooperation, trust, integrity, care for members, professionalism and ethical practice.

Abacus is owned by its member institutions: 108 credit unions and mutual building societies and represents 18 friendly societies though the Friendly Societies of Australia.

About ACFS
The Australian Centre for Financial Studies (ACFS) facilitates industry-relevant and rigorous research and consulting, thought leadership and independent commentary.  Drawing on expertise from academia, industry and government, the Centre promotes excellence in financial services.  The Centre specialises in leading edge finance and investment research, aiming to boost the global credentials of Australia’s finance industry; bridging the gap between research and industry and supporting  Australia and Melbourne as an international centre for finance practice, research and education.

The Centre provides access to and links between academics, finance practitioners and government and draws on expertise and experience from across these groups, to facilitate knowledge creation and transfer. ACFS (previously known as the Melbourne Centre for Financial Studies) is a not-for-profit consortium of Monash University, the University of Melbourne, RMIT University and Finsia having commenced in 2005 with seed funding from the Victorian Government.  Across the consortium partners ACFS has links with over 100 finance academics and over 200 postgraduate students engaged in finance research.

Media Release PDF | Full Report PDF

Media contact details:

Prof Deborah Ralston
Director
Australian Centre for Financial Studies
T: +61 3 9666 1050
info@australiancentre.com.au

Mark Degotardi
Head of Public Affairs, Abacus – Australian Mutuals
T: +612 8299 9053
info@abacus.org.au
www.abacus.org.au

Prof Kevin Davis
Research Director
Australian Centre for Financial Studies
T: +61 3 9666 1050
info@australiancentre.com.au

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ACFS Boardroom Briefing: Indonesia – Giant in the Making

Posted on September 6, 2011
Filed Under Event News, Funds Management & Superannuation | Leave a Comment

Presentation by Mandiri Investasi
Monday, September 5 2011
Event sponsor: AFM Investment Partners

Summary:

Speakers from Mandiri Investasi suggested that Indonesia is one of the most misunderstood countries in the world. For instance, Indonesia has experienced continuous growth since 2001. There has been “no lingering crisis” rather just “growth and democratisation”.

Indonesia’s stock market is roughly ¼ the market capitalisation of the ASX. There is much scope for growth in financial services with the debt to GDP ratio at only 27%. This for instance represents a credit penetration rate little more than half that of China and Brazil. This low leverage is also seen as one of the reasons for Indonesia’s strong growth throughout the global financial crisis.

However, Indonesia’s future may be to become one of the largest Islamic Financial Services market in the world. Presently Islamic Syariah bonds account for only 5.3% of issuance in the AUD77bn Indonesian Government Bond Market. Two reasons were cited for the slow take off Sharia-compliant financial services. Firstly, the market is difficult to standardise given differing interpretations from Middle Eastern and Malaysian jurisdictions. And secondly, liquidity is low in such products because a prevalent view that trading may not be sharia-compliant.

Like any emerging market Indonesia has to address corporate governance and corruption issues. The establishment of a new Corruption Watchdog and a successful counter-terrorism campaign in recent years have allayed fears.

With continued high population growth and greater foreign investment inflow, Indonesia is expected to return to its pre-1998 trend of above 6%pa economic growth rates. It is expected to continue growing after China has slowed due to a younger more fertile population.

Inflation is significantly a function of food and oil prices which are capped by government subsidies, although government involvement in these two sectors is likely to be wound back over the next decade.

Major growth sectors are expected to be those that cater to growing population, higher intra-country trade and higher income levels. Being a massive archipelago, much infrastructure spending will go to building new ports.

Mr. Priyo Santoso, Chief Investment Officer of Mandiri Investasi suggested that for investors seeking a defensive source of alpha, Indonesia should be considered. With larger US pension funds now looking at funds devoted to China and India, Santoso foresaw a future trend for dedicated Indonesian-specialist funds.

Notes taken by David Michell, ACFS

Presentation PDF

About ACFS Boardroom Briefings
To promote excellence in financial services and boost Australia’s global credentials, ACFS draws on its international network of experts to present relevant and unique speakers to the Australian finance sector. Boardroom Briefings are invitation-only events run for selected stakeholders such as sponsors, partners and supporters, where they have the opportunity to interact more intimately with the speaker to conduct a more targeted discussion.

Contact details:
Australian Centre for Financial Studies
T: +61 3 9666 1050
info@australiancentre.com.au

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Future Directions for Financial Services

Posted on September 3, 2011
Filed Under Banking, Financial Institutions and Markets, Funds Management & Superannuation, Publications | Leave a Comment

Leadership Series 2011 – Financial Services Council Deloitte Lunch
Friday September 2, 2011
Speaker: Jeremy Duffield, Chairman, Australian Centre for Financial Studies

Speech highlights:

• Jeremy Duffield fears that the focus on the immediate, the current economic climate and regulatory consultation and implementation, has meant that there has not been enough analysis of the likely impact of the end of the commodity cycle.
• He highlighted that now more than ever “financial services are a joint product between government and the private sector”.
• Duffield’s concern about the government ”trying to take hold of the reigns of industry innovation” has been widely reported.
• He cited the Melbourne Mercer Global Pension Index, developed by the Australian Centre for Financial Studies and Mercer, which “confirms we have one of the best retirement systems in the world”
• “we’re squarely behind Bill Shorten’s big push to take super contributions up to 12%.”
• As a market veteran, Duffield was able to recall the period to 1980 when the “Dow Jones Average had made no net progress over the past 13 years”. However, the silver lining with the current volatile environment is that equity valuations are cheap.
• Duffield concluded with a broader comment about the role played by financial services in society and how a lack of consensus on societal objectives can harm everyone.

“If we’re to live in this beneficent social compact where we benefit from a private delivery of what is seen as a social outcome, we must focus on meeting the government’s objectives, as well as our consumers’ and our own. And we must accept compromise to maintain the integrity and cohesiveness of the effort. We cannot afford the hard-edged political divisions and failures to act that are hurting the US and Japan so badly.”

Full Speech PDF | About Jeremy Duffield

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Message from the Director – September 2011

Posted on September 2, 2011
Filed Under ACFS eNewsletter, Message from the Director | Leave a Comment

On behalf of the Australian Centre for Financial Studies (ACFS) team, I would like to thank all of our supporters for their support of our bid for the Centre of Excellence for International Finance and Regulation (CIFR). Although the Monash University led bid of which ACFS was a key component was unsuccessful, we did provide a well-developed and cohesive submission, proudly endorsed and supported by the Victorian Government as well as 45 national and international key industry partners. That support reflected the breadth and diversity of the ACFS linkages and was vital in demonstrating the capability and credibility of our bid.

We were very heartened by this high level of support and we look forward to maintaining and building on our existing relationships and in developing new avenues for partnership between industry and academe.

ACFS would also like to congratulate the members of winning CIFR bid led by University of New South Wales, and congratulate John Trowbridge who has been appointed as interim Director of the Centre for International Finance and Regulation.  It is indeed a very exciting and challenging time ahead for John and his team. ACFS is pleased to note that we currently work with a number of the winning consortium members individually.

Again, thank you to all of you who have provided formal and informal support for our Centre. We look forward to building on our strengths as we move forward. 

Deborah Ralston
Director

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