Of Financial Advice and Advisors

Posted on April 4, 2013
Filed Under ANZSFRC, Banking, Financial Institutions and Markets, Funds Management & Superannuation, Insurance, Media Release, Policy, Publications | Leave a Comment

The Australia-New Zealand Shadow Financial Regulatory Committee releases Statement No. 11 exploring some of the challenges facing the financial advice industry in providing appropriate and quality  advice. The committee offer some suggestions to policy makers for mitigation, to reduce the impact of poor financial advice on future financial wellbeing.

Some recent high profile cases (e.g., Storm, Blue Chip and ING) have highlighted problems arising from poor financial advice and, as a result, prompted various legislative initiatives relating to advisor obligations, fee structures, and the like. In this Statement, we consider some of the challenges facing the financial advice industry and offer some suggestions for how these might be mitigated. 

As a first point, we note that, in contrast to most other expert-service markets, relatively few people make use of financial advisory services. For example, surveys indicate that fewer than 50% of United States households do not use a financial advisor, a figure we suspect is even lower in Australia and New Zealand. The rest, presumably, rely on a do-it-yourself strategy… Full Text | PDF

Recommendations:

• Aspiring financial advisors and planners should be encouraged to obtain education in finance or economics to at least the undergraduate degree level.
• Ideally governments should aim to reduce the complexity of tax and welfare benefit arrangements and thus the need for such privately advantageous, but with little if any social value, financial advice. And, correspondingly, educational programmes for financial advisors should be less skewed towards knowledge of the tax and benefits system, and place more emphasis on investment theory and fundamentals.
• The large parents of financial advice groups should consider using a range of monitoring and governance mechanisms such as “mystery shopper” techniques to assess quality of advice, as well as specialist internal audit/compliance arrangements focused on ensuring quality of advice and product suitability.
• Governments should investigate the further development of such comparison sites, and that financial advice contracts include information on resources available  for clients to check risks and costs of advice by reference to such sites before the contract is finalized and advice implemented (during a required cooling off period).

The full Statement is being released at 8.30 am Friday NZ time at the  4th Financial Markets and Corporate Governance Conference in Wellington NZ. 

For the full statement and more information on ANZSFRC, please visit our website at: http://www.australiancentre.com.au/acfs-links/anzsfrc/

Media contact details:

Professor Kevin Davis
Research Director, Australian Centre for Financial Studies &
Professor of Finance, University of Melbourne
info@australiancentre.com.au
+61 3 9666 1050

Professor Glenn Boyle
Economics and Finance, University of Canterbury
ph +64 3 364 3479

About ANZSFRC
Following the example of the Shadow Financial Regulatory Committees in Asia, Europe, Japan, Latin America and the United States, a group of well known professors from Australia and  New Zealand, who are all experts in the fields of banking, finance, and the regulation and supervision of financial institutions and markets, set up the Australia-New Zealand Shadow Financial Regulatory Committee (ANZSFRC). The ANZSFRC had its inaugural meeting in Sydney in December 2006 when its first statement entitled “Managing Bank Failure in Australia and New Zealand: Rapid Access Matters” was issued during the 2006 Australasian Finance and Banking Conference. Co-chairs of the ANZSFRC are Prof. Glenn Boyle and Prof. Kevin Davis. Glenn Boyle is Professor of Finance at the University of Canterbury, Christchurch. Kevin Davis is Research Director of the Australian Centre for Financial Studies and Professor of Finance at the University of Melbourne.

View previous statements released by the committee

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AUSTRALIA AND NEW ZEALAND SHADOW FINANCIAL REGULATORY COMMITTEE

STATEMENT No. 11

3 APRIL 2013, WELLINGTON

Of Financial Advice and Advisers

 Some recent high profile cases (e.g., Storm, Blue Chip and ING) have highlighted problems arising from poor financial advice and, as a result, prompted various legislative initiatives relating to adviser obligations, fee structures, and the like.  In this Statement, we consider some of the  challenges facing the financial advice industry and offer some suggestions for how these might be mitigated.

As a first point, we note that, in contrast to most other expert-service markets, relatively few people make use of financial advisery services.  For example, surveys indicate that fewer than 50% of United States households use a financial adviser, a figure we suspect is even lower in Australia and New Zealand.[1]  The rest, presumably, rely on a do-it-yourself strategy.  Yet very few people follow such a strategy when it comes to, say, medicine or dentistry or the law – in these cases they turn to experts.  Some might say this is because finance “isn’t rocket science”, and so expert advice isn’t needed.  Yet the planning of space journeys relies mainly on well-known laws of motion, gravity and the like, and so is arguably less difficult than the construction of optimal investment plans for individual investors, which are subject to the vagaries of markets and the unpredictability of human behaviour.  Similarly, very few people would undertake their own root canal treatement, but the consequences of getting that wrong are potentially less serious than undertaking an inappropriate investment strategy.  So on the face of it, the limited use of financial advisers seems somewhat puzzling, but to economists and policy-makers the only relevant issue is whether this under-utilisation has consequences for resource allocation and welfare.   

One reason why it might not is that most people, for most of their lives, have little or no need for professional investment advice.  Faced with mortgage or rent payments and other fixed costs, the ability to achieve discretionary savings is limited.  Instead, saving primarily occurs via the superannuation systems that operate in both Australia and New Zealand, and these implicitly provide investment advice in the form of a limited number of approved investment schemes.  While individual choices of scheme may often err on the conservative side (especially given the pension schemes that also operate in both countries), totally inappropriate investment strategies are effectively ruled out.

Nevertheless, the need for more detailed financial advice arguably becomes greater as workers enter the 55-65 age group, either because they realise that they haven’t saved enough for retirement and need alternative strategies in order to be able to do so, or because they have retired and need to decide what to do with the proceeds from their superannuation scheme.  Yet, as we have noted, relatively few households actively seek, or act upon, professional investment advice.  This appears to be an act of commission rather than omission – financial advisers and planners consistently rank lowly in surveys of most trusted professions.[2] 

Such mistrust may be well-founded.  As well as the recent disasters referred to above, there is significant evidence that investment advisers add little value, and may well destroy it.  Both academic studies and surveys by consumer advocates reveal that poor and inappropriate advice is ubiquitous and that it results in poor investment performance.[3]  

Why is this?  Three, closely related, reasons stand out.  First, we have reviewed the educational requirements for financial advisers and find them to be particularly light, especially when compared with other professions.  While we know of no formal tests of the link between investment advice quality and adviser educational background, and accept that better education and training is no guarantor of better performamce, we believe it self-evident that more extensive, in-depth, and theoretical training in finance and investments would produce higher-quality advice in most cases.  We therefore recommend that aspiring financial advisers and planners be encouraged to obtain education in finance or economics to at least the undergraduate degree level.   

Second, a significant source of demand for financial advice has little or nothing to do with investment strategies, but instead arises from the complexity of, interaction between, and frequent changes to, taxation and government provided welfare benefits (such as pensions). Technical advice is then required by individuals who wish to arrange their affairs to optimize their tax and benefit position.  Consequently, much of the educational requirements and ongoing training undertaken by financial advisers revolves around ensuring up to date knowledge of tax and government benefit arrangements, resulting in an insufficient emphasis on more fundamental aspects of financial education necessary for the provision of good investment advice. Ideally governments should aim to reduce the complexity of tax and welfare benefit arrangements and thus the need for such privately advantageous, but with little if any social value, financial advice. And, correspondingly, educational programmes for financial advisers should be less skewed towards knowledge of the tax and benefits system, and place more emphasis on investment theory and fundamentals.

Third, appropriate remuneration for financial advice faces considerable difficulties. Because it is generally possible to identify the personal gains (tax savings etc) from tax and benefits advice, individuals are generally willing to pay upfront fees for such advice.  However, this is less common in the case of more general financial advice such as development of lifetime financial plans or investment advice. The value added arising from such advice can only be assessed over the longer term – and even then performance assessment is complicated by identification of an appropriate counterfactual, i.e., what strategy would have been followed and what outcome achieved if the advice had not been followed? The consequent aversion of clients to upfront fees encourages other less direct forms of remuneration which are linked to the implementation of the financial advice. These include such arrangements as: fees based on assets under advice; commissions from providers of recommended financial products; or salary payments to financial advisers from employer-providers of recommended financial products on which margins are made. These arrangements, particularly the latter two, worsen potential conflicts of interest between the interests of the client and those of the adviser. And, because they are less visible to the client relative to asset based fees, this creates a competitive disadvantage for independent financial advisers who, when commissions are banned, must rely on the visible forms of adviser remuneration of up front fees or fees on assets under management.

That competitive disadvantage is one possible factor influencing the trend towards increasing consolidation of financial advice groups as subsidiaries of major product providers (such as Banks and Life Offices) and the decline of independent/individual advisers. This trend has both good and bad features. Among the negative features are increased agency problems (and potential conflicts with fiduciary duties) of the link between the adviser and product supplier, less visible remuneration arrangements (and all up costs to the client), and possible lessening of competition in both the advice and product spaces. In general, clients of such groups should expect that financial product choices will be limited primarily to those of the product parent provider. But while choice may be limited after entering an agreement, as long as there is sufficient choice between adviser groups (and potential clients are aware of the link between the adviser group and the parent) this should not be an issue. At the moment, there appears to be adequate competition (although different branding of subsidiary financial advice groups to that of the parent may reduce client awareness of the relationship). On the plus side, financial advisers working for large organisations can be expected to provide advantages to clients from having to comply with the institution’s own processes and practices (“rogue advisers” seem less common than “rogue traders”) and from access to a larger institutional knowledge base. Provided that the institution has in place effective governance and compliance arrangements (and concerns to protect reputation should help achieve this) risks of unsuitable advice should be reduced. And if not, and systematic errors are made, the large size of the parent makes the possibility of effective ex post class action law suits feasible. But this emphasizes the need for appropriate internal oversight and governance mechanisms to ensure that unsuitable products aren’t sold to clients. Adequate standards were not apparent in the aftermath of the Global Financial Crisis as evidenced by bank involvement with Storm Financial in Australia and sales of subprime mortgage bonds in NZ. The large parents of financial advice groups should consider using a range of monitoring and governance mechanisms such as “mystery shopper” techniques to assess quality of advice, as well as specialist internal audit/compliance arrangements focused on ensuring quality of advice and product suitability.

Regardless of the type of financial advice provider used, clients face the difficult problem of assessing the worth and suitability of advice received. Despite the best efforts of regulators and parent firms, it should be recognized that financial advice can vary greatly in quality and suitability – and that clients are not well placed to assess where advice received lies on the quality and suitability spectrum.  They need some form of easily accessible, independent, mechanism for checking these features. Here, two factors are particularly relevant. First, there is a public good element in the provision of comparison/assessment tools. This has been recognised already with the development of retirement income calculators such as “Sorted” in New Zealand and “MoneySmart” in Australia.  But further development of free website tools to check risk and appropriateness involved in financial plans appears warranted. A second factor is the potential for advances in technology, involving ease of access and familiarity for individuals to use web based applications, to partially offset the incompatibility of low financial literacy and increasingly complex financial products. While efforts to improve financial literacy remain warranted, there may be better payoffs from provision of “black box” facilities which provide guidance and assessment on “how” or “what” without individuals needing to understand the intricacies of “why”.  Such facilities could enable individuals to benchmark the risk level involved in advice received and could also extend to cost comparisons (such as at a less general level  than is provided by the “Sorted” comparison of fees for Kiwi Saver products). We recommend that governments investigate the further development of such comparison sites, and that financial advice contracts include information on resources available  for clients to check risks and costs of advice by reference to such sites before the contract is finalized and advice implemented (during a required cooling off period).

 

Outsourcing and Superannuation: Strong partnerships can lead to increased benefits

Posted on March 4, 2013
Filed Under Publications | Comments Off

Professors Deborah Ralston (The Australian Centre for Financial Studies) and Sarath Delpatchitra assess possible implications of  Prudential Standard SPS 231 Outsourcing by analysing the results of a survey of the Superannuation industry study conducted in partnership with the Australian Institute of Superannuation Trustees. Professor Ralston uses these results to assess the nature of relationships between superannuation funds and external service providers to determine the likely impact of the new regulation.

Outsourcing is widespread in Australian superannuation funds across a range of functions, specifically actuarial services, administration, asset consulting, auditing, custody, legal services, sales and marketing and investment services. In a recent APRA study of 115 of the larger Australian superannuation funds, each outsourced at least one function, and nearly two-thirds outsourced six or more.

Outsourcing in financial institutions imposes a significant set of accountability and risk issues for management. As the Federal Reserve Bank ofNew York(1999) and the Bank of International Settlements (2005) point out, while outsourcing means that direct managerial responsibility for the activity is transferred to a third party provider, accountability for the function is retained by the financial institution.

The literature suggests that one of the key means of mitigating risk and achieving successful outsourcing relationships is establishing strong partnerships with external service providers. Relationship type, that is whether the two parties are engaged in a genuine partnership as opposed to a transactional relationship, has been found to be a key predictor of outsourcing success in a number of studies.  It is been found to be positively influenced by factors such as participation, communication, information sharing, and top management support, and negatively affected by age of relationship and mutual dependence (Lee and Kim, 1999).

The Australian Prudential Regulation Authority (APRA) has responded to the potential risks that may result from outsourcing with Prudential Standard SPS 231 Outsourcing. SPS 231 is designed to improve the management of outsourcing risk in superannuation funds and harmonise such regulation with that of banks. This Prudential Standard, which is one of 12 to be enacted on superannuation funds, covers the need for a formal outsourcing policy and risk management strategy, minimum requirements for outsourcing agreements, and due diligence and on-going monitoring requirements. The standard elevates the management of outsourcing within super funds by requiring a formal Board policy, and a legally binding agreement in place for all outsourcing of material business activities. Funds will need to demonstrate that due diligence has been carried out before contracting suppliers and that there are sufficient monitoring processes in place to manage the outsourced services.

To some extent SPS 231 simply codifies APRA guidance to funds and what is considered to be good practice treatment of outsourcing in the industry. The extent to which this new prudential standard impacts on different funds will therefore be a reflection of their current practice and the nature of relationships with investment outsourcing service providers.

In a recent a survey of 26 not-for-profit super funds conducted in collaboration with the Australian Institute of Superannuation Trustees (AIST), the nature of the relationship between funds and their asset consultants, investment managers and custodians was examined.  The survey provides some insight into how superannuation funds work with investment service providers and the extent to which superannuation funds are maximising the benefits of outsourcing.

Overall the survey suggests that there is a high level of trust between funds and all three types of service providers, with this being highest for asset consultants. There is a particularly high level of confidence in the service providers’ expertise and ability to perform their jobs effectively, with integrity and openness.

Respondents displayed quite divergent views when asked about the overall success of outsourcing relationships with service providers, as shown in Table 1.

Table 1: Overall success of the outsourcing relationship

 

The majority of funds rated the success of their relationship with asset consultants as high or very high, but two funds felt it to be poor. These two funds were both smaller in size, of less than $1bn, and had a partnership type relationship. One fund had a relationship of less than five years and the other had been with their asset consultant for between five and ten years. This result suggests that there may be issues of switching costs to be born by funds in changing asset consultants.

There is a greater commonality of views with respect to investment managers, where only one fund rated the success of the relationship as very high, but almost half though it to be high and the majority rated the relationship as satisfactory. The fact that no funds indicated less than a satisfactory rating for overall success may well indicate that where there are problems, mandates with investment managers can be terminated with relative ease.

Views on the success of relationship with custodians were diverse. Overall success with custodians was seen to be very high for one fund, high for 12 respondents, eight found it to be satisfactory, and two funds rated the overall success of the relationship as poor or very poor. The funds that considered this to be a poor relationship had both been with their custodians for more than 10 years, one in a transactional and one in a partnership style relationship.  The length of relationship and lack of success suggest either inertia on the part of the fund or high switching costs. Conversely, the one fund that recorded a very high success rating had been in a largely partnership relationship with their custodian, also for more than 10 years.

To explore the links between the nature of the outsourcing relationship and overall success, overall success was regressed against relationship type, monitoring costs and length of relationship for each of the outsourcing service providers.

Despite views expressed by some respondents, there is no evidence of any significant relationship between success and these variables for either investment managers or custodians. (This conclusion can be drawn from the fact that the regression had a very weak explanatory power with an R² of less than 10 per cent). The results for the asset consultant regression are shown in Table 2, and interpreted as follows.

Table 2: Regressions results for asset consultants: success v. partnership, monitoring costs, length of relationship and size

R² = 0.30, Number of Observations =24, ** sig. at 5%

While the regression had a reasonable explanatory power with an R²of 30 per cent, the only variable that was significant was that of relationship type. Partnership is a significant factor in the overall success of the relationship between funds and asset consultants.

Consequently, it would appear that success is more likely when funds have a partnership rather than a transactional relationship with asset consultants. This supports previous research that relationship type is a critical factor for outsourcing success, although this is not the case for investment managers or custodians. A possible explanation for this outcome may lie in the nature of asset consulting which requires shared decision-making and commitment to shared objectives, rather than a transactional approach.

In conclusion, we can surmise that the nature of relationships between superannuation funds and their external service providers are generally strong, monitoring costs are insignificant and there is no indication of a negative relationship between success and the length of relationship. This suggests that superannuation funds (or their asset consultants) are already following robust due diligence and monitoring processes and terminating contracts as required, minimising risk and increasing the benefit derived from the outsourcing arrangement.

Based on this study it would appear that the introduction of the SPS 231 will, in general, have little impact on the operations and processes of many not-for-profit funds. However, for those funds which do not already have written detailed contracts with investment outsourcing service providers, with specified service levels and committed resources for monitoring purposes, the new prudential standard may lead to a review of these functions and potentially a reduction in the number of investment managers. For larger funds this may lead to more in-house investment management, and for smaller funds provide yet another incentive for consolidation.

The research on which this brief article is based upon is reported in more detail in “Will  Prudential Standard SPS 231 Outsourcing reduce investment outsourcing risks in superannuation funds?” The research was conducted by Associate Professor Sarath Delpatchitra and Professor Deborah Ralston*.

Professor Deborah Ralston is the Executive Director of the Australian Centre for Financial Studies.

 

An Earnings Driven Market

Posted on March 4, 2013
Filed Under Publications, Research Review | Comments Off

John Fowler, Research Fellow, Australian Centre for Financial Studies

Martin Jenkinson, Research Officer, Australian Centre for Financial Studies

The Australian Centre for Financial Studies (ACFS), in association with ANZ Trustees, has developed an Australian Equities Database (AED) which contains monthly data of all major equity fundamentals.  The database presently reaches back to January 1948, with advanced plans to extend back to January 1926 and even possibly to 1900.  Both ACFS and ANZ Trustees are now collaborating with Sirca to establish the AED on a web server. The following article is based on data from the AED.

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Investors are faced with an enormous volume of data on which to base their investment decisions. Over the past year this pressure has been further increased by the extreme volatility of capital markets and the almost constant updates of (often contradictory) news regarding the global economy. Aside from the distraction of information overload, reflexive investment decision making can lead to sup-optimal returns due to overreaction, herd behaviour and/or representativeness bias. All of which raise the question of how to manage investment decision making – should the investment decision be based on longer term market and economic variables rather than the latest news headline?  And if we choose the former, what indicators should we use? This article investigates the relationship of equity returns with two fundamental variables over a period of just over 60 years, 1950 to 2012. The aim of this note is to report on our observations of these variables, interpretation of the results is left to the reader.

The first relationship which we review is the correlation between corporate earnings and the AED Price Index (PI). Our proxy for corporate earnings is the Gross Operating Surplus (GOS) of Private Enterprises as reported in the National Accounts. The nominal value of the GOS series has been converted to an index and then compared to the AED Price Index, both  standardised to the same base of September 1959 = 100.  The comparison between the two series’ is shown in Figure 1 and the growth by decades in the two measures is outlined in Figure 2.  Separate estimates indicate a correlation of 0.978.

      Figure 1:  Chart of the PI and GOS Indices                 Figure 2:  Annual Growth Rates by Decade  

The figures above suggest an overall strong relationship between reported corporate earnings and the pricing of equities.  Thus, a fundamental earnings relationship would seem to underlie the equity returns of a generally efficient market. However, significant variations from the underlying fundamental variable are also visible and these can last for protracted periods. A measure of this divergence is the ratio of the Price Index to the index of published earnings (GOS), as shown in Figure 3.  A generally positive bias in the ratio is noted, possibly suggesting behavioural influences similar to those mentioned in the introduction but this is beyond the purpose of this article.

 Figure 3:  Ratio of the AED PI to the Corporate Earnings Index 

 

 

 

 

 

 

 

 

 

As a second review of the apparent relationship between Earnings and Equity Prices, we tested the relationship of the AED Earnings per Share (EpS) series against the AED Price Index series for the same 60 year period. The AED EpS series for the total market is a weighted average of the EpS data presented in the AED tables.  As can be seen from Figure 4, there is once again a very high correlation between the two variables.

Figure 4.  Comparison of AED Price Index to AED average Market EpS 

 

 

 

 

 

 

 

 

 

 

The aim of this paper is general only, so deeper analysis of these apparent relationships has not been undertaken. However, it would seem clear from these observations that corporate earnings do indeed underlie equity pricing and thereby drive long-term capital appreciation in the stock market.

The second relationship which we note is between the stock market Price Index and growth in the money supply. Growth in the money supply has often been cited as being positively linked to capital appreciation and in the case of the “Greenspan Bubbles[1]” has also been blamed for major market crashes. The concept of money supply driving the capital appreciation of risky assets was immortalised in Walter Bagehot’s words “John Bull can stand many things but he cannot stand two per cent”.[2]  To map the relationship between the two variables we once again use the average market capital gain as measured by the AED Price Index, while growth in the money supply is calculated as an index using the M3 measure of money. Figure 5 shows that across the 60 year period of our review, average growth in the two variables was almost identical. However, the intra-decade relationship between the two was inconsistent. Growth in the money supply lagged market capital appreciation in the decades of the 1950s and 1960s but lead in all subsequent decades, particularly in the 1970s and 2000s.

Figure 5:  Comparison of Equity Price and Money Supply Growth, 1950 to 2012  

 

In the period commencing in the decade of the 1970s, average money supply growth (at 10.9%pa) has led average Equity capital appreciation (at 8.3%pa) by an average 2.6% pa for the 40+ year period.  Establishing a causative relationship between the two variables is complex but the data would seem to suggest that, contrary to popular belief, a high level of growth in the money supply does not necessarily equate to above average returns in the stock market.

Over the sixty year period reviewed both variables (Corporate Earnings and Money Supply) have grown at a similar rate to prices in the stock market.  Corporate Earnings have been shown to have a much more consistent relationship across this time-period. While the concept of earnings driving stock returns is not a new one, in times of volatility and fear, it can be easy to forget. So rather than focusing on the latest buzz stock metric or the latest shock news headline it may be worth remembering the words Benjamin Graham first wrote in 1949 and remain true today. “Price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.”

 

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Appendix: The ANZT-ACFS Australian Equities Database

Introduction

The Australian Equities Database (AED) is a multi-stage project with the potential to digitise past monthly equity data back to 1926 and possibly 1900. The aim of AED is to fill a large gap in the present provision of digitised Australian equity data which is scarce prior to 1980. The database will provide data on all listed stocks for the period across twenty different variables. The database is being built by the Australian Centre for Financial Studies in collaboration with ANZ Trustees and SIRCA.

The Australian Equities database is intended to become a valuable resource for:

• The evaluation of equities, portfolios and markets
• Testing the viability of long-term investment strategies
• Practitioners and academics seeking to conduct research on the characteristics of individual stock and sector behaviours across business cycles and during various macro-economic states.

Figure 1: Snapshot of the Australian Equities Database

 

 

 

 

 

 

 

 

 

 

 

 

Status

The database is in the development stage with data collection and implementation completed for the period 1948-2002.

 

Development

The database is currently undergoing improved usability, robustness updates and web access for users. It is expected that the database will provide users with data manipulation, portfolio construction and sector analysis tools. Development is also being undertaken to ensure that the database will also provide historical cash earnings data and price to cash ratios.

 

Going Live

It is expected that the database will go live for public use by the end of 2013 and will be available via the Sirca website: www.sirca.org.au

Australian Corporate Bonds – The missing asset class for retail investors

Posted on February 13, 2013
Filed Under Banking, Financial Institutions and Markets, Contracted Research and Consulting, Funds Management & Superannuation, Publications, Sponsorship Support | Leave a Comment

An independent report prepared for National Australia Bank by the Australian Centre for Financial Studies.

In partnership with NAB, ACFS is developing a five-part series of reports that explores Australian Corporate Bonds as an asset class and analyses the past, present and potential future of the Australian Corporate Bond market.

This first report in the series “Australian Corporate Bonds – The missing asset class for retail investors” provides a snapshot of the current state of the Australian Corporate Bond Market as well as an introduction into the mechanics of corporate bonds and the value they can add to a diversified investment portfolio.

What are bonds?
A bond is a form of debt instrument issued by a borrower, evidencing a promise
to make specifi ed coupon payments and repayment of the principal amount at
designated dates. Historically, when issued as paper certifi cates, holders would
collect interest payments by clipping off the relevant coupon attached to the bond
and presenting to the paying agent. Nowadays, as with equities, ownership of most
bonds is evidenced by electronic entries in a registry and interest payments are made
automatically to the registered holder.
Bonds are issued for a specifi ed face (or par) value, such as $100 and the coupon
interest paid as a designated percentage of that face value at specifi ed intervals.
Thus, if the coupon is fi xed at 6 per cent per annum, paid semi-annually, the interest
payments on $100 face value would be $3 every six months until the maturity date –
when the face value is due to be repaid.
Bonds can be traded (bought and sold) by investors at mutually agreed prices, such
that the original purchaser does not necessarily have to hold the debt until maturity.
As the promised future cash fl ows on such a bond are fi xed, an increase in market
interest rates after a bond has been issued will cause its market price to fall. So also
will an increase in the market’s perception of the issuer’s risk and ability to make the
promised repayments.
The coupon rate may alternatively be specifi ed as a fl oating interest rate which is
linked to, and varies in line with, some market indicator rate such as the Bank Bill
Swap rate in Australia. A Floating Rate Bond’s price is sensitive to market interest
rate movements, but the price can vary for other reasons such as changes in investor
concerns about default risk.
Bonds can be issued by governments, companies and other organisations. As the
issuer may default on the promised repayments, the coupon required to attract
investors will be higher for issuers perceived to be more likely to default. Similarly,
the lower expected recovery rate if default occurs, then the higher the required
coupon. One relevant factor is the seniority status of the bond relative to other
claimants against the issuer, as well as the extent to which a defaulting issuer is likely
to possess valuable assets which can be sold to meet the claims of creditors.

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

 

 

Australia’s Remittance Boom To Continue, But Country Lags In Partnerships To Improve Cost And Service With New Technology, Study Finds

Posted on December 1, 2012
Filed Under Banking, Financial Institutions and Markets, Contracted Research and Consulting, Media Release, Publications | Leave a Comment

ACFS cites untapped potential in market worth $7 billion and growing; ‘We’re missing a trick,’ ACFS says.

Sydney, Australia 28 November 2012 – Australia’s USD$7 billion plus remittance industry will continue to grow, driven by the influx of migrants, but the country has left untapped an opportunity to improve costs and services to consumers through collaboration within the financial services sector, according to a study released today by the Australian Centre for Financial Studies (ACFS).

The independent report, “Remittances: Their Role, Trends and Australian Opportunities”, was authored by the ACFS’s Research Director, Professor Kevin Davis, and Research Officer Martin Jenkinson, with funding support from Western Union.

Speaking at the launch of the findings today in Sydney, ACFS Executive Director Professor Deborah Ralston said: “This research is one of the most comprehensive reviews of the remittance sector in Australia to date. We looked at the extent of remittances, the structure of the industry, the emergence of new technologies and how trends in the sector were impacting developing and developed markets.
“There is considerable scope for greater collaboration between Australian deposit takers such as banks, credit unions and building societies with Money Transfer Organisations who have “money-in-minutes” transfer capabilities and a global network advantage. Partnerships could lead to increased usage and contribute to substantially lowering the cost of providing remittance services – thereby reducing cost for consumers and increasing revenue for service providers.

“Given that 70% of remittances go to developing countries and form a significant part of the income of those nations, there is strong public interest as well as sound commercial reasons for greater collaboration between banks and traditional money transfer organisations to reduce the cost of transactions,” said Professor Ralston.
Western Union’s President and Chief Executive Officer, Hikmet Ersek, was on a visit to Sydney and said at the launch of the study: “This research highlights the enormous opportunity for Australian banks across what is now a $7 billion industry.

“Australia has led the way for decades in leveraging the benefits of immigration – long-term and short-term, which is driving prosperity at home and improving the financial and social economies of developing countries, particularly within the APAC region.

“Remittances within the Asia Pacific region continue to increase as a result of strong GDP growth and an aging population. And with more than two billion people in the world with limited or no access to banking services, the potential for the banking sector to diversify traditional revenue streams and access untapped markets is substantial.
“In the past three years, remittances via Western Union within the APAC region grew over four times faster than the rest of the world.
2.

“Our business lies at the nexus of cash, technology and globalization and we are already bringing together these forces by working with banks and other financial sector players around the world to facilitate affordable financial access with convenience,” said Mr Ersek.

Professor Ralston concluded: “The Australian banking sector has the opportunity to expand its reach and revenue potential by merging its technology with, and drawing on the significant resources of, MTOs to expand services beyond its traditional national borders, particularly to those countries at the nation’s door-step.”

ACFS estimates the direct contribution remittances make to Australian GDP to be in the range of AUD 336 million AUD 588 million per annum.

Key Research Report highlights:

GLOBAL WORKER TRENDS/COST

• The increasing globalisation of the work force means that many more millions of people are leaving their home countries to work abroad. For these individuals, convenient and fast access to international remittance services is important to support their families at home, particularly families in rural or less developed areas.
• The high fees faced by migrants and others for making remittances have been an issue of concern for policy makers both in Australia and internationally. There is greater scope for fee reductions through policies which address impediments to lowering resource costs incurred by remittance providers.

AUSTRALIAN BANKS

• Australian banks transmit the majority of international remittances through the SWIFT network in the form of transfers from one bank account to another and as international bank drafts, with funds delivered within a timeframe of one to three days. These remittances require a customer to have a bank account during the whole or part of the transaction cycle.
• They also do not serve consumers, including their own account holders, who require end-to-end service to areas unserved or under-served by banks, or who need to send cash to recipients virtually instantaneously.

MONEY TRANSFER OPERATORS

• Specialist money transfer operators (MTOs) such as Western Union, MoneyGram, and a large range of smaller institutions and informal operators have developed the networks, technology, and skills to provide virtually instantaneous transfers of funds between individuals in disparate parts of the globe, including rural and less served areas.
• MTOs lead transfers where the principal for remittances in the USD 1,000 to USD 5,000 range. Remittances higher than USD5000 are normally conducted through banks. Providing service at lower levels particularly in countries with poor financial services infrastructure is a resource-intensive and costly activity that banks have been unwilling or unable to replicate.

REGULATION

• The Australian Government has taken a global leadership position in its response to the perceived risk of remittance transfers with the recently strengthened Anti-Money Laundering and Counter-Terrorism Financing Act (2006 – section 6).
• The more stringent reporting and registration requirements coupled with the public availability of the register and enforcement of digressions suggest that Anti-Money Laundering and Counter-Terrorism Financing risks associated with compliant remittance service providers have been significantly reduced as a result of AUSTRAC’s actions.
• But greater regulation has another consequence. It contributes to remittance costs, and so may inadvertently prevent development of more efficient practices and processes.

Media contact details:

Prof Deborah Ralston

Executive Director

+61 3 9666 1010;

+61 419 650 318

deborah.ralston@australiancentre.com.au

www.australiancentre.com.au

Pia De Lima VP

Corporate Communications

Western Union Asia Pacific

+852 9261 8155;

pia.delima@westernunion.com

About the Australian Centre for Financial Studies

The Australian Centre for Financial Studies (ACFS) facilitates industry-relevant and rigorous research, 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 as an international centre for finance practice, research and education.

For more information visit: www.australiancentre.com.au

About Western Union

The Western Union Company (NYSE: WU) is a leader in global payment services. Together with its Vigo, Orlandi Valuta, Pago Facil and Western Union Business Solutions branded payment services, Western Union provides consumers and businesses with fast, reliable and convenient ways to send and receive money around the world, to send payments and to purchase money orders. As of September 30, 2012, the Western Union, Vigo and Orlandi Valuta branded services were offered through a combined network of approximately 510,000 agent locations in 200 countries and territories. In 2011, The Western Union Company completed 226 million consumer-to-consumer transactions worldwide, moving $81 billion of principal between consumers, and 425 million business payments.

For more information, visit: www.westernunion.com

 

 

 

 

Will Draft Prudential Standard SPS 231 Outsourcing reduce investment outsourcing risks in superannuation funds?

Posted on October 3, 2012
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By Sarath Delpachitra* and Deborah Ralston**

Abstract

The Australian Prudential Regulation Authority (APRA) is soon to implement, Draft Prudential Standard SPS 231 Outsourcing, designed to improve the management of outsourcing risk in superannuation funds and harmonise such regulation with that of banks. Superannuation funds will receive more attention than banks in this regard, however, given the extent and prevalence of outsourcing to related parties in the superannuation industry and the resulting potential for increased risks. The purpose of this paper is to examine the likely impact of the legislation given the nature of outsourcing relationships in Australian not-for-profit superannuation funds, in terms of three factors identified in the literature, that is relationship type, length of relationships, and monitoring costs. Responses to a survey of 26 superannuation funds are analysed to determine whether these factors have a bearing on the success, and consequently risk, of investment outsourcing with asset consultants, investment managers and custodians. The study finds little evidence to support the relevance of these factors, although relationship type was found to be significantly related to success in funds’ relationships with their asset consultants. This may well be due to the complex shared decision-making involved in this function.  The lack of significance found between success, and length of relationship and monitoring costs suggests that funds are managing their outsourcing relationships well, monitoring them effectively and terminating contracts when required. It might be expected, therefore, that the new prudential standard will have little impact on outsourcing in not-for-profit funds.

Introduction

Outsourcing in financial institutions imposes a significant set of accountability and risk issues for management. As the Federal Reserve Bank ofNew York(1999) and the Bank of International Settlements (2005) point out, while outsourcing means that direct managerial responsibility for the activity is transferred to a third party provider, accountability for the function is retained by the financial institution.

Regulation of outsourcing risks in Australiais soon to be harmonised for banks and Registrable Superannuation Entities (RSEs) under the Draft Prudential Standard SPS 231 Outsourcing, released by APRA in April 2012. This Prudential Standard, which is one of 12 to be enacted on superannuation funds, covers the need for a formal outsourcing policy and risk management strategy, minimum requirements for outsourcing agreements, and due diligence and on-going monitoring requirements. As the APRA Discussion Paper (2011) points out, more attention will be paid in these standards to aspects of outsourcing in superannuation funds than is the case with banks, given the extent and prevalence of outsourcing to related parties in the superannuation industry and the resulting potential for increased risks.

Outsourcing is widespread in Australian superannuation funds across a range of functions, specifically actuarial services, administration, asset consulting, auditing, custody, legal services, sales and marketing and investment services. In a recent APRA study of 115 of the larger Australian superannuation funds, each outsourced at least one function, and nearly two-thirds outsourced six or more. Not-for-profit funds are more likely than retail funds to outsource. Of those that outsourced the investment management functions of asset consulting, investment management and custody, almost all used only one provider for asset consulting and custody, but around half contracted more than 10 investment managers. Consequently, selecting, monitoring, managing and remunerating service providers have become major functions of trustees (Lui and Arnold 2010a).

Given the widespread use of outsourcing in the industry and the impending prudential standard, this paper presents the result of a survey of 26 not-for-profit super funds, which examines the nature of the relationship between funds and their asset consultants, investment managers and custodians.  This survey provides some insight into how super funds work with investment service providers. In light of these relationships, the likely impact of Draft Prudential Standard SPS 231 is discussed.

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 * Sarath Delpatchitra is an Associate Professor of Finance at Flinders University.

** Deborah Ralston is a Professor of Finance at Monash University and Executive Director of the Australian Centre for Financial Studies.

† The paper is the outcome of a collaborative project between AIST and ACFS. The authors would like to thank Prof Kevin Davis of ACFS and Tom Garcia of AIST for their valuable comments.

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Download the Full Paper Here

What do Dividend Reductions imply?

Posted on September 26, 2012
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La Trobe University’s Balasingham Balachandran assesses the information content of dividend reductions in an Australian context. By excluding firms that use dividend reductions to repurchase shares from the sample, the study may solve a long-standing contradiction between theory and empiricism. The paper also finds that the information content provided by dividend reductions must be interpreted on a country specific basis.

What is the information content of dividend reductions of Australian firms? What do they tell us about future earnings?

These questions have been extensively addressed in theUSand research has produced two apparently contradictory stylised facts: one, the belief that dividend reductions have information content; and two, the empirical evidence that seems to contradict this belief.  Available research documents significant negative price reactions to the announcement of dividend decreases and omissions, but there is generally a lack of empirical support for a decline in earnings subsequent to dividend decreases and omissions.

The Australian situation differs from theUSin two aspects which may give rise to different results. First, in theUS, dividends are paid on a quarterly basis, the amount of dividend paid each quarter being equal. InAustralia, most firms pay dividends twice a year, with relatively smaller amounts paid at the interim (first half yearly) and larger amounts at the final level (second half yearly). Since interim dividends are declared and paid prior to the availability of the annual accounting results, the amount of information available to investors at this earlier stage is less than that available when the final dividend is paid. Second, an imputation tax system operates inAustraliawhere Australian companies provide resident shareholders with franking credits for company tax paid inAustraliathat can be used to offset their personal tax on dividend income.

Our research addresses these questions by focussing on dividend reductions which are not associated with contemporaneous share repurchase activity. We exclude cases where repurchase activity exists because US studies have found that some managers would use savings from dividend cuts to finance repurchases (which grew substantially at the expense of, and as a substitute for, dividends in recent decades). Surprisingly, US studies of dividend decreases have not controlled for this factor.

Following prior literature, we empirically examine the information content of dividend decreases and omissions of Australian firms by comparing performance against their peers. We do this by matching them with firms in the same industry with similar prior performance  and similar market to book ratios. Abnormal earnings (ie earnings relative to peers) are negative during the year of, and for around three year after the announcement of dividend reductions. In contrast, we find insignificant abnormal earnings when we look at companies making dividend reductions and contemporaneously engaging in repurchasing activity, hence emphasizing the need to avoid contamination of results from including firms reducing dividends to enable use of cash savings to repurchase stock. Our results are robust when we use abnormal operating performance instead of abnormal earnings.

The reduction in franking credit or franking status of a dividend or the timing of dividend payments (interim or final) does not have any significant relationship with future earnings. However, we find that while the tax status of the dividend does have a significant impact upon size of the dividend reduction, it has no relationship with future earnings and thus does not provide any information content.

We also find that dividend reductions are associated with negative stock price reactions and that the magnitude of the price reaction is negatively related with the percentage of the dividend reduction and the reduction in franking credit. The market reacts more aggressively to interim dividend reductions than to final dividend reductions.

Firms that pay franked dividends may reduce their dividend if there are insufficient imputation credits to pass on in comparison with the previous year’s level, even in situations where the management does not expect earnings to decline in future years. However, as a result of the tax preference for dividends of Australian resident investors, managers will be reluctant to reduce the franked dividend too dramatically. We find that, the higher the degree of franking prior to the dividend reduction, the lower the size of the dividend reduction which is consistent with management’s reluctance to reduce dividends as enhanced by tax preferences.

Overall, our study demonstrates that dividend reductions that are not associated with share repurchases do have “information content,” that is, they provide (negative) information regarding future earnings. This evidence shows that conditioning on repurchasing status has important implications for the information content of dividends. This demonstrates that the information content of dividends depends upon institutional features that vary internationally and focusing solely on US data restricts the external validity of empirical studies on information content of dividends.

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This work is based on the paper accepted for publication at the Journal of Corporate Finance: Balachandran, B., Krishnamurti , C., Theobald, M., Vidanapathirana , B. 2012. Dividend reductions, the timing of dividend payments and information content, Journal of Corporate Finance, http://dx.doi.org/10.1016/j.jcorpfin.2012.08.002. The research was funded by a grant from the Australian Centre for Financial Studies.

Balasingham Balachandran was a recipient of the 2007 and 2008 Australian Centre for Financial Studies Academic Research Grants based on submissions, Rights Offerings, Renounceability Underwritten Status, Ownership Structure and Liquidity and Dividend Reductions and Signalling in an Imputation Environment respectively.

Bank Ratings: Sources of Difference

Posted on September 26, 2012
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Emawatee Bissoondoyal-Bheenick of Monash University and Sirimon Treepongkaruna of the University of Western Australia examine the determinants of credit ratings for banks in Australia and the United Kingdom. The paper responds to the post-GFC criticism of credit rating agencies by exploring the difference in methodologies used by the agencies to determine ratings and to what extent the ratings are based on publicly available quantitative factors.

The recent Global Financial Crisis (GFC) has focused attention on the integrity of rating agencies and the information value of the ratings they assign. Our research[1] examines the questions of: what are the determinants of credit banks ratings; how do they differ across ratings agencies; and are there any inter-country difference in application?

 Analyzing ratings by Standard & Poor’s, Moody’s, and Fitch for UK and Australian banks, we find that:

1. Quantitative factors that reflect asset quality, liquidity risk, capital adequacy and operating performance are the key determinants of bank ratings across the rating agencies;
2. Macroeconomic variables and market risk factors do not seem to be contributing factors in explaining bank ratings for both countries; and
3. The apparent weightings given to the different quantitative factors differ both across countries and between the ratings agencies. For example, the results indicate Fitch have more reliance on performance ratios as compared to Moody’s and Standard and Poor’s. Further the results across the two countries indicate that Fitch modeling place more weight to macroeconomic factors in Australia as compared to the UK, Similarly, the total capital ratio is more relevant for bank ratings in Australia rather than the UK. This is across both Standard and Poor’s and Fitch.

As well as providing investors with summary measures of default risk of securities issued by banks, and thus affecting the cost of bank funding, changes in bank credit ratings have other important implications for banks. For example, banks suffering downgrades must provide substantially increased collateral to counterparties. And even though regulators have attempted to reduce emphasis in bank capital requirements on ratings, they are still an important component of Basel III.

We model the quantitative determinants of banks ratings over the period 2006-2009. We evaluate ratings determinants across two key world markets,UKandAustraliaby the top three rating agencies: Standard & Poor’s, Moody’s and Fitch. We provide forecasts of ratings from our quantitative model to assess how accurately ratings can be predicted using only publicly available, quantitative information.

 The categories of ratings considered in this study include foreign currency as well as local currency ratings from the three rating agencies with AAA being the highest investment grade ratings and D representing default. We separate our study by focusing an individual rating categories (that is we have 21 rating grades to consider, where each rating represents a numerical grade) as well as broad rating categories (that is we have 9 categories that is , AA+, AA and AA- are considered as one category of rating). The modeling framework we use is the ordered response “probit model”

The main finding of the study is that quantitative measures are only a part of the input into bank rating decisions. On average, asset quality ratio, liquidity ratio, capital adequacy and operating performance measures are the key inputs to the determinants of ratings. The market risk factors and the macroeconomic factors (GDP, inflation) do not seem to have the same impact on bank ratings. Quantitative measures, as focused on in our study, provide information on the historical performance and on banks’ fundamental structural features.

 One reason why these measures do not tell the whole story is that examination of past experience has to be supplemented by medium-term projections and by the construction of scenarios that will include financial situations that could occur after various shocks to the financial system. That may help to explain why there are differences in the relative importance of the quantitative factors studied across the two countries as mentioned above.

We then consider how accurately we can predict bank ratings using the quantitative publicly available data. The forecast works better for the short-term ratings than the long- term ratings across the three rating agencies. For the long- term ratings, approximately 50 percent of the discrepancies are a one-notch or two-notch difference. . These results substantiate what the rating agencies cite as being the determinant of bank ratings; the assignment of ratings is not a purely quantitative analysis but involves a number of qualitative factors that should be taken into consideration.

What does this research imply? Basel III strengthens bank capital requirements and introduces new regulatory requirements on bank liquidity and bank leverage as well as highlights the important role that the credit rating agencies will have to play in the future. In Basel II one of the principal factors of financial risk management was out-sourced to companies that were not subject to supervision: credit rating agencies. Ratings of creditworthiness and of bonds, financial securities and various other financial instruments were conducted without supervision by official agencies. The proposals of new Basel III requires that rating agencies need to pay particular attention to the banks ratings that they provide given that the committee  has assessed a number of measures to mitigate the reliance on external ratings of the Basel II framework. The measures include requirements for banks to perform their own internal assessments of externally rated securitisation exposures, the elimination of certain “cliff effects” associated with credit risk mitigation practices, and the incorporation of key elements of the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies into the Committee’s eligibility criteria for the use of external ratings in the capital framework. As such when providing bank ratings, rating agencies need to be very cautious as they do not want to be subject to criticism again.

Our study indicates that the capital adequacy and liquidity measures are key determinants of banks ratings. However, the Tier 1 ratio does not seem to have the same significance as the total capital ratio used in the analysis ( this is the case for bothUKandAustralia). A possible explanation could be because the rating agencies do not reveal the weight assigned to these key inputs in the determinants of the model. With the changes to come in the future, it seems that rating agencies weighting on Tier 1 capital should be reasonably high to be able to provide accurate bank ratings. Another observation in this study is that while liquidity ratios are significant, the importance that liquidity factor plays seems to be more pronounced inUKrather thanAustralia. This can be possibly because of the difference in the definitions used by regulators inUKandAustralia. While our study indicates that the focus, definitions and weights assigned by the rating agencies may be different, bank ratings, will remain a key area of concern for regulators and players in the financial market.

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This work was based on the paper An Analysis of the Determinant of Bank Ratings: Comparison Across Ratings Agencies. The research was funded by a grant from the Australian Centre for Financial Studies and can be accessed via An Analysis of the Determinant of Bank Ratings: Comparison Across Ratings Agencies.

Emawtee Bissoondoyal-Bheenick and co-author Sirimon Treepongkaruna were recipients of the 2009 Australian Centre for Financial Studies Academic Research Grants based on the submission, Determinant of Ratings in Banking and Financial Industry.

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For more information regarding the study please contact Emawtee Bissoondoyal-Bheenick

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There is something about capital structure arbitrage

Posted on September 26, 2012
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Vincent Xiang, Michael Chng and Victor Fang of Deakin University investigate a well-known trading strategy amongst the hedge fund and algorithmic trading community known as Capital Structure Arbitrage. The investigation identifies some interesting relationships between the equity and credit default swap markets and how their divergence from equilibrium may provide price discovery information and present profitable trading opportunities.

Section 1: Introduction

With the rapid growth in the credit default swap (CDS) market, a pairs-trading type strategy known as capital structure arbitrage (CSA) has become increasingly popular among hedge funds and bank proprietary trading desks. It is also a well-known convergence strategy in the algorithmic trading community. CSA is essentially designed to exploit pricing discrepancies between a firm’s equity and debt value relating to credit risk.

The structural credit risk pricing of Merton (1974) views equity as a call option written on the firm’s assets, with the probability of non-exercise equivalent to the probability of default. Hence default risk information is embedded within firm’s stock prices, with an increase in default risk causing (ceteris paribus) a reduction in stock price. Meanwhile, the CDS spread provides an observable price for the firm’s default risk. Thus, a negative relationship should exist (cet. par.) between the CDS spread and equity price.

In Figure 1, we plot the cross-sectional average CDS spreads (CDS_t) and stock prices in Panels A and B respectively for a sample of 174 U.S investment-grade firms between Jan-2005 and Dec-2009. The graphs show an evident inverse co-movement between CDS_t and equity prices, which suggests a strong credit risk pricing information linkage between the CDS and equity market.

Figure 1: Cross sectional average of CDS spreads and stock prices

Using the CreditGrades[1]model, we extract a time-series of implied credit default spreads (ICDS_t) from stock prices, which constitute the price of credit risk that is perceived by the equity market. This implied price is directly comparable with the observable CDS_t. Hence, an economic link exists between CDS_t and ICDS_t  in equilibrium, such that they are a cointegrated time series. That is, they tend to move, and be pulled, together over the long run, but can deviate from each other in the shorter run.

The rationale behind CSA is to simultaneously set equity and CDS positions to capture short-run divergence between CDS_t and ICDS_t that is expected to converge in the future due to their inherent economic link in equilibrium. While similar in nature to pairs-trading, CSA avoids the controversial issue of identifying appropriate pairwise stocks. This is simply because CDS_t and ICDS_t are indicators of the same firm’s credit risk.

Section 2: CSA in action

In Figure 2, we plot the cross-sectional average CDS_t and ICDS_t for our firm sample. We extract individual firm’s ICDS_t from the CreditGrades model, which is a benchmark model used by the credit risk industry.

Figure 2: Cross sectional average of CDS spreads and ICDS

A substantial divergence between firm’s CDS_t and ICDS_t indicates credit risk mispricing between the CDS and equity markets. However, their equilibrium link implies that CDS_t and ICDS_t are expected to converge in the future. CSA trading algorithms are essentially designed to profit from the above scenario.

However, the CSA trading algorithms employed in previous studies (such as Yu (2006)) suffer from various limitations in practice. The poor convergence rate (of CDS_t and ICDS_t) and typical delta-hedging approaches for capital allocation between CDS and stocks are arguably two major weaknesses that require further attention. In our CSA research project, we improve on these two aspects of CSA, which we argue will vastly enhance the profitability that the strategy has to offer.

Section 3: Our CSA trading algorithms

Our trading algorithm incorporates both long-run credit risk pricing relation and short-run credit risk price discovery between the CDS and equity markets. Modelling the long-run pricing equilibrium relationship reinforces the co-movement of the two markets so that any divergence is transitory and is expected to converge. Modelling the short-run dynamic pricing adjustments allows us to identify which market is causing the mispricing that generates the initial divergence. This intuitively suggests that it should also be the same market that we will allocate more capital towards.

We then examine and ascertain the price discovery process between CDS_t and ICDS_t. Based on this we form risk-arbitrage positions. This is how it works. If the CDS market leads the price discovery process, the stock market would be forced to clear the pricing disequilibrium, and vice versa. If there is a bi-directional price discovery process, both markets would jointly adjust on the path to equilibrium. Based on the above, we can classify the price discovery process into the following scenarios: (i) the CDS market solely dominates in the price discovery process (C1), (ii) the CDS and equity markets both jointly contribute to the credit risk price discovery process (C2). (iii) the equity market solely dominates in the price discovery process (C3). Thus, we can form arbitrage positions as follows, where the α term in the “signal” is to ensure the temporary mispricing between the two markets are relatively sufficient.

The positions are then liquidated when the initial divergence is removed ie the CDS_t and ICDS_t are back in equilibrium.

Section 4: The value of CSA in the current trading environment

Our research shows that CSA trading performance can be enhanced by improving the accuracy of CDS_t extraction and appropriate allocation of investment capital between the CDS and stock positions based on their relative credit risk price discovery contribution. There is a significant improvement in the convergent trade and the proportion of trades close at convergence reaches almost 91%.[2]

Our overall strategy generates a mean holding period loss of -0.25% ie for trades on all C1, C2 and C3 firms. However, the mean holding period return for C1 firms only is at 0.15%. The outperformance of trading C1 firms is also evident in terms of profitability. On average, we expect 42 days for the divergent prices to revert. But for C1 firms, the mispricing requires only 36 days to converge. In contrast, it takes 41 (54) days for price divergence on C2 (C3) firms.

Section 5: Conclusion and recommendation for fund managers and investors

Capital structure arbitrage is built on the premise that the law of one price prevails across the CDS and equity markets. The strategy’s implementation requires a comprehensive knowledge about credit risk information dynamics between the two markets. The long-run credit risk pricing equilibrium relation establishes the necessary condition that diverging prices would eventually converge, and the short-run price discovery mechanism incorporates the adjustment process on the path to convergence. By incorporating the cross-market credit risk information dynamics into the trading algorithm, a CSA trader can reduce the risk of non-convergence, as well as risk of severe capital losses. We show that profitability is enhanced by allocating capital conditional on the relative credit risk price discovery role of the CDS and stock markets.

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[1]The CreditGrades model is jointly developed by four leading institutions in the credit market, including RiskMetrics, JP Morgan, Goldman Sachs and Deutsche Bank. As stated in the CreditGrades technical document, “The purpose of the CreditGrades model is to establish a robust but simple framework linking the credit and equity markets.”

[2] We also replicate previous CSA trading algorithm of Yu (2006). However, the vast majority of positions fail to converge. This result contradicts the concept of CSA that is designed to profit from convergence of temporary mispricing. Similar non-convergence risk are reported in Yu (2006).

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References

Finger, C. C., V. Finkelstein, J.-P. Lardy, G. Pan, T. Ta and J. Tierney (2002). CreditGrades Technical Document, RiskMetrics Group.

Merton, R. C. (1974). “On the Pricing of Corporate Debt: the Risk Structure of Interest rates.” Journal of Finance 29(2): 449-470

Yu, F. (2006). “How Profitable Is Capital Structure Arbitrage?” Financial Analysts Journal 62(5): 47-62.

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The research on which this brief article is based is reported in more detail in “There is Something about Pairs-Trading”. The research was funded by a grant from the Australian Centre for Financial Studies.

Vincent Xiang and co-authors Michael Chng and Vincent Fang were recipients of the 2005 and 2006 Australian Centre for Financial Studies Academic Research Grants based on submissions, Understanding the Risks in and Rewards for Pairs Trading and A Heuristic Approach to Asian Hedge Fund Allocation respectively.

To read the full paper please contact Vincent Xiang

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Financial Crisis Management – Power and Accountability

Posted on September 17, 2012
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Funds Management & Superannuation, Insurance, Media Release, Policy, Publications | Leave a Comment

FRDP 2012-5
September 17, 2012

The Australian Treasury released a consultation paper on September 12, 2012 canvassing views on a wide range of proposals to improve the power of the prudential regulator (APRA) for dealing with regulated financial institutions at risk of failure. Some of the changes involve harmonization of powers across the different categories of regulated institutions, but others involve quite substantial increases in APRA’s power. While appearing generally warranted (and reflecting international developments and standards), there is no attention paid in the consultation paper to the necessary links between power and responsibility. The proposals give APRA significant discretion to use available powers, but are silent on the question of accountability and performance appraisal for decisions made about such use.

The Global Financial Crisis identified a range of problems in the failure management and resolution powers of financial regulators globally. While Australian regulators were not confronted with the need to manage the exit of failing or failed prudentially regulated institutions (banks or other ADIs, insurance companies, friendly societies, superannuation funds), the international experience focused attention on whether APRA’s powers were adequate. With the development of international standards against which national financial systems will be judged, and the need for international regulatory coordination in dealing with complex institutions operating across national borders, appropriately strengthening APRA’s powers has become important.

Legislative changes in recent years have addressed a number of shortcomings in APRA’s powers[1], but many more changes are signaled in the Treasury consultation paper issued in September 2012.[2] While those changes are presented as “Strengthening APRA’s Crisis Management Powers”, and undoubtedly relevant to dealing with (or preventing) a financial crisis, they relate primarily to actions which APRA can take in dealing with any individual troubled financial institution under its regulatory radar.

The proposed changes involve some degree of harmonization of powers across the range of institutions supervised and also aim to ensure consistency and clarity between various pieces of sector-specific legislation and more general legislation such as the Corporations Act 2001. They address, inter alia, issues such as APRA’s powers to give binding directions, appointing external managers to troubled institutions, and ultimate resolution/wind-up powers including compulsory transfers of business.

No doubt there will be many concerns expressed about the expansion of regulatory powers, although two aspects of the changes should be noted. First, they only apply to prudentially regulated institutions. Second, they generally relate only to actions which APRA might take when such an institution is perceived to be in financial distress (or worse), when APRA needs to take actions to protect the interests of those stakeholders for whom the imposition of prudential regulation is designed to protect. While those limitations are consistent with and enhance APRA’s ability to meet its responsibilities there are some wider ranging consequences worthy of note.

One issue is that the regulated institutions involved often undertake a much broader range of activities than those giving rise to prudential stakeholder-protection concerns. Those activities may be undertaken through a wide range of business organizational and legal structures which, in principle, suggests that institutions wishing to shift other activities outside of the regulatory yoke could do so by appropriate structuring of their business arrangements.

However, while it may be only the continuity or safety of particular economic functions or financial products and services which prudential regulation seeks to achieve, it is ultimately the institutions involved whose failure threatens that objective which must be regulated and supervised. And whereas the original focus of prudential regulation was “micro” oriented on safety of individual institutions, greater emphasis is now being given to risks to systemic stability from spillovers and interrelationships due to financial institution failures.

One feature of the proposed changes is to extend APRA’s failure management powers to the broader group of which a regulated institution is a part. This encompasses non-operating holding companies (NOHCs) which have a prudentially regulated institution as a subsidiary, as well as subsidiaries of a prudentially regulated institution.

The application of powers to the broader group reflects both the potential for conflicts of interest between group members which can create impediments to speedy and successful resolution, when part of the group is in financial distress, as well as the potential for spillovers and contagion between members of the group. Notably, however, there is no discussion of whether there might be merit in prescribing limitations on allowable group structures (and interrelationships) involving prudentially regulated institutions which could influence how such failure management powers might best be designed and expanded.[3]

A second consequence of the proposed changes is that while they relate to APRA’s powers in dealing with a failing institution, stakeholders (shareholders, investors, customers etc) will take the potential of future APRA actions into account in current dealings with any (currently robust) regulated institution. Because APRA’s powers involve decision making which affects allocation of losses and wealth transfers in a failing institution, this can be important in determining the terms on which stakeholders will deal with any institution where there is some future risk of failure. Where such decisions involve discretion (rather than application of pre-determined rules) they can impose an additional source of risk for potential stakeholders.

A third consequence relates to that discretionary nature of APRA’s powers. Discretionary power should be accompanied by accountability and performance assessment to determine whether those powers have been used appropriately. At the broad level, the prudential regulator can make two types of errors – failing to identify and act early enough in the case of a troubled institution, or wrongly identifying a sound institution as troubled and imposing unwarranted interventions on its activities. At a more specific level, reallocations of wealth and social costs associated with resolution of a failed institution should be subject to public purview – at least after the event.

There is no real discussion in the consultation paper of how such accountability is to be achieved, nor of the availability of information to be provided. Clearly, speed and secrecy are important in dealing with a troubled financial institution (and underpin the proposals to provide some relief from continuous disclosure obligations of ASX-listed financial institutions which are in financial distress and with which APRA is dealing). But ex-post disclosure of the processes, terms and conditions involved in final resolution of a failed institution should be mandatory.

Similarly, there is no discussion of the extent to which rules might be preferable to discretion in some circumstances. For example, APRA can appoint a statutory manager to an ADI if it considers that it “may become unable to meet its obligations; may suspend payment; or it is likely that the ADI will be unable to carry on business in Australia consistent with the interests of depositors or financial system stability in Australia”. This involves a judgment call on the part of APRA, which must be based on information available to it, and which could lead to either forbearance (about which much discussion occurs in the US context) or premature intervention (which may be more likely in Australia) by the regulator.

Such uncertainty over regulatory response is likely to influence managerial decision making within regulated financial institutions which are at risk of becoming financial distressed. Whether requiring APRA to undertake such actions when certain pre-specified, verifiable, triggers (such as some significant breach of minimum capital requirements) would have preferable effects on decision making in regulated institutions is worthy of further consideration.

There are many legal issues and matters of detail associated with the proposed changes to APRA’s crisis management powers which will elicit comment and response. How those powers will be applied in practice (albeit hopefully rarely), what are the implications for management decision-making and incentives in regulated institutions of the discretion provided to APRA, and how performance of APRA in implementing those powers is to be judged are also issues worthy of more detailed analysis.

This FRDP was prepared by Kevin Davis, Research Director, Australian Centre for Financial Studies.
info@australiancentre.com.au

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Britain’s Banking Reforms – Is this the future shape of Banking?

Posted on September 10, 2012
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Funds Management & Superannuation, Media Release, Policy, Publications, Research Review | Leave a Comment

FRDP 2012-4
September 10, 2012

The recent British White paper^[1] presenting Government plans, based on the 2011 Vickers Report^[2], for reforming British Banking involves radical and far reaching changes. They will, no doubt, be opposed by banks (to whom the private cost is estimated in the White Paper at being between four and seven billion pounds p.a.). But the global political and ideological tide has swung sufficiently away from a more laissez faire approach towards banking that it would be surprising if they were not largely implemented, and could be a fore-runner to likely developments elsewhere.

The proposed retail bank ring fencing reforms of the British Government are based on two general premises prompted by experiences in the Global Financial Crisis. First, the excessive complexity and interdependencies between large financial institutions have led to inadequacies in bank risk management and supervisory capabilities, and to systemic financial stability, problems. Second, implicit government guarantees (particularly of large systemic financial institutions) have been shown to exist and have created costs to taxpayers and distorted competition. In that latter regard, the Bank of England estimated in 2010 that the implicit government subsidy to major UK banks was over 100 billion pounds (although some other studies using different approaches have generated lower estimates).^[3]

In dealing with these problems, the UK Government has faced the “British dilemma” of wanting to maintain “The City” as a pre-eminent international financial sector while reducing the exposure of the taxpayer (and the economy) to adverse events emanating therein. Some form of structural or operational separation between “utility” and “casino” banking (as commercial and investment banking are sometimes described) is one solution, and finds reflection in the UK proposals for “ring fencing” of retail banking activities.^[4]

Other key elements of the plan include:

• increasing bank resilience by requiring much increased capital requirements (or Primary Loss Absorbing Capacity, PLAC) than implied by Basel 3 for some institutions
• introduction of a “bail-in” tool giving regulators the power to impose losses on certain bank creditors before the point of insolvency is reached
• Depositor preference for insured depositors (and the Financial Services Compensation Scheme (FSCS), should it pay out insured depositors)

Retail Ring-Fencing

Ring-fencing is designed with the objective of not limiting the range of activities which a financial group can undertake, but requiring a structure which prevents weaknesses in one part of the organization spilling over into another part which undertakes a specific designated set of activities. Those latter activities are taking deposits from, and providing payments services to, retail and small business customers, and the first ring fencing component involves mandating that only ring-fenced banks can take such deposits.

The second component involves identifying what activities the ring-fenced bank can and cannot undertake. On the funding side, raising debt funds in wholesale markets or (to some limited degree) from other members of the group are permitted. On the asset side, the only, but significant, restriction on lending is to other financial institutions (including group members). Dealing in securities and derivative markets or trading activities, and creation of exposures to other financial institutions, are not permitted except where necessary for managing liquidity, or risk associated with provision of simple risk management products to customers, and provision of payments services.

The third component relates to governance and legal structure. The ring-fenced bank board is required to have at least 50 per cent of independent directors. It is required to be a separate legal entity within the group, with “economic independence” from the remainder of the group and should be able to achieve operational independence if separation is required.

Bail-in Powers

Bail-in powers, which would apply to all banks, differ from requirements for banks to issue contingent capital. The latter are hybrid securities with contract terms which involve mandatory conversion to equity upon certain specified “triggers” being met. Legislating for a bail-in tool (which has been supported by the G20 endorsement of Financial Stability Board proposals) involves giving regulators the power and discretion to determine that the value of certain liabilities of a troubled bank should be written down (or converted to equity) in order to prevent its insolvency and (hopefully) enabling continued operations. Such legislation involves potential alterations to strict seniority rules, since secured debt, insured deposits, commercial claims, and very short term liabilities may be excluded.

Depositor Preference

The introduction of depositor preference also affects the seniority of claims and the consequences of a closed resolution of a troubled bank. Under insured depositor preference, the FSCS stands in place of the depositors it has paid out, and thus has first claim ahead of other creditors on the remaining bank assets. This seniority, and consequent increased recoveries, means that the likelihood of having to impose levies on other banks (and possible contagion that may cause) is reduced. It should, in principle, also increase the monitoring and risk sensitivity of other creditors to the bank.

It is worth noting that this type of arrangement already exists in Australia, with depositor preference (although for all, not just insured, depositors) having been a long-established policy and with APRA standing in place of compensated depositors of a failed bank under the Financial Claims Scheme.

Primary Loss Absorbing Capacity (PLAC)

The British plans are for both ring-fenced banks and G-SIBs to be required to have PLAC of 17 per cent of risk weighted assets. This is substantially above the Basel III minimum requirements, but includes long-term unsecured debt which can be “bailed in”.

 

An Assessment

The British proposals can be assessed on a number of criteria, including effects on banking sector competition, financial stability, economic efficiency, effectiveness of regulation, and restrictions on “economic liberty”. It is important to note that the consequences can be considered at both a societal and a bank level. To the extent that banks have received uncompensated benefits from taxpayers (the implicit government subsidy referred to earlier), a reduction in those benefits is a cost to bank shareholders, but a warranted redistribution from a societal perspective. If the changes affect bank behavior there could be net social benefits (less financial crises) or net private and social costs (borne by bank shareholders and/or their customers) if efficient intermediation is retarded.

Competitiveness Implications

Perceptions that government will ultimately bail-out stakeholders in a troubled bank have adverse consequences for financial sector competition. Non-bank institutions face a risk premium in raising funds, while larger banks may, if thought to be “too big to fail”, have a competitive advantage over their smaller rivals. The objective of retail ring fencing is to limit such perceptions to a subset of financial activities where they are likely to be correct, and with other regulatory changes being aimed at reducing the value of such implicit government guarantees. Higher capital (PLAC) requirements aim to reduce the likelihood of bank failure and demands for government support, while bail-in powers and depositor preference (in the case of ring fenced banks) increase the likelihood that private sector suppliers of funds will bear the cost of resolving a troubled bank.

Consequently, a more level playing field should be created in the market for wholesale funds, since the ability of banks to benefit from implied guarantees and potential bail-outs should be reduced. The potential impact on the market for retail funds is less clear, since the competitiveness of other institutions such as finance companies issuing (risky) retail debentures etc., will depend upon how much the risk reduction benefits of ring fenced deposits are counterbalanced by the costs and restrictions imposed upon their issuers.

The consequences for competition in loan markets appear minor, because there are no restrictions upon types of institutions that can undertake particular forms of lending.

Financial Stability

Threats to financial stability, involving contemporaneous problems in multiple banks can arise either from common exposures to shocks, spillovers through inter-bank financial linkages, or from contagion. None of the proposals prevent potential exposure to common shocks, although it is to be expected that loan portfolio composition and other exposures including market risk would differ significantly between ring-fenced and other banks. The ring-fencing requirements aim explicitly to prevent spillovers by severely limiting exposures of ring fenced banks to other financial institutions and capital markets. The FSCS aims to reduce the risk of contagion for ring fenced banks.

Whether ring fencing increases or reduces the risk of failure of a financial conglomerate is an open question. Without ring fencing, adverse shocks to one part of the institution may be moderated by offsetting positive shocks to the other part, thereby reducing the risk of institutional failure. However, should failure occur, it is of the whole institution. With ring fencing, any such moderating influences on the non-ring fenced part are not permitted. While this may increase the risk of failure, it is failure of the non-ring fenced part of the institution, not of the whole institution. The ring fenced bank component will not fail – although its longer run ability to maintain and attract customers following the failure of its associated entities is open to question.

Economic Efficiency

Ring fencing, as opposed to complete structural separation, does not prevent bank owners from having investments in the full range of banking activities through equity holdings in the financial group. It does, however, limit the potential ways in which various banking activities can be interrelated. It precludes retail deposits being used by non ring-fenced banks to support their lending activities, both directly and indirectly (via restrictions on ring-fenced bank exposures to other financial institutions).

It is conceivable that such restrictions could inadvertently bias the pattern of flows of funds. That would be the case if restrictions on the use of funds by ring fenced banks were severe – such that deposits could only be used for certain types of lending. The British proposals have, at this stage, avoided such restrictions.

To the extent that ring fencing reduces the coverage of implied guarantees, the pricing of funds flowing into non-ring fenced entities could be expected to be more risk sensitive, leading to better allocation of funds.

There are undoubtedly operational costs arising from ring fencing requirements, including information technology costs. How significant these would be is unclear.

Regulatory Effectiveness

Perhaps the most difficult question is the practical one of whether ring fencing can be made to work in practice. Ring fenced banks need to engage with financial markets and other institutions for the purposes of managing liquidity and interest rate risk and hedging exposures created by transactions with customers. Identifying whether transactions (such as those in foreign exchange and derivative markets) are for these purposes, or involve creation of exposures and proprietary trading may be problematic. This is also an issue facing implementation of the Volcker Rule in the USA. And whether regulators and politicians will actually allow failure of important non-ring fenced banks remains a moot point.

Economic Liberty

Ring fencing does not, necessarily, mean limiting the range of activities which a financial conglomerate (which includes a ring-fenced bank) can undertake through its other arms. So any claims which might be made about interference with economic liberty are somewhat specious. The taking of retail deposits, without the prospectus requirements facing other institutions raising funds and with equal seniority of existing and new depositors, is already limited to licensed banks. Ring fencing limits the uses of those funds, and requires particular organizational and operational structures. Those restrictions can be seen as a quid pro quo for the rights to take deposits, to operate under the protection of limited liability, to be highly levered (even with the increased PLAC requirements), to participate in the deposit insurance scheme, have access to Central Bank liquidity facilities, and, arguably, benefit from an implicit guarantee from government.

 

Conclusion

Overall, the British ring-fencing proposals for retail banking attempt to improve financial stability and competition while minimizing certain costs for financial institutions and for economic efficiency. Of course financial institutions will observe significant costs in the form of reduced benefits from implicit government guarantees, but removal of any such uncompensated transfers of value from taxpayers to bank shareholders is good policy.

Whether ring-fencing can be implemented effectively in practice remains to be seen? But if it can, it may serve as a template for changes world wide by financial regulators who are all dealing with an acknowledged problem of implicit guarantees and expectations of government bail-outs of failing financial institutions.

 

This FRDP was prepared by Kevin Davis, Research Director, Australian Centre for Financial Studies.
info@australiancentre.com.au

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Wikipedia: August is the eighth month of the year in the Julian and Gregorian Calendars and one of seven months with a length of 31 days. →

Yes: Bonds are risky too!

Posted on August 23, 2012
Filed Under ACFS Commentary, Banking, Financial Institutions and Markets, Funds Management & Superannuation, Media Release, Media Watch, Policy, Publications | Leave a Comment

Published in AFR as “Yes, bonds are a risky investment too” 22 August 2012

Christopher Joye (AFR, 14 August) argues that the investment strategies of Australian Super Funds, with their heavy weighting towards equity, have been built on shaky foundations. In particular he takes aim at the conventional wisdom that the expected return on equities provides a significant premium over the risk free rate on bonds.

If that is not the case, the higher risk of equities (volatility of returns) has been taken by super funds without sufficient benefits in the form of higher expected returns. And if that is the case, members should be voting out the trustees and management of their super funds for implementing bad strategies. But, of course, superannuation governance doesn’t work that way – but that is another story.

With the benefit of hindsight, that wonderful analytical tool, we would all have adopted different investment strategies over recent years. Shifting from equities to bonds could have given a double whammy to overall returns under some trading strategies.

Not only have equity returns been abysmal in some years, but long term government bond rates have been on a downward trend for thirty years, as the accompanying chart indicates. Good returns were there (in hindsight) if an investor had been smart enough to buy long term (10 year) bonds, sell them a year later when interest rates had fallen, and then reinvest in 10 year bonds and keep repeating the strategy.

The reason for the good returns is that as interest rates fall, the price of existing long term bonds increases giving capital gains upon sale. Of course, this is a risky strategy – interest rates might subsequently go in the other direction – and the chart shows that this was indeed often the case.

Consequently, good returns on the “bond rollover” strategy were accompanied by relatively high risk, as Christopher Joye finds. Not as much risk, nor quite as high a return as from investing in equities though. And on those numbers, the question can be raised of whether the game played by our super funds was worth the candle?

But they were not, and should not have been, playing the alternative game. Super funds should be long term investors. A “bond rollover” strategy involves taking the capital gains when rates fall, and reinvesting in now lower yield bonds. That might turn out to be good, if rates fall further, but if they don’t there is now a lower annual yield than if the original bond had been held.

In hindsight, the alternative risky “bond rollover” game was worth the candle – and perhaps smart investors should have seen the downward trend in long term government rates. But that is a completely separate issue from what is the expected return on risky equities relative to passively investing in risk free assets.

That equity (or market risk) premium (over the 10 year government bond rate) has been calculated using long term historical data to be around the six per cent p.a. mark. Tim Brailsford, John Handley and Krishnan Maheswaran have provided such calculations in a recent article in the journal Accounting and Finance.

But it is worth noting that those calculations compare (as is commonly done) the annual return on equities with the yield to maturity on 10 year bonds (at the start of the corresponding year). That does not necessarily provide good information on a suitable investment strategy. It tells us (if we believe that historical information is relevant, and we have no other valuable information) how much the expected return on an equity investment exceeds the current 10 year bond yield to maturity.

It is indeed an apples and oranges comparison, as Christopher Joye remarks, which does not include possible capital gains or losses on bonds which are not held to maturity, by implementing the risky strategy which I describe as “bond rollover”. That worked well over the past three decades (in hindsight) because of the downtrend in interest rates. The market (or equity) risk premium is meant to give the expected differential between a risky (equity) investment and a risk free investment (which the “bond rollover” strategy is not).

A more interesting calculation is to ask what would be the expected difference in returns from investing in equities rather than from adopting a “risk free” investment strategy. Ideally this would involve comparing the annual return on equities with the yield to maturity on a one year government bond.

Unfortunately, we don’t have readily available data on one year bond yields, but Brailsford et al provide something similar – the annual returns from investing in a sequence of 90 day Treasury notes or Bank Bills. Lo and behold, over the period 1980 to 2010, the premium in equity returns is again very close to 6 per cent.

With hindsight, the risky trading strategy involving bonds may have done very well on a risk adjusted basis relative to investing in equities. But without hindsight, a strategy of investing in a “risk free” manner in government bonds would have underperformed equities quite substantially.

None of this is to say that Australian super funds may not be too heavily biased towards equities rather than bonds. But at the moment, with 10 year bond rates below 3 per cent p.a. there is little scope for interest rates to decline much and generate future returns like the past good returns on the risky bond rollover strategy.

And bonds ain’t just bonds. If Australian super funds had invested heavily in corporate bonds or other structured “fixed interest” products, the blow out in credit (default) spreads (and resulting plummeting in prices) at the time of the financial crisis might have led to even worse returns. And if they all were competing for the scarce supply of Australian Government Bonds, even 3 per cent might start to look high!

This Commentary is written by Professor Kevin Davis, Research Director of the Australian Centre for Financial Studies. info@australiancentre.com.au

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Why Stapled Securities?

Posted on June 15, 2012
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Funds Management & Superannuation, Media Release, Policy, Publications, Research Review | Leave a Comment

FRDP 2012-3
June, 2012

Australia is relatively unique internationally in permitting business entities to issue stapled securities, which are used by many A-REITS and Infrastructure Funds. In this FRDP the merits of such structures are examined, reasons for Australia being an international outlier in permitting such structures considered, and the question posed of whether that is an appropriate regulatory approach.

Introduction

Stapled Securities involve the stapling together of separate securities such as a share in a company and a unit in a trust which cannot be traded separately. This type of structure, of which there are many variants, has been used quite intensively in Australia by A-REITS (real estate investment trusts) and infrastructure funds.^[1]

At the end of 2011, 15 out of 18 listed infrastructure funds and 28 out of 49 listed A-REITs had stapled security structures. The major banks have also previously utilised stapling in the construction of non-innovative tier one (NIT-1) capital instruments, such as StEPS (issued by ANZ), PERLS (CBA), SPS (Westpac) and NIS (NAB).

But stapling is relatively uncommon in the rest of the world. In mid 2011 the Canadian authorities introduced new tax legislation to prevent emerging use of stapled structures by REITs, and the USA has prevented such structures since 1984. There are few instances of stapling to be found internationally, although a number of Malaysian banks had used stapling to create NIT-1 capital instruments, and there is some emerging interest in stapling in Asia. In 2011 HKT was spun out of PCCW on the Hong Kong exchange as a stapled structure, while in May 2012 there were media reports that Formula One is to undertake an IPO on the Singapore exchange using stapling.

Stapling of securities is not, at first glance, a value adding activity, because it reduces investor choice. Investors should prefer non-stapled securities which can be traded separately, enabling them to choose the combination of the securities which best meets their individual preferences – including tax positions. (This is sometimes referred to as a “clientele” effect).

Hence, it needs to be asked how stapling of securities might create value, and why the Australian authorities are willing to allow stapling in contrast to most of their overseas counterparts.

Value creation by stapling

Stapling of securities requires some form of contractual relationship between the entities whose securities are being stapled. At the simplest level, the securities could be issued by the one entity, such as the debt security (loan note) and equity structure used in the spin-off of Envestra from Boral in 1997. Another possibility is for one security, such as a preference share, to be issued by a parent company and the other, such as a loan note, by a subsidiary, such as in the creation of NIT-1 stapled securities by the Australian banks. A third approach is for contractual operating agreements between a company and a “related” trust (or several trusts) to underpin the stapling of the securities. In that latter form, the trust might own physical assets and lease them to the company for use in generating income. Figure 1 illustrates.

Figure 1: Stapling – A Simple Example

The most obvious rationale for stapling is tax arbitrage. If stapling reduces the total tax bill paid on income generated by a particular business activity, stakeholders (other than government) benefit. Figure 1 provides a simple illustration of how this can work. Because the trust is a “pass-through” entity for tax purposes, income it receives is not subject to company tax as long as paid out to unit holders. Consequently lease payments by the company reduce its taxable income and company tax paid, and increase the income of the trust on which company tax is not paid.^[2]

In the case of the Australian banks, the structures were designed to reduce company tax paid to foreign governments, via tax deductibility of interest payments issued by the subsidiary. While consequently higher company tax was paid in Australia, this also generated offsetting franking (tax) credits for investors.

Other potential sources of value creation result from possible market imperfections or investor behavioural biases. Constraints on companies paying dividends when unprofitable may mean that trusts are better able to distribute available cash flow to investors. Attaching franking credits to stapled securities which are more “debt-like” may appeal to low tax rate investors who do not want increased equity exposure. Higher leverage might be possible through the use of “internal” debt provided via stapled securities without creating owner-creditor agency problems, and high pay-out ratios may reduce owner-manager agency problems by preventing managers squandering free cash flow.

The ASX practice of measuring market capitalization by the aggregate value of stapled securities rather than the equity component alone also means that size of the business is overstated relative to a similar entity with separate equity and debt. This can bring advantages where fund managers invest primarily in larger capitalization stocks.

But the possibility that such structures are established by the sponsors of the business involved to extract wealth from investors and consolidate their control over the business should not be discounted. Virtually all such structures are opaque and complex, and result in governance arrangements which give investors limited control rights. Sponsors of the business (such as investment banks) can generate fee income streams as the responsible entity for the trust and from providing external management and other services for the operating company, and may profit from selling assets into the structure.^[3]

Unfortunately investors, and advisors, do not appear to fully understand the nature of the cash flow streams which they receive from such structures. Typically some part of that cash flow will be a return of capital – but the total cash flow is generally described as a “yield”, causing stapled securities to appear to be high (and stable) yield investments. This exploits a well known behavioural bias of investors of unwillingness to consume out of capital rather than income. And this is amplified by the unusual practice, accepted by the ATO, of referring to the capital return component as “tax deferred income” – rather than as a return of capital.

Why is Stapling a predominantly Australian phenomenon?

The rationale for preventing stapling in most other countries is straightforward – to prevent tax arbitrage which reduces company tax collections. However, Australia operates a dividend imputation tax system. If shareholders are Australian residents, the payment of company tax is “washed out” by tax (franking) credits attached to dividend payments and which reduce tax paid at the investor level.

Consequently, the dividend imputation tax system means that the incentive for the Australian government to legislate against such structures is much reduced.^[4] The main cost to government tax revenue arises from distributions to foreign shareholders – where otherwise the franking credits arising from company tax would not reduce individual tax.

And, paradoxically, given the popularity of stapling in Australia, the imputation tax system should also reduce the incentives for Australian business entities to adopt such structures in order to avoid company tax. But if overseas investors are a significant clientele, there may be some tax arbitrage involved.^[5]

Whether the Australian government should review whether stapled security structures should be allowed is an open question. It is possible that tax revenue is adversely affected, although details on foreign ownership of stapled securities are not easy to come by. But as an example, assume a ball-park guesstimate of distributions on stapled securities of $5 billion p.a. which has largely avoided payment of corporate tax. If foreign investors receive $2 billion of that amount, there is $0.6 billion of company tax avoided, which would not have been offset at the investor level by use of attached franking credits.^[6]

Operators of stapled structures would no doubt argue that there are real efficiencies associated with stapling. But whether any such perceived benefits are truly social benefits, private benefits at the expense of taxpayers, or involve wealth transfers to operators of such structures and insiders at the expense of third party investors, has not been rigorously investigated. While most listed infrastructure funds have used stapling (and some of which have exited the market), only around 60 per cent of A-REITS do so. The apparent ability of non-stapled A-REITS to compete suggests that stapling is not a necessary condition for efficient operations.

Since: (a) there may be some erosion of the tax base where foreign investors are involved; (b) there is no obvious tax cost to domestic investors from un-stapling, (c) real efficiency benefits from stapling are unproven; and (d) stapling increases the opportunities for financial engineers to exploit investor biases and inadequate information to redistribute wealth to themselves, further investigation and consideration of the merits of permitting stapling would seem warranted.

Footnotes:

[1] More detail on stapled securities can be found in Kevin Davis “Stapled Securities: Antipodean Anomaly or Adaptable Innovation”

[2] Similar effects could be achieved by the trust making a loan to the company, which buys the assets, with interest payments from the company to the trust reducing company tax paid. There are a number of complicating factors in design of such arrangements including efficient use of depreciation tax shelters. The imputation tax system used in Australia also complicates the analysis – as discussed later.

[3] Details of external management agreements and fee structures between the controlling entities and the stapled structure are generally not available.

[4] There has been more interest in preventing the attachment of franking credits to the NIT-1 stapled securities by banks, but that appears to be more related to the “debt-like” nature of those securities.

[5] For business activities with large up-front capital and depreciation costs and finite lives, the timing of overall tax cash flows is affected by stapling, and risks of franking credits being “trapped” in a corporate structure may be reduced.

[6] Withholding tax arrangements are also relevant here.

This FRDP was prepared by Kevin Davis, Research Director, Australian Centre for Financial Studies.
info@australiancentre.com.au

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The Australian Banking Sector Post-GFC

Posted on June 5, 2012
Filed Under Banking, Financial Institutions and Markets, Inquiry Submissions, Media Release, Policy, Publications | Leave a Comment

Submission to the Senate Economics Committee

The post-GFC period has been one of significant regulatory change for the banking sector, both internationally and domestically. The period has been marked by volatility, uncertainty and instability with further regulatory change still in the wings. The likely effects of these impending regulatory changes are yet to be fully discerned.

In a recent submission to the Senate Economics Committee, the Australian Centre for Financial Studies highlighted a number of issues relevant to the Committee’s Inquiry into the post-GFC banking sector.

The recommendations that were made in the submission are summarised below.

Recommendation 1: The degree of competition in the financial sector and the extent to which undesirable barriers to entry exist warrant review as part of a major review of the workings of the financial sector. One aspect of that review should include an assessment of the extent to which implicit and explicit government support conveys competitive advantages to particular financial institutions.

Recommendation 2: Consideration should be given to whether the systemic importance of the Big Four Banks (or any other financial institutions) warrants some form of special regulatory treatment.

Recommendation 3: (a) the deposit guarantee cap under the FCS should be reduced; (b) consideration should be given to charging a fee for the deposit guarantee on competitive neutrality grounds.

Recommendation 4: Consideration, on grounds of competitive neutrality, should be given to allowing any fee imposed for the deposit guarantee to be paid in the form of either cash or debits to franking account balances.

Recommendation 5: As part of a suggested review of the Australian financial system and its regulation, a substantive cost-benefit study of the impact of recent and proposed regulatory changes on the economy should be undertaken.

Recommendation 6: The merits of allowing banks (and other lenders) to adopt mortgage loan arrangements giving them complete discretion to adjust interest rates on existing loans should be examined.

Recommendation 7: A wide-ranging review of Australia’s financial system and its regulation is warranted.

View the full Submission

View other Submissions on the Parliament of Australia’s website

View other ACFS Submissions

Contact details:

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

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Small–Cap Equity Raisings: Are the ASX Proposals the best option?

Posted on May 14, 2012
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Media Release, Policy, Publications | Leave a Comment

FRDP 2012-2
May 10, 2012

The Australian Securities Exchange has recently released a consultation document Strengthening Australia’s equity capital markets^[1] outlining inter alia proposals aimed at improving access to additional equity capital for small and mid-sized listed firms.^[2] In essence, such firms would be able to issue additional new shares:

• by way of a placement, of up to 10 per cent of market capitalization (in addition to the current 15 per cent limit not requiring shareholder approval)^[3];
• subject to a maximum discount to market price of 25 per cent;

if they have obtained shareholder approval to do so at the latest Annual General Meeting.

This proposed regulatory change would be likely to fail a rigorous social cost-benefit analysis and appears to take no account of available research findings regarding seasoned (secondary) equity offerings. The proposal is flawed for four reasons (which apply to varying degrees in different circumstances):

1. It relaxes constraints on market discipline of corporate managers, making it easier for them to pursue private objectives of empire building rather than maximizing value for existing shareholders. It also exposes potential (albeit “sophisticated”) investors to unnecessary risks due to imperfect information.
2. It creates the potential for significant wealth transfers from existing shareholders to new investors through the dilution effects of placements.
3. It creates the potential for placements to lead to significant shifts in voting power.
4. Other changes to equity raising arrangements, including those for rights issues, have potential to meet the objectives of the regulatory change at a more favorable benefit- cost ratio.

Rationale for Regulatory Change

Underpinning the ASX proposals is the perspective that small to medium sized listed companies face difficulties in raising additional equity capital. Difficulties can include such factors as: high issuance and administration costs; time lags and risk of failure of an offering of securities; high required returns of potential investors. Placements are perceived by the ASX as offering a lower cost and quicker method of raising equity than alternatives such as rights issues. Whether investors who might participate in a placement have a lower required return on equity than current shareholders, such that raising funds in that way would be to the benefit of the latter is an empirical question (about which more will be said later).

While there may be greater difficulty or costs in using rights issues under current regulatory arrangements, they have been a popular form of secondary equity raisings. Regulatory changes allowing accelerated “non-traditional” rights issues have assisted in this regard.^[4]

Some recent data is provided by Connal and Lawrence (2010)^[5] who examine secondary equity raisings by ASX listed firms during 2008 and 2009, and Table 1 summarizes their findings.

Type	Number	Amount raised ($ bill.)	Average size (% of shares)	Average Discount (%)	Average time taken (days)
Placements	140	44.8	19	12.3	17
Rights – Non renounceable	57	31	47	25.2	34
Rights – Renounceable	21	15	70	37	43
Share Purchase Plans	61	8	7	11	45

Source: Connal and Lawrence (2010)

What is particularly noticeable from Table 1 is the fact that the average discount on placements is well below that on rights issues. And despite there being no maximum discount constraint on placements of up to 15 per cent of outstanding equity (which are currently allowed without need for shareholder approval) the average discount figure shown in Table 1 is around half the maximum of 25 per cent proposed by the ASX. Other studies examining earlier periods have also found that the typical discount on placements is well below that on rights issues, and generally quite a bit lower than the 2008-2009 figures.

The ASX appears to have given no substantive justification for allowing up to a 25 per cent discount, and the figure appears anomalous (and high) given both data from past placements and when compared to a 20 per cent maximum discount allowed for non-renounceable rights issues.

Issue 1: Corporate Governance, Market Discipline and Placements

Ideally, management acting in the best interests of shareholders will not pursue fund raising strategies to the detriment of shareholders. However, given the self-interest of managers and directors, that requires very strong corporate governance arrangements and standards, if the resulting agency problems are to be overcome. Where are these least likely to be found? Arguably in relatively small companies with entrenched boards, limited shareholder monitoring by institutional investors, and opaque activities. This is precisely the group at which the ASX proposals for relaxing rules regarding placements are aimed, and where management bias towards self-interested objectives such as expansion is likely to be significant.

It should be noted that international studies have generally found that the announcement of placements leads, on average, to short-term positive abnormal stock returns, to the advantage of existing shareholders – although there is generally subsequent long-run underperformance. This short run “bounce” has typically been interpreted as reflecting evidence of “certification” by new investors that the firm appears undervalued or that they intend to play an active role in monitoring management.

But, in a recent US study by Barclay et al (2007)^[6], it is found that “when there is a large discount on a large- percentage block sold to someone who does not become active in firm affairs [around 80 per cent of their sample of placements], the associated stock returns tend to be large and negative.” Thus while some placements might, despite involving some discount, temporarily add value for existing shareholders, large, high discount placements to passive investors look more likely to be value destroying. And while placements to potentially active investors may add value, there is the risk that information must be provided to such parties which, despite regulatory standards and disclosure requirements, may be more comprehensive than that available to existing shareholders.

A major problem with the proposed changes is that they reduce market discipline upon management, enabling it to raise capital to undertake projects which are value destroying. The reason is straightforward. While the funds provided by new investors may be used to fund a particular project, those investors obtain returns based on profitability of both existing and new projects. New investors may be aware that the new project is not value enhancing, but if their share of proceeds from pre-existing projects is sufficiently high, they will be willing to provide funds. This can occur when new shares are issued to outsiders at a discount to the current market price. The resulting dilution of interests of existing shareholders is a transfer of wealth to outsiders, meaning that their investment of funds does not depend solely upon whether the proposed use of those funds is value enhancing. Even if the placement is to some existing shareholders, there is still a wealth transfer between shareholders. Box 1 provides a simple arithmetic illustration.

In contrast, under a rights issue there is no such wealth transfer biasing shareholder decisions on whether to participate. (If the planned use of funds is not perceived to be value enhancing, or interpreted as a signal that the current share price is overvalued, shareholder responses to the proposed issue will be reflected in a lower share price and wealth loss – with this possibility acting as a constraint upon managerial decision making).

BOX 1: Funding Negative NPV Projects by Placement Discounts

Consider a company which has 100 shares on issue with market price of $10 each and earning the required return of investors of 10 per cent p.a. (ie $100 p.a. on the market capitalization of $1,000). It makes a placement of 25 shares at a 25 per cent discount to market price, ie $7.50 each and raising $187.50 in total, to new investors to fund a project generating only 8 per cent p.a. (ie $15 p.a.). The new investors own 20 per cent of the company giving them a return of one fifth of total earnings of $115 p.a., ie $23, which is a return of 12.27 per cent p.a. Even though the new funds raised have been applied to a negative NPV project, the providers of those funds receive a rate of return in excess of the required return. This is because the issue discount enables them to obtain a higher share of earnings from the firm’s existing activities than would be implied by comparing the size of their subscription relative to initial market capitalization.

While placements are required to be made only to “sophisticated investors” the empirical evidence from international studies that firms making placements tend to subsequently under-perform raises the issue of investor protection. For Australia, Brown et al (2006)^[7]and Brown et al (2009)^[8] have also shown that firms making placements subsequently under-perform and do worse than firms issuing equity via rights issues. Brown et al (2006) attribute this to a preponderance of small loss making firms among those making placements, and managers taking advantage of temporary overvaluation of their equity to time equity raisings. Brown et al (2009) also note that speed of issue and other characteristics of placements mean that they can be more readily made to take advantage of temporary stock price overvaluation. They also find that issuing firms with better governance (based on the indicators they construct) are less likely to have longer run underperformance.

Evidence such as this (and that of Barclay et al) should raise warning flags about loosening the bounds on managers of small firms to make large placements at large discounts. Poor, value-destroying, decision making is facilitated. “Sophisticated investors” who participate in placements are assumed to be informed and capable of assessing management ability and equity values, but that does not appear to be necessarily the case. “Caveat emptor” may, quite reasonably, underpin the attitude towards protection of “sophisticated investors”, but that is no reason to unnecessarily increase their exposure to bad options which they are not well placed to adequately evaluate.

Issue 2: Shareholder Wealth Dilution

Where a placement is made at a discount to investors who are not existing shareholders, the potential financial costs to existing shareholders can be high. This can occur regardless of whether the new funds are used for expansion or replacement of debt. Suppose a company with 100 shares on issue with a current market price of $10 per share makes a placement to third parties of 10 shares at a price of $8 per share (ie a discount of 20 per cent). The pure dilution effect of this can be found by noting that the market capitalization of the company (assuming no pure announcement effect on the stock price) would now be $1,080 (compared to $1,000 previously) and, with 110 shares now on issue, the share price would decline from $10 to $9.82 – a loss of around 2 per cent. The larger the discount and the larger the issue, the greater is the cost to existing shareholders. Under the ASX proposals, the loss could be up to 5 per cent if 25 per cent additional shares were issued at a 25 per cent discount. This is higher than the all-up (transactions, underwriting etc) costs to existing shareholders of a fully underwritten renounceable rights issue.

It is argued by the ASX that shareholder rights are protected by the requirement that shareholders have voted at the last AGM to give management the flexibility to make a placement of an additional 10 per cent of equity capital at a discount of no more than 25 per cent. This places significant, unsubstantiated, trust in the effectiveness of shareholder voting arrangements. It is not hard to imagine scenarios in which a small number of large shareholders with a combined majority could vote in favour of such a resolution in the expectation that they have a significant probability of being the favoured participants in any such placement, to the detriment of other shareholders. More generally, rarely do board initiated proposals get voted down by shareholders – which could be due to their being perceived as being in shareholder interests or because shareholders are unable to assess the merits of those proposals and assume (perhaps wrongly) that directors are acting in the best interests of all shareholders.

Issue 3: Control Rights

The third matter for consideration is the potential change in voting rights of shareholders. With a pro-rata rights issue, shareholders who do not participate are compensated for their dilution in voting rights through sale of their rights in the case of a renounceable issue. In the case of a non-renounceable issue, investors can sell existing shares to finance new purchases and avoid wealth dilution from the discount. However, the transactions costs of doing so may be relatively high for small shareholders, causing them not to pursue this strategy and hence suffer the costs of dilution. (It is difficult to see what social benefits arise from permitting non-renounceable rights issues, other than possibly the company avoiding the costs and time lags associated with listing and trading of rights on the exchange).

In the case of a placement, existing shareholder voting rights are automatically diluted, and potentially quite substantially. Placements have the potential to change the balance of voting power and/or to further entrench boards and management when made to “friendly” investors. While directors could face legal challenges if placements created marked shifts in the balance of control, their ability to make placements to “friendly” investors is not so constrained.

In that regard, the recent study by Barclay et al (2007) of a large sample of placements by US companies is instructive. Their study “suggests that private placements are often made to passive investors, thereby helping management solidify their control of the firm” and the evidence “favors managerial entrenchment as the explanation for many private placements”.

Connal and Lawrence (2010) note the absence of any requirement in Australia for companies to disclose the identity of recipients of shares via a placement. While privacy arguments can be advanced as a rationale for this, it is not apparent that this is sufficient justification for not holding management and directors accountable to shareholders for their dilutionary decisions by requiring appropriate disclosure.

Issue 4: Alternative Issuance Mechanisms

The ASX notes that the proposed changes make issuance arrangements more in line with those in a number of other countries. Why that is a good objective is far from apparent.

But more importantly, the critical question to be answered is why would any manager, acting in the best interests of all existing shareholders, prefer to use a placement rather than a rights issue. Potential arguments which can be advanced include: speed of issue; regulatory and transaction costs and impediments; access to cheaper funding; risks of not successfully completing the required capital raising; legal risks faced by directors arising from the capital raising. Under current regulatory arrangements some of those arguments may have merit, but imply a review of regulations and rules affecting all types of equity raisings, particularly rights issues, to ascertain what changes are best, rather than simply accepting the change proposed by the ASX. This is particularly so given that advances in electronic communications and transactions have opened up a range of options which were not feasible when current rules and regulations were fashioned.

Consider first speed. Over the past decade or so, regulations have been changed which enable listed companies to undertake rights issues in a number of alternative “non-traditional” ways. These include accelerated institutional rights issues, followed by a retail rights or entitlement issue. The time delays involved here are not substantial, and there has been no evidence provided that they necessarily compare unfavourably to those associated with a placement.

Regulatory costs may be another factor which reduces the appeal or increases the costs of rights issues. Information provision requirements are one example, although since 2007 there has no longer been a requirement for a prospectus for rights issues. And while conveying information to multiple shareholders can be costly, electronic communications provide the potential to dramatically reduce such costs.

Transactions costs are also potentially greater when funds are raised from a large number of investors (as with a rights issue) rather than by placement with one or a few institutional investors.

But it is worth considering these issues in more detail. Electronic communications arguably can make it feasible for a company to inform and provide details to a large number of shareholders of a forthcoming rights issue at a cost no larger than for a placement. Currently, many shareholders do not receive company communications electronically, and the requirement that information be mailed out imposes costs.

Enabling companies to make rights issue announcements solely by electronic means would overcome that cost impediment. And with the capacity for subscriptions for new issues to be made by way of BPay or other electronic means, the transactions costs of receiving smaller amounts of funds from many subscribers should not be markedly greater than those associated with a placement.

While solely electronic communications would disadvantage shareholders not accessing such information and thus not participating, it should be possible to implement arrangements to protect such shareholders. (Even without such safeguards, the cost to them maybe no more than that associated with placements). Such arrangements could involve the automatic sale of rights of investors who do not subscribe to the issue at their theoretical value to underwriters. (Similar arrangements already apply in the case of investors outside Australia and New Zealand in the case of renounceable rights issues where rights which would have accrued to such investors are required to be sold and proceeds remitted to them). Requiring that prior shareholder approval be obtained at an AGM for electronic-only notification of rights issues would also be necessary

Conclusions

Based on the preceding analysis the following conclusions can be drawn.

1. Company management acting in the best interests of all shareholders should raise new equity capital by providing existing shareholders with the opportunity to participate in pro-rata issues (such as rights issues) unless there are discernible benefits to them from alternative issue methods such as private placements.
2. Placements made at a discount reduce market discipline upon management, can facilitate entrenchment and weaken governance, and enable management to more easily pursue private goals at the expense of shareholders. Management may also be better able to use placements to “time the market” by issuing equity when their private information indicates stock is overvalued to the detriment of new investors.
3. Placements may provide net benefits for existing shareholders if associated “certification” and “monitoring” service benefits from the new shareholders outweigh dilution effects. However, this is unlikely to be the case where large placements at large discounts are made to “passive” investors by poorly governed companies. Substantial evidence of longer run underperformance by companies which have made placements suggests that this latter case is pervasive.
4. Lower transaction and regulatory costs of raising funds by placements, relative to rights issues, may have provided some justification for use of placements in the best interests of existing shareholders the past. However, modern electronic technology opens new possibilities for lower cost pro-rata type issue techniques to existing shareholders which warrant consideration and potential regulatory changes to accommodate.
5. The ASX proposal to allow smaller companies to make substantial additional placements at large discounts lacks merit on these grounds, and should be rejected in favour of a broad ranging review of issuance arrangements and options. This should include a review of the merits of current arrangements allowing all companies to make placements of up to 15 per cent of shares, at any discount, without shareholder approval warrant review. The merit of not requiring companies to make public the identity of participants in private placements also warrants review.

Footnotes:

[1] http://www.asxgroup.com.au/media/strengthening_australias_equity_capital_markets_2Apr12.PDF

[2] The ASX uses a market capitalisation of $300 million as the cut-off point for defining small to mid cap stocks which includes around ¾ of listed stocks of which around half are resource stocks.

[3] It appears from the consultation document (Chapter 7) that the 10 per cent limit relates effectively to shares on issue at the time of the proposed placement rather than at the time of the AGM. The latter could be 115 (or a higher) per cent of shares on issue at the AGM date if a 15 per cent placement (or a rights issue) has been made in the interim.

[4] An overview of alternative capital raising methods can be found in http://www.asx.com.au/documents/about/20100129_asx_information_paper_capital_raising_in_australia.pdf

[5] Connal, Simon J and Lawrence, Martin, Equity Capital Raising in Australia During 2008 and 2009 (August 16, 2010). Available at SSRN: http://ssrn.com/abstract=1664889 or http://dx.doi.org/10.2139/ssrn.1664889

[6] Michael J. Barclay, Clifford G. Holderness, Dennis P. Sheehan, Private placements and managerial entrenchment, Journal of Corporate Finance, Volume 13, Issue 4, September 2007, Pages 461-484

[7] Brown, Philip S. and Gallery, Gerry T. and Goei, Olivia (2006) Does market misvaluation help explain share market long-run underperformance following a seasoned equity issue?. Accounting and Finance 46(2):pp. 191-219.

[8] Brown, Philip R., Lee, Michael, Owen, Sian A. and Walter, Terry S., Corporate Governance and the Long-Run Performance of Firms Issuing Seasoned Equity: An Australian Study (April 13, 2009). 22nd Australasian Finance and Banking Conference 2009. Available at SSRN: http://ssrn.com/abstract=1378485 or http://dx.doi.org/10.2139/ssrn.1378485

This FRDP was prepared by Kevin Davis, Research Director, Australian Centre for Financial Studies.
info@australiancentre.com.au

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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

Superannuation over the past decade: Individual experiences

Posted on May 4, 2012
Filed Under Contracted Research and Consulting, Funds Management & Superannuation, Publications, Research Review, Sponsorship Support | Leave a Comment

The Australian Centre for Financial Studies and AIST have established a three-year research partnership with the first year involving an analysis of the Household, Income and Labour Dynamics in Australia (HILDA) data to review what has happened with superannuation in the last 10 years and where should we be looking with regards to superannuation policy to improve it in the future.

The HILDA project is funded by the Department of Families, Housing, Community Services and Indigenous Affairs (FaHCSIA) and managed by the Melbourne Institute. This year involves the third “wave” (2002, 2006 & 2010) when specific questions about superannuation have been asked and provides a rich data set to examine around 9,000 individual and household experiences with superannuation.

Professor Kevin Davis, Research Director, Australian Centre for Financial Studies unvieled the report, “Superannuation over the past decade: Individual experiences“  at CMSF 2012. Yesterday, Kevin presented the report at an AIST Thought Leadership Event Series function in Adelaide, where a roundtable was convened to discuss the findings and provide direction to where the next phase of research should be focussed. Issues discussed included:

• determinants of differences in super balances;
• evolution of super balances over time;
• extent of voluntary super contributions and understanding of employer contributions;
• retirement intentions and more.

Executive Summary

This report uses data from the HILDA survey to examine individual and household superannuation experiences over the past decade. It draws on only a very small portion of the information available in that survey which includes data about individual characteristics and experiences beyond that which superfunds have about their members. The report includes the following findings:

• The gap between average super balances of males and females increases with age, but
  • This does not appear to be attributable to gender per se but rather reflects gender-related differences in things such as labor force participation and incomes; and
  • The gap is not apparent at ages below the early 30s where differences in labor force participation experience are less likely to have emerged.
• Examining super balances/wages at different ages can indicate if individuals are “on track” to achieve adequate retirement income. For males, the average ratio is around 2.5 at age 50, that is at 50 the average male has saved two and one half times his annual wage.  This ratio climbs rapidly, reaching around 4.5 or four and one half times their annual salary (for those in the survey) by the early 60’s.This is partly due to the decline in average wage and salary income which sets in from around that age. That income effect partly offsets the lower consumption needs of pre-retirees in terms of having funds available for voluntary super contributions – an issue which warrants consideration in terms of age-related setting of the cap for concessional contributions.
• There are still around 10 per cent of employees with some defined benefit super
• Most older single retirees have little or no super, but many have significant housing wealth. Most single non-home-owner retirees also have no super balances, but their responses to a question about their financial position show over 80 per cent regard themselves as “reasonably comfortable” or “just getting along” and only 6 per cent as “poor” or “very poor”. Responses of other retiree groups (eg home-owners) reinforce an impression that the old-age pension is relatively effective in providing an adequate living standard safety net.
• The message of the higher future official pension age of 67 had not really gotten through to the middle-younger aged cohorts by 2010. Males have plans to retire at 64 and females earlier. But the planned retirement age has increased by around 2 years since 2006 (although there are no signs of a greater response by females for whom the official age has increased by more).
• Three quarters of employees make no personal contributions to super above their employer contributions.
• Around 15 per cent of singles below 50, but very few couples, report having zero super. While some of those singles may be self-employed and thus outside the compulsory contribution arrangements, lack of take-up of tax-beneficial contribution arrangements is a concern. Over age 70 two-thirds or more have zero super.
• There is evidence of increased awareness of super, however, although 12 per cent of employees still don’t know the amount of the employer super contribution (and 3 per cent think it is below 9 per cent).  This is a sizable percentage increase over 2002 and 2006, when  21 and 14 per cent respectively  were unaware.
• For mid-career individuals (aged between mid 30s and mid 50s in 2010), average super balances increased by about 50 per cent between 2002 and 2006 and also between 2006 and 2010.
• Super has become a higher part of total wealth over time for singles and in 2010 was around 35 per cent for those aged 30, but lower for older singles. For couples, the share of super is relatively constant by age group at around 20-25 per cent, and hasn’t changed much over time – reflecting the commensurate  growth in both house prices and superannuation asset values.
• Comparisons of super balances of the average individual aged “X” in 2002 with one of the same age in 2006 and 2010 indicate that:
  • Average balances are higher in the later years, but that there was a greater increase between 2002 and 2006 than between 2006 and 2010, and importantly,
  • Whereas average balances tended to decline after age 50 in 2002, they are increasing in 2010.
• Higher educated individuals tend to have more super, even after allowing for the effect of higher income.

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Research Feature: Buybacks – Beware

Posted on May 3, 2012
Filed Under Corporate Finance, Publications, Research Review | Leave a Comment

Christine Brown (Monash University) and Kevin Davis (ACFS) consider the likely effects of planned legislative changes to arrangements for off-market share buybacks. Reduced tax benefits to participants in buybacks will reduce the likely discount of buyback prices to current market prices. Those lower discounts mean that the previous 14 per cent cap (due to ATO tax rulings) which led to massive scaling –back of applications would generally not be binding, making its planned removal of little consequence. Off-market buybacks will still occur, but at smaller discounts to current market prices – which is to the disadvantage of non-participating shareholders.

With draft new legislation on tax treatment of off-market share buybacks under consideration , the future of this popular capital management tool is open to question. The proposed changes will reduce the tax benefits to participants and consequently the discount of the buyback price to current share market price. This makes them less attractive to companies as a capital management technique, while the reduced discount is of less benefit (possibly controversially, given past concerns) to non-participating shareholders. While the previous 14 per cent cap on the discount permitted by the Australian Tax Office distorted pricing and participation, its removal is likely to be of minor significance. Our ballpark calculations suggest that it seems unlikely that tender outcomes will often, under the proposed regime, lead to discounts in excess of 14 per cent.

Despite the global financial and economic gloom, there is increasing discussion of some Australian companies contemplating returning surplus cash to investors, including by way of off-market share buybacks. These have been popular in the past (although viewed by some as unfair to some shareholders) because designation of some (small) part of the repurchase price as the “capital component – sale price” generated capital losses for tax purposes for participants, while the remainder of the price was a franked dividend. Those tax benefits to participants meant that the buyback price emerging from the tender was at a discount to the current share market price. Whether the size of the discount provided sufficient benefit to non-participating shareholders to offset the tax (franking) credits distributed to participants was the cause of angst to some.

BHP’s $6 billion buyback in February 2011, JB HiFi’s $170 million buyback of 10 per cent of its shares in March 2011, and Perpetual’s $70 million buyback of 7.5 per cent of its shares in October 2011 are some of the most recent. However, this is a much reduced usage of the technique compared to a few years ago when tax uncertainty contributed to something of a hiatus in usage.

That uncertainty still persists, although draft legislation to introduce suggested changes by the Australian Tax Board was released on the Treasury website in October 2011 (and responses to that are still under consideration). These proposed changes will create new uncertainties about the potential benefits to companies contemplating buybacks and investors contemplating participation.

For companies, will the discount of the repurchase price to current market prices be sufficient to warrant using this approach to returning cash to shareholders (rather than some other form of capital management such as special franked dividends)? For (particularly retail) investors the risk arises from participating in the tender with a “final price” bid (as most do) – where they agree to sell at whatever price is established in the tender. The risk they face is that the discount could be unexpectedly high.

Our (albeit rough) calculations indicate that the discount of buyback prices to current market price will be less than in the past, to the disadvantage of companies (and their non-participating shareholders), but to the benefit of government tax revenue. And while that lesser discount is to the advantage of participating shareholders, their reduced ability to claim losses from the buyback for capital gains tax purposes offsets that advantage.

There are two major changes in prospect. One (not part of the draft legislation, but recommended by the Tax Board) is the removal of the effective restriction (due to tax rulings by the ATO) on buybacks being done at prices more than 14 per cent below the current market price. Our previous research (forthcoming in the journal Accounting and Finance) showed that this was a binding constraint on many buybacks (without it, the discounts would have exceeded 14 per cent, often quite substantially). Consequently there was major scaling back of participant offers, and a cost (of a higher than equilibrium buyback price) imposed on non-participating shareholders.

The second change is to reduce participant claims of large capital losses for tax purposes because of the designated capital component being only a small part of the buyback price. In essence, where the designated capital component is lower than the investor’s original purchase price (cost base), the draft legislation proposes that the adjusted capital component (sale price for tax purposes) will be the minimum of the investor’s purchase price and the buyback price. Whereas, for example, an investor who had previously bought stock at $15 and participated in a buyback at $12, of which only $4 was the capital component, could claim a capital loss for tax purposes of $11, the allowable capital loss will now only be $3. An investor also participating who had previously bought at $8 would have previously had a capital loss for tax purposes of $4, and now will have a zero tax loss.

Low tax rate investors will still be attracted by the franked dividend component of the buyback and willing to participate at a buyback price below the market price. And there is still some benefit on the capital gains/loss tax side if that occurs (because of the use of the buyback price rather than current market price in working out gains or losses) – but that benefit is much less than previously. Because of this reduced appeal of participation to investors, the discount of the buyback price to market price should be lower.

Hence, even though the 14 per cent maximum discount has been removed, it may no longer have been relevant anyway.

Estimating the likely discount for new off-market buybacks is problematic, and depends upon the specific characteristics of the buyback (size of buyback, capital component, likely franked dividend amount etc). The price at which shareholders originally bought their shares (the capital gains cost base) also matters.

But we can make some ballpark estimates of likely buyback outcomes by making three assumptions.

First, we assume that the “marginal investor/participants” (whose tender offers will determine the size of the discount) are superannuation funds. Because of the large franked dividend component of off-market buybacks (although the dividend/capital component mix may change in response to other features of the proposed new tax rules), it is these investors who gain the most value from participating, and whose bids drive the final outcome.

Second, we assume that these marginal investors will have realised short term capital gains in the rest of their investment portfolios, so that they can use capital losses from the buyback to offset tax liabilities on those gains. Third, we assume that potential participants have a cost base (original purchase price) similar to the current market price of the share.

With these assumptions, it is possible to do some rough calculations of the likely tender outcomes for hypothetical buybacks. What we find (and calculations are available on request) is that the buyback price as a proportion of the current market price is unlikely to be much less than around 83 per cent (when franked dividends are 80 per cent of the buyback payment), and becomes higher as the proportion of the buyback price which is franked dividend decreases. If, for example, the franked dividend comprises half of the buyback price, the minimum buyback price at which these investors would participate is around 88 per cent of the current market price (compared to around 80 per cent under the previous rules).

Thus, the proposed legislative changes do not appear so drastic as to render off-market buybacks extinct. Government tax revenue will benefit from the reduction in allowable capital gains tax losses generated. Consequently, discounts of the buyback price to market price will be lower. This is not to the benefit of non-participating shareholders (although the previous 14 per cent cap on the discount prevented them from reaping full benefits from the tender mechanism). And whether the new tax arrangements make logical sense is a question best left for fuller discussion.

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This Research Feature is written by Christine Brown, Professor of Finance and Discipline Head, Finance, Department of Accounting and Finance, Monash University; and Kevin Davis, Research Director, Australian Centre for Financial Studies.

The research on which this brief article is based upon is reported in more detail in “Taxes, Tenders and the Design of Australian Off-Market Share Repurchases”. The research was presented at various conferences including the 2010 La Trobe Corporate Finance and Governance Conference, and 2010 FMA International Conference.

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Research Feature: ASX small firm listing concessions: How have they worked?

Posted on May 3, 2012
Filed Under Corporate Finance, Publications, Research Review | Leave a Comment

Zoltan Murgulov and Madhu Veeraraghavan (Monash University) and Alastair Marsden (The University of Auckland) examine the performance of small firms which have listed on the ASX under the “commitments test entity” rules. There were around 350 such companies in the decade ending in 2009. While there is no evidence that the more relaxed listing requirements have led to any greater propensity for subsequent delisting, there has been evidence of longer-run underperformance relative to other IPOs.

Following amendments to the Corporations Law in 1999, changes to the ASX listing rules enabled small and unprofitable companies to list on the ASX as Commitments Test Entities (CTEs). This approach appears to be unique internationally; although second board or sub-markets often exist – such as the Alternative Investment Market (AIM) of the London Stock Exchange (LSE). While, for example, the AIM has less rigorous reporting requirements than for the main board, the ASX enforces the same rules for CTEs as for other listed companies while also imposing additional reporting requirements for at least the first two years of listing.

In the period between 1999 and 2009 approximately one-half of ASX listed non-mining IPOs were CTEs (351 companies in total by our calculations). Compared to other IPO companies, they:

• are generally significantly smaller;
• are more concentrated in ‘technology’ industries;
• issue seasoned equity earlier and more frequently after listing on the ASX; and
• are not more likely to delist due to financial distress or bankruptcy.

Did these listing concessions increase the supply of equity capital to small companies in a cost-effective manner without exposing investors to excessive risk? Read on!

Overview of CTE listing rules

Companies seeking listing on the ASX under the general admission criteria must satisfy either the profits test (involving meeting minimum requirements based on past, current, and directors’ statements about future, profitability) or the assets test (involving, inter alia, minimum net tangible assets or market capitalisation requirements). The CTE arrangements meant that entities not meeting the profits test, but which had raised sufficient cash in the IPO, could list on the ASX as a CTE, where the company makes commitments to spend the IPO proceeds as agreed in consultations with the ASX. These rules improve access for relatively small and recently established entities to source public equity finance. The listing standards for CTEs are not overly restrictive. For example, a company that is not a going concern, does not have accounts’ history for the previous three years and is currently unprofitable, can list on the ASX as a CTE by raising (say) $10 million capital from investors conditional on making commitments to the ASX about the investment of the proceeds.

The ASX enforces compliance with the agreement in respect to the use of the IPO proceeds by requiring CTEs to submit quarterly reports, which must disclose a consolidated statement of cash flows, financing and investments activities, acquisitions and divestments, payments to related entities, as well as any payments and loans provided by the entity to the company directors and their associates. Reports are generally required for at least a two year period, until the firm reports four consecutive quarters of positive cash flows from operations. These additional reporting requirements are then removed and the market is notified by the ASX.

CTE Firm Characteristics

Because CTE IPOs tend to be in “high-tech” industries (software, hardware, pharmaceuticals, biotechnology, healthcare, etc.), whereas other (non-mining) IPOs are in more “conventional” industries (diversified financials, capital goods, commercial services and supplies), CTE IPOs are likely to be viewed as more speculative investments by investors.

Compared to other (non-mining) IPOs CTEs:

• list on the ASX around five years after their incorporation (versus 12 years others);
• have average offer value around $16 million (versus $48 million for other IPOs);
• are more likely to be underwritten and with higher underwriting fees; and
• are more likely to be backed by a venture capital firm (one quarter of CTEs versus 5 per cent in a matched group of non-CTE firms).

CTE Performance

IPO stag profits or initial listing day returns over the period 1999 to 2009 were 24% for CTEs and 19% for non-CTE IPOs; however, investing in CTEs is risky with approximately 27percent of CTE IPOs have a first trading day closing price below the offer price. Also three-year post-listing abnormal returns to CTEs were negative on average and also more negative than the returns to concurrent non-CTE IPOs listed on the ASX.

Only 26 percent of CTEs forecast positive earnings in their IPO prospectus, while only around 16 percent of CTEs forecast positive cash flows from operations in the post-offer year (significantly less than non-CTE IPOs). The majority had not escaped the CTE reporting requirements at the end of two years (i.e. had not established continued profitability for four quarters), but those forecasting positive cash flows or earnings at their IPO were more likely to have done so. Thus, prospectus information seems to contain some valuable information for the investors!

CTE Financial Management

Compared to other IPOs, CTE firms are significantly more likely to use the offer proceeds for internal purposes (working capital or investments in the company), rather than using the offer proceeds to repay debt or to make acquisitions. Our analysis indicates that they are significantly more likely to sell additional equity within three years of listing, and more so if they have higher listing day returns and subsequent short-term returns (in the first trading month).

Conclusion

The CTE rule increased opportunities for investors to invest in small-cap companies and enabled a relatively large number of predominantly small and young IPO companies to raise equity finance at reasonable costs. It also appears that the CTE listing rules facilitated VC firms in raising external capital for some of their target firms and possibly providing a mechanism for partial early exit subsequent to expiry of any escrow period.

There was little difference in short term investor returns vis a vis other IPOs, but longer term stock underperformance was worse for CTE IPOs. However, CTEs have not been more likely to delist due to financial distress or bankruptcy. Whether the listing process of CTEs by the Exchange creates some form of “certification” effect, which influences investor demand (both at IPO and for subsequent seasoned issues) and has subsequent implications for stock price performance, and for delisting incentives despite poor profitability, are issues warranting further study.

Recent proposed changes to listing requirements flagged in an ASX consultation paper  indicate the ASX is considering[1] amending the listing requirements to increase the annual capital raising limit to allow small and medium capitalisation companies more flexible access to equity finance. In the 2013 financial year, the ASX is to provide funding to assist production of independent quality analysis of ASX listed companies (for companies with less than $1billion in market capitalisation); this is likely to result in analyst coverage of some small and medium size companies for which currently no independent research coverage is available. The proposed changes to the ASX rules and incentives to provide analyst coverage of small and mid-cap companies are likely to further increase the appeal of CTEs to investors.

[1] “Strengthening Australia’s equity capital markets” ASX proposals and consultation, The Australian Securities Exchange (April 2012).

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The research on which this brief article is based upon is reported in more detail in “Commitments Test Entity Initial Public Offerings on the ASX” and “Commitments Test Entities on the ASX: Quarterly Reporting and Subsequent Seasoned Equity Offers”. The research was funded by grants from the Australian Centre for Financial Studies, and led to presentations in various seminars and at conferences, including Monash University, Massey University, Australasian Banking and Finance Conference, and the Australian Centre for Financial Studies Banking and Finance Conference.

Zoltan Murgulov and co-authors Alastair Marsden and Madhu Veeraraghavan were recipients of the 2008 and 2010 Australian Centre for Financial Studies Academic Research Grants based on submissions, A Study of Companies Listed on the Australian Securities Exchange based on the Commitments Test Entity Rule and Initial Public Offerings by Commitments Test Entities on the ASX respectively.

To read full paper, please contact Zoltan Murgulov

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Research Feature: Management Earnings Forecasts

Posted on May 3, 2012
Filed Under Corporate Finance, Publications, Research Review | Leave a Comment

Paul Mather of La Trobe University investigates the firm characteristics that are likely to lead to more accurate and timely voluntary earnings forecasts. Quality earnings forecasts and timely disclosures are shown to reduce information asymmetries in capital markets and can lead to improved price discovery, this is particularly apparent amongst firms that have built a reputation for accurate forecasting. There is found to be a high correlation between firms with high growth options and the likelihood of a firm issuing timely and accurate management earnings forecasts. The implication is that high growth options may encourage good corporate governance practice.

Management earnings forecasts (forecasts) are voluntary disclosures made by companies that inform stakeholders about their expected future financial performance. In Australia, management typically release forecasts as part of a routine information event such as the Chairman’s address at the AGM or with the release of the half-yearly earnings. Alternatively, management may release a non-routine forecast at any other time.

Australian Stock Exchange (ASX) listing rules require listed companies to continuously disclose information likely to have a material effect on share price. More specifically, the regulatory components of the Australian continuous disclosure regime are in two parts. First, the ASX Listing Rule 3.1 which requires that an entity immediately advises the ASX of any information concerning the entity that it becomes aware of (with a few exceptions), that a reasonable person would expect to have a material effect on the price or value of the entity’s securities. Second, S1001A of the Corporations Act which provides the statutory penalties for breach of the aforementioned Continuous Disclosure requirements. The Australian Securities and Investments Commission (ASIC) centrally regulate the application of the continuous disclosure requirements. The continuous disclosure regime and mechanisms for its enforcement are designed to try and ensure that the market is fully informed and to reduce information asymmetries between management and shareholders.

Overseas capital markets also have regulatory frameworks that affect forecasts. In the US, Regulation Fair Disclosure (Regulation FD) was promulgated in 2000 and requires all publicly listed companies to disclose “market moving” information to all investors at the same time. Prior to this, periodic (usually quarterly) analyst conference calls was the common practice where management discussed the quarterly results but also provided forecast information and answered questions about future prospects. Small investors were excluded from this process that potentially exacerbated market information asymmetries which was the driving force behind Regulation FD that prohibits such selective disclosure.

Further differences in the legal and regulatory environment include, that Australia, similar to Canada, has a lower threat of private shareholder litigation than does the US (Baginski et al., 2002). However, the US Private Securities Litigation Reform Act of 1995 gives safe harbour to companies issuing forecasts providing some protection from law suits if forecast outcomes are not achieved. In contrast, Australia has no safe harbour for any earnings forecasts. A ramification of these legal and regulatory differences is that in Australia company announcements must be made direct to the ASX which then releases these announcements to all market participants at the same time. Selective disclosure of price sensitive information is not permitted in Australia. The Australian requirements significantly pre-date the introduction of Regulation FD in the US.

Research shows that forecasts have information content and influence stock prices (Pownall et al. 1993) by reducing information asymmetry (Nagar et al., 2003). Also, the form of the forecasts appears to affect the market reaction.  Although not entirely conclusive, there is some evidence that more specific forecasts such as point forecasts are more informative relative to other forms of forecasts (Baginski et al., 1993). Similarly, interim forecasts are a lot more informative than annual forecasts (Pownall et al., 1993). It is also argued that markets react differently to good-news as opposed to bad-news forecasts. Bad-news forecasts are considered to be fundamentally informative while stock prices react quicker to good-news forecasts when a firm has built a reputation for accurate forecasting (Hutton and Stocken, 2009).

Given the responsiveness of markets to earnings forecasts and the regulatory oversight over such disclosures, it is to be expected that better governed firms with well structured boards will pay particular attention to the form and accuracy of their forecasts. Indeed, Principle 5 of the Corporate Governance Principles and Recommendations with 2010 amendments (ASX Corporate Governance Council, 2010) encourage the development of written policies and procedures designed to ensure compliance with continuous disclosure obligations. Two US studies examine and largely find an association between US firms’ corporate governance mechanisms such as institutional holdings, corporate board and audit committee characteristics and the quality of their earnings forecasts (Ajinkya et al.,2005; Karamanou and Vafeas (2005).The only published research in an Australian context reports a significant positive relationship between the likelihood and frequency of firms issuing management earnings forecasts and audit committee independence and independent director reputation but not board independence. However, there is some evidence that director independence is related to more specific forecasts (Chan et al., 2008).

If earnings forecasts potentially reduce information asymmetries in capital markets, they are likely to be particularly useful in the presence of moral hazard associated with growth options. Work currently in progress (funded by an ACFS research grant) examines whether the relationship between board characteristics such as the independence, reputation and financial expertise of directors and forecasts will be strongest in firms with high growth options.  Preliminary findings suggest that the strong relationship between the likelihood of firms issuing management earnings forecasts, their specificity and accuracy and many of the board characteristics examined is driven by firms with high growth options (Chan et al., 2012).

In sum, the ASX listing rules require listed companies to continuously disclose information likely to have a material effect on share price. Management earnings forecasts are influential, reduce information asymmetries and have capital market consequences.  Empirical evidence to date is consistent with the proposition that effective corporate governance is associated with better quality forecasts suggesting that regulators can improve capital market disclosures by continuing to encourage listed companies to implement good corporate governance practice.

References
Ajinkya, B., S. Bhojraj and P. Sengupta, (2005), ‘The Association between Outside Directors, Institutional Investors and the Properties of Management Earnings Forecasts’, Journal of Accounting Research, Vol.43, pp.343-376.

ASX Corporate Governance Council, (2010),Corporate Governance Principles and Recommendations with 2010 amendments.
Baginski, S. P., J. M. Hassell and M. D. Kimborough, (2002), ‘The effect of legal environment on voluntary disclosure: Evidence from management earnings forecasts issued in US and Canadian markets’, The Accounting Review, 77, 25-50.
Chan, H., R. Faff, P. Mather and A. Ramsay, (2008), “The Relationship between Directors’ Independence, Reputation and Management Earnings Forecasts”, Corporate Ownership and Control, Vol 6, No 2, pp 404-419

Chan, H., R. Faff, A. Khan, and P. Mather, (2012), “Board characteristics, management earnings forecasts and growth options”, 3rd Annual Finance and Corporate Governance Conference, Melbourne

Hutton, A., and P. C. Stocken., 2009.Prior forecasting accuracy and investor reaction to management earnings forecasts.Working paper, Boston College and Dartmouth College.

Karamanou, I and N. Vafeas, (2005), ‘The Association between Corporate Boards, Audit Committees, and Management Earnings Forecasts: An Empirical analysis’, Journal of Accounting Research, Vol. 43, pp. 453-486.
Kasznik, R., and B. Lev, 1995, To warn or not to warn: Management disclosures in the face of an earnings surprise. The Accounting Review70 (1): 113–134.

Nagar, V., D. Nanda, and P. Wysocki, 2003, Discretionary disclosure and stock-based incentives.Journal of Accounting and Economics34: 283–309.

Ng, J., I. Tuna, and R. Verdi., 2006, Management forecasts, disclosure quality, and market efficiency.Working paper, The Wharton School, University of Pennsylvania.

Pownall, G., C. Wasley, and G. Waymire, 1993, The stock price effects of alternative types of management earnings forecasts. The Accounting Review68 (4): 896–912.

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Paul Mather and co-authors Howard Chan, Robert Faff and Alan Ramsay were recipients of the 2007 Australian Centre for Financial Studies Academic Research Grants based on submission, The relationship between corporate governance and management earnings forecasts being informative in a continuous disclosure environment. A similar presentation was made at the 2007 AFAANZ Conference, The association between directors’ independence, reputation and management earnings forecasts; and a journal publication in Corporate Ownership and Control:

Chan, H.W.H., Faff, R., Mather, P., and Ramsay, A.. 2008. “The relationship between director independence, reputation and management earnings forecasts”, Corporate Ownership and Control, 6 (2, Winter): pp. 404-419.

To read full paper, please contact Paul Mather

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A Debt rather than Deficit Fetish would be less harmful

Posted on May 2, 2012
Filed Under ACFS Commentary, Banking, Financial Institutions and Markets, Media Watch, Policy, Publications | Leave a Comment

Published in The Conversation, Don’t forget the debt: there’s more to fiscal prudence than a return to surplus, 2 May 2012

Treasurer Swan’s commitment to bring the Government budget into surplus in 2012-13 may be a political imperative, but is not good economics. The focus for prudential fiscal management should instead be on what budget outcome is consistent with an appropriate path for government debt outstanding.

A budget deficit outcome of $10 billion or so would not appear inconsistent with prudence, and effects of fiscal policy changes on economic activity also need to be taken into account.

Just as we do not expect businesses to operate without some debt outstanding, so we should not expect Governments to be debt free. Some part of their expenditures are capital investments benefitting future generations and warrant some degree of funding by borrowing rather than by current taxation (ie deficit financing).

What is an appropriate level of government debt? There is no unique right answer, but lots of wrong answers.

Levels such as currently found in Europe and the US are clearly not the right answer. Meeting the level of interest payments involved imposes budgetary constraints on other real budget expenditures in order to avoid a vicious debt spiral, and national financial credibility is threatened.

Neither is a zero level of government debt optimal for a country which has substantial public sector assets and capacity to raise income via taxes. And zero debt means an absence of a government securities market – not something appreciated by financial markets.

In thinking about appropriate government debt levels and implications for budget surplus/deficit settings, it is common to focus upon the debt to GDP ratio. Scaling by GDP makes sense since that is indicative of a government’s capacity to raise funds (via taxation) to repay debt principal and interest.

At June 2011, federal government debt/GDP was 13.7 per cent, more than double the low reached in the mid 2000’s, but still well below the average of 17.9 per cent for the period 1983- 2000. Keeping that ratio roughly constant would not seem like a bad fiscal objective – certainly better than aiming for a massive fiscal shift to a budget surplus at a time when the economic outlook is unsettled.

How does the debt/GDP ratio evolve over time? There are three relevant factors. First, interest owed on existing debt (and included in the budget deficit) adds to the numerator, pushing the ratio up. But, second, growth of GDP adds to the denominator, and drags the ratio down.

While the arithmetic (and accounting) is a bit complex, these two factors arguably cancel out at the moment. Historical government debt costs are in the order of 6 per cent p.a (public debt interest in 2011-12 was projected at $11.6 billion on debt of $191 billion). But rollover of some higher-yield debt at lower current market rates, suggests a figure of 5.5 per cent as a reasonable estimate going forward. Projected nominal GDP growth is also in that order of magnitude (although forecasting is a risky business).

That leaves the third contributing factor which is the primary budget deficit – the deficit of Government expenditure on goods and services, excluding interest payments, over taxation revenue. With the other factors driving the debt/GDP ratio roughly cancelling out, a zero target for this variable would lead to the ratio remaining roughly constant.

For 2011-2012, the planned deficit was approximately $32 billion, and public debt interest projected at $11.6 billion, such that the primary deficit was around $20 billion. Dropping that to zero would leave an overall budget deficit of around $11-12 billion (the interest component) which appears to be consistent with not much change in the government debt/GDP ratio.

While the above estimates are indicative (and parameters and  forecasts involved subject to debate), the critical take-home message is not about the numbers per se. Rather it is that the budget deficit/surplus should not be the sole focus of attention when thinking about prudential government fiscal management.

The implication of budget settings for the evolution of the government debt position is a much better focus of attention when fiscal prudence is being discussed. And at the current time, on that criteria, it is far from obvious that prudent fiscal management involves a massive shift in the budget outcome to overall surplus.

This Commentary is written by Professor Kevin Davis, Research Director of the Australian Centre for Financial Studies.

info@australiancentre.com.au

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Too Big To Swallow

Posted on April 30, 2012
Filed Under ACFS Commentary, ANZSFRC, Banking, Financial Institutions and Markets, Media Watch, Policy, Publications | Leave a Comment

Published in Business Spectator, The big four elephants in the room, 30 April 2012

It has been reported that the European Union is considering draft laws for substantial additional capital requirements for its large banks. This would be a broadening of similar Basel Committee recommendations for 29 large banks which it decided warranted designation as Globally Systemically Important Banks (G-SIBs). The Financial Stability Board also indicated to G-20 Ministers on 16 April that it is considering how to best develop principles for regulators to apply in dealing with Domestically Systemically Important Banks (D-SIBs).

What then about the big four Australasian banks which are domestic or regional SIBS, whose financial stability is so important to the smooth functioning of the Australian and New Zealand (and Pacific Islands) economies and financial systems? On the criteria used for the Basel Committee for G-SIB status of cross-jurisdictional activity, size, interconnectedness, possible substitutability of their role in providing financial system infrastructure, and complexity, they score quite highly (although not high enough to be G-SIBs).

The Australia-New Zealand Shadow Financial Regulatory Committee (ANZSFRC), an independent group of senior academics, has argued that there is a case for different regulatory treatment of the big four compared to smaller banks and deposit takers. Why? The reason is that the big four are “too big to swallow”.

The ANZSFRC note that “it is the negative social externalities of failure of SIBs which give rise to proposals for special regulatory treatment.” And “resolution arrangements (including “bail-outs” due to too big to fail considerations) which exist to shield stakeholders from loss have the moral hazard downside of reducing market discipline and allowing (if not inducing) socially excessive risk-taking by SIBs.”

Possible competitive advantages from perceptions of government protection are also relevant, although in the case of domestic deposit markets the $250,000 deposit guarantee cap of the Financial Claims Scheme should make that less relevant.

Generally, APRA is able to limit externalities of failure of smaller troubled institutions by facilitating a smooth exit through takeover by another competitor. But this is not really a feasible option should one of the big four get into trouble (either in Australia or in the New Zealand subsidiaries).

While there is a budget appropriation of $20 billion for the Financial System Stability Special Account to assist in dealing with a troubled bank, that is unlikely to be adequate in the case of the big four (each with $400 billion or more assets in Australia). Given the opaqueness of large banks, the scale of possible hidden risks would make any potential acquirer hesitant.

There are also substantial Trans Tasman complications which would arise from financial distress in any of the big four. The New Zealand authorities have a quite different approach to resolving troubled large banks.

They have eschewed deposit insurance in favour of an “Open Bank Resolution” approach. Depositors and other creditors would be given a sufficient “haircut” (ie writing down of the value of deposits) such that the bank is restored to solvency and can continue operating. It has yet to be put to the test, and there are many sceptics, particularly when it is realised that government guarantees of the remaining deposits will be necessary to prevent depositors fleeing the bank.

While there is substantial Trans-Tasman regulatory cooperation (and each is required to consider implications of their actions for the financial systems of both) there seems little doubt that there would be cross-border spillovers from problems arising in either country.

So, failure of a large Australasian bank would create massive problems for financial stability. And while some would argue that is unlikely given recent shows of strength, this requires a longer term perspective (and the banking problems of the early 1990s should be a reminder of what can happen).

What is the appropriate regulatory response? Some argue that requiring downsizing such that no bank is too big to swallow is appropriate – but that seems like a political non-starter, and may involve economic costs.

Strong effective prudential supervision is a key component. And other regulatory responses should be kept simple, but effective. Higher capital requirements, perhaps in the form of contingent capital (hybrid securities which convert into equity when trouble strikes) fit that requirement.

(The ANZSFRC statement can be found at http://www.australiancentre.com.au/acfs-links/anzsfrc/)

This Commentary is written by Professor Kevin Davis, Research Director of the Australian Centre for Financial Studies.

info@australiancentre.com.au

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A system at risk: the case for regulatory overhaul in Australia’s banking sector

Posted on April 20, 2012
Filed Under ANZSFRC, Banking, Financial Institutions and Markets, Media Watch, Policy, Publications | Leave a Comment

Published in The Conversation, 16 April 2012

Following the recent release of  Statement No. 10 by the Australia-New Zealand Shadow Financial Regulatory Committee (ANZSFRC) exploring whether the systemic importance of the big four Australasian banks warrants their being subject to special regulatory treatment, The Conversation digs deeper through an interview with Professor Kevin Davis, Research Director for the Australian Centre for Financial Studies, and Co-Chair of the ANZSFRC.

The focus of the statement by the Australia-New Zealand Shadow Financial Regulatory Committee asks whether the systemic importance of the big four Australasian banks warrants special regulatory treatment. Firstly, what constitutes a systemically important bank?

One of the issues that came out of the global financial crisis was recognition that there are substantial interrelationships between banks, particularly the large, complex banks, which means that if they fail or get into financial difficulty, it creates spillover effects or what is often referred to as negative social externalities, which impact on the functioning of the economy and financial system……

What is the Australian government’s policy on dealing with the prospect of bank failure? Is the system well equipped to handle the possibility of contagion, given the interconnectedness of our main financial institutions?

The Australian regulators have done a lot of work over recent years in putting together better plans and mechanisms for dealing with failures of banks. These are good moves, although we still have some issues on how they would deal with one of the the big four, if they were to get in trouble here or in their New Zealand subsidiaries.

In our statement, we’ve coined the phrase “too big to swallow” as being an issue that distinguishes the big four from the other banks in Australia and New Zealand……

International regulators have recommended additional capital requirements for 29 international banks, but Australia’s big banks aren’t included. Why is that?

The international body looked at 73 large international banks, which included the major Australian banks, but ultimately it didn’t include them in their final list of global, systemically important banks.

It’s a mixture of several things, I think. Australian banks aren’t global. They are very important regionally, but they’re not systemic in that global sense. Also, their activities are much more focused on plain lending – in particular, housing finance – and……

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Do the Big Four Australasian Banks Require Special Regulation?

Posted on April 12, 2012
Filed Under ANZSFRC, Banking, Financial Institutions and Markets, Media Release, Publications | 1 Comment

The Australia-New Zealand Shadow Financial Regulatory Committee releases Statement No. 10 exploring whether the systemic importance of the big four Australasian banks warrants their being subject to special regulatory treatment.

The Australia-New Zealand Shadow Financial Regulatory Committee (ANZSFRC), an independent group of senior finance academics, today released its latest statement. It addresses the question of whether the big four Australasian banks warrant any special regulatory treatment by virtue of being systemically important banks (SIBs). International regulators have recommended additional capital requirements for 29 international banks (but not including our big four) because of the negative social externalities which failures of such institutions cause.

The Big Four are Regional SIBs (R-SIBs), dominating the financial markets of Australasia. Given likely spillovers and contagion should either an Australian parent or its New Zealand subsidiary get into financial trouble, Trans-Tasman arrangements for dealing with a troubled R-SIB are important. While there are quite striking differences in resolution policies in the two countries, these do not appear to pose insurmountable problems. But greater clarity from the Australian government on how it would deal with a troubled SIB would assist.

Summary:

• the fact that the big four would likely be “too big to swallow” by other banks, if in trouble, means that a different regulatory approach is appropriate compared to other smaller institutions where regulators can arrange smooth exit via takeovers (or allow failure)
• requiring additional contingent capital (which are hybrid securities which convert into equity when a bank is in distress) for the big four has merit
• there is merit in considering making a relatively simple leverage ratio the primary bank capital requirement instead of the increasingly complex and costly risk weighted capital requirements which the Basel Committee favours
• while Australian and New Zealand policies for resolution of troubled banks are quite different, and the Big Four are SIBs in both, those differences do not look to pose insurmountable problems in dealing with potential failure of either the Australian parent or subsidiary. A requirement for conversion of operations to Non-Operating Holding Company (NOHC) structure (where both Australian and New Zealand operations were separate subsidiaries of the NOHC) would reduce direct spillover effects. But, in the absence of greater clarity from the Australian Government on how it would deal with a troubled SIB, risk of Trans-Tasman contagion and runs would remain.

For the full statement and more information on ANZSFRC, please visit our website at:

http://www.australiancentre.com.au/acfs-links/anzsfrc/  

The Australian Centre for Financial Studies 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 and disseminate knowledge creation and transfer throughout the greater finance community via its various activities.

The Australian Centre for Financial Studies (previously known as the Melbourne Centre for Financial Studies) is a not-for-profit consortium of Monash and RMIT Universities and Finsia with Affiliated Universities of Deakin and Melbourne, having commenced in 2005 with seed funding from the Victorian Government. 

END

Media contact details:

Professor Kevin Davis
Research Director, Australian Centre for Financial Studies &
Professor of Finance, University of Melbourne
T: +61 3 9666 1050   M: +61 409 970 559

Can a Corporate Bond Market solve the Super Equity Bias?

Posted on March 22, 2012
Filed Under ACFS Commentary, Banking, Financial Institutions and Markets, Funds Management & Superannuation, Publications | Leave a Comment

Published in AFR, Traps lurking in new corporate bond market, 20 March 2012

The stars appear to be in alignment for a beneficial structural reform of the Australian financial system to kill two birds with one stone. On the one hand, almost everyone seems to support initiatives to develop a local corporate bond market to broaden corporate funding sources. On the other, almost everyone believes that super funds have an excessive equity bias and need more fixed interest (bond) investments.

But corporate bond market development and super fund investment switches towards those securities, even if it were to happen, would not bring all the benefits sometimes touted. There are macro-financial issues to consider.

For example, development of a domestic corporate bond market would not reduce Australian reliance on overseas funding – that is driven by our savings and investment imbalances and consequent balance of payments outcomes. The conduits through which international financing would occur may change, but not the aggregate.

Similarly, super funds holding less equity might reduce their exposure to stock market volatility. But in aggregate, someone has to hold those equities and bear that risk. Exactly how the structure of equity holdings might change, and that risk be redistributed among Australians (and international investors) is not clear. But Australian residents could end up just transferring the risk out of their super accounts onto other parts of their financial wealth.

The implications of these sorts of interlinkages run more deeply, as can be seen by asking the following question. If Australian companies can meet more of their financing requirements by issuing bonds, what other source of financing will be less used? (And don’t think that creation of a bond market will magically lead to more corporate investment and thus increased financing needs, rather than involving primarily a substitution effect!)

Consider first the possibility of bond financing replacing some equity funding, such as by a bond issue financing a share buyback. That could achieve both objectives at once (reducing the equity bias and expanding debt markets) and there may be merit in the Treasury looking at measures to promote arrangements such as bond for equity swaps.

For example, allowing a company to provide all shareholders with pro rata tradable rights to swap some of their equity for new bonds to be listed on the exchange, would not involve any redistribution of wealth among shareholders. (And it involves substituting a more senior claim on the company for part of their equity). It is difficult to see why such an offer to existing shareholders would necessitate major disclosure requirements. Subsequent potential purchasers of those rights or of the bonds could evaluate their merits based on available company information, traded market prices, and information about the key characteristics of the bonds.

But it needs to be asked whether any such financial restructuring involving increased leverage (more debt, less equity) is good corporate strategy. In Australia, the imputation tax system reduces or removes tax benefits of debt financing. And while debt may “look” cheaper”, increased leverage increases the cost of equity, as shareholders demand a higher rate of return to reflect increased risk.

There may be benefits from bond issuance, in the form of better signalling of corporate prospects or improved monitoring and market discipline, but in the current state of the financial world, it seems unlikely that higher leverage is likely to be attractive, suggesting that corporate bond issues would not generally be substituting for equity financing.

That indicates that corporate bond issues are likely to be primarily at the expense of bank loans – and Basel III capital and liquidity requirements are also providing incentives for banks to encourage corporate use of debt markets rather than providing on-balance sheet lending. But what other market wide adjustments would be a consequence, and will investor demand for corporate debt be there?

If banks focus more on leading corporates to the debt markets rather than on-balance sheet lending, their funding requirements also decline. One possible adjustment process could be reduced bank reliance on international capital markets, with more of our balance of payments financing involving direct foreign purchase of Australian assets such as equities. While that might help super funds reduce their equity bias, it is only one among a wide range of adjustment possibilities (about which we understand relatively little).

Another possibility could be less bank reliance on domestic term deposits, with investors switching from deposits to corporate bonds. And here is a real killer in terms of the much desired retail corporate bond market. What yield must be offered to individual investors (including self managed super funds) to encourage them to invest in risky corporate bonds rather than bank deposits which are guaranteed up to $250,000 at each bank.

This Commentary is written by Professor Kevin Davis, Research Director of the Australian Centre for Financial Studies.

info@australiancentre.com.au

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Armageddon was Yesterday. Today we have a Problem

Posted on March 12, 2012
Filed Under Banking, Financial Institutions and Markets, Event News, Funds Management & Superannuation, Media Release, Publications | 1 Comment

The future is bleak was the general message delivered by internationally acclaimed author and financial market expert Satyajit Das at an Australian Centre for Financial Studies presentation last Tuesday which drew a diverse audience of fund managers, bankers, directors, academics and students.  

During the presentation, held at the National Australia Bank Auditorium, Das expanded on the sentiments of his latest book Extreme Money, arguing that unsustainable easy money or “Botox economics” was the only reason for the post 2008 ‘recovery’ and that we are already starting to see growth falter now that stimulus is being withdrawn.

According to Das’ assessment of the Eurozone, Greece and Portugal will be labeled as a lost cause within the next two years, with Italy and possibly Spain and Ireland to follow the same path within the next decade. Das was highly critical of the austerity measures being levied onto these counties arguing that they will significantly hinder economic and tax revenue growth. Statistics showing that Greece’s tax revenue had decreased by 7 percent since last year provided support to his claim. He was also highly skeptical of the European Bailout Fund, referring to it as “the only six times leveraged distressed debt hedge fund in the world”.

Das was equally scathing on the United States, bringing attention to the unrealistic assumptions being used to forecast future budgets. These assumptions include 5 percent year-on-year GDP growth (growth is currently at less than 2 percent) and complete elimination of the Bush administrations tax cuts. He was however positive that the United States would be able to continue to inflate its way out of debt problems while retaining its reserve currency status, arguing that the U.S. Dollar has the most powerful backing imaginable, superior military strength.

A warning was issued to those who believe that emerging markets will support Australia’s continued economic growth arguing that Chinese growth is fraudulent and driven merely by investment spending financed by government owned bank debt. The general belief that China is relatively debt free was also challenged, with Das citing local government debt, lending by policy banks and debt incurred by government owned enterprises as strategies for moving large amounts of debt off the sovereign’s balance sheet. According to Das, these factors, when added to reduced demand for imports by developed countries, will result in slower growth in emerging markets and a sharp reverse in the terms of trade currently supporting the Australian economy.

His conclusion was equally sober, forecasting a period of extended stagnation, reduction in real wages and reduced living standards. The general message being that rather than continuing to cover up problems through excess liquidity and engineering growth through financial manipulation, we must focus on solving the underlying drivers of these problems and return to generating growth through the creation of real value.

Earlier that day Das also presented to some of Melbourne’s most respected financial leaders at an ACFS sponsored boardroom briefing held at the Future Fund before heading to Sydney for a final presentation held at Ernst and Young.

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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.

Notes taken by Martin Jenkinson, ACFS

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

Banking Profitability, Bank Capital and Competition

Posted on February 20, 2012
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Publications | Leave a Comment

FRDP 2012-1
February 20, 2012

In this Australian Centre for Financial Studies Financial Regulation Discussion Paper, Professor Kevin Davis looks at Australian bank capital and bank profitability. The evidence regarding whether banks are making excessive profits is mixed, although high market to book ratios for the major banks (stock market value of equity relative to its accounting book value) are indicative of some inadequacies in competition. In order to generate the returns that shareholders require on the value of their investments, high market to book ratios (averaging around 1.5) mean that the major banks need to target accounting returns in the order of 15 per cent p.a. or more. The majors compete with each other within that constraint.

But that leaves unanswered the question of why other competitors who should be able to operate with lower target accounting returns are not exerting a restraining influence on bank pricing and profitability. It also leaves unanswered the question of how market to book ratios for the major banks evolved to such levels – with inadequate competition over many years being a prime suspect. This FRDP provides an overview of the issues, but more detailed research is needed to evaluate whether calls for greater regulation or special taxation have merit.

There is currently much heated debate over whether Australian banks are exploiting a privileged position to make excessive profits. The major banks (to varying degrees) have been announcing record high dollar profits, while at the same time increasing loan interest rates and reducing employee numbers. With memories of government support to the banks during the Global Financial Crisis still relatively fresh, there have been a range of calls for regulation or taxation targeted at preventing “excessive profits”.

To determine whether the major banks are making excessive profits it is important to be clear about the interpretation of profit rates and rates of return, and to recognize the different perspectives arising from differences between the book value of equity (shareholders funds) and its share market value. Those differences help explain why CEOs of the major banks believe they are engaged in a highly competitive game, while others point to their high profit rates as evidence of inadequate competition.

An analysis of bank market to book ratios and alternative measures of rates of return is suggestive of past and present inadequacies in banking competition, and of accounting profit rates of 15 plus per cent being somewhat higher than is needed to meet shareholder demands. But this is a complex topic where assumptions can be disputed and more research is required. Moreover, even accepting those conclusions, no simple, politically palatable, policy conclusions are readily apparent.

Understanding rates of return

It is important to note that profit rates reported by banks (and other firms) are accounting measures, which relate accounting profits to the book value of equity. Thus, for example the CBA’s recent announcement of a half year profit of $3.6 billion for the six months ending December 2011, was reported as a return on equity of 19.2 per cent p.a. on (the book value of) shareholder equity of $38.9 billion. But at the end of 2011, CBA had some 1.6 billion shares on issue which at a share price of around $50 gave it a market capitalization of around $78 billion – approximately twice the book value.

For shareholders who had bought CBA shares at around $50 (the level they have hovered around for two years) the half yearly earnings of $2.31 per share would, if repeated in the second half year, give earnings of $4.62 for the year, which is an annual return on their investment of around 9.2 per cent. That does not seem like an excessive rate of return, and a similar gap between accounting and shareholder rates of return prevails if the latter are measured as dividends received plus capital gains relative to the share price!

How is this vast gap between the accounting and economic (shareholder) rates of return reconciled and explained?

Financial accounting academics have developed a relatively simple framework (known as the residual income model) within which to study this type of issue. It posits that market value (MV) and book value (BV) of equity at any date t are related as:

MVt = BVt + Present value of expected future abnormal earnings.

In turn, abnormal earnings at any future date τ are given by (roeτ – rτ)BVτ-1, where roe is the accounting rate of return achieved and rt is the required rate of return of shareholders, both applied to the book value at the start of that period. The formula includes the expected value of such abnormal earnings into the distant future, and these need to be discounted to a present value to allow for the delay and risks.

The intuition is straightforward. If investors think that managers will be able to use the financial resources (book value of capital) available to them to generate a return (roe) greater than that required (r), they will be willing to bid up the share price (market value) above its book value. In an efficient market, the share price (market value) will settle at a level which investors believe is consistent with their receiving just their required rate of return.

Market value, Book value and Bank CEO’s: Between a rock and a hard place?

While the precise relationship between accounting rates of return and shareholder equity returns and book and market values is complex, the message should be clear. Bank CEOs need to deliver profits (or confirm expectations of future profit growth) which are sufficient to meet the rate of return required by their shareholders on the market value of their investment. If the market to book ratio is greater than unity, the required accounting rate of return on book equity will exceed the required return of shareholders. If accounting profits (both current and forecast) are not sufficient to deliver the required return for shareholders on the market value of their investment, the share price will fall.

It is somewhat difficult to feel sympathy for highly remunerated bank CEOs but, with high market to book ratios they are caught between a rock and a hard place. Unless they deliver apparently excessive accounting profits and incur political and social wrath, they will not meet the demands of their shareholders for a fair return on their investment. And with most Australians being bank shareholders (through superannuation if not directly) that alternative would not be a popular outcome either.

For the major banks this is the situation they face. Table 1 presents recent figures for the market to book ratio for Australian banks, and shows that the four majors have ratios well in excess of unity. It also highlights a significant dichotomy between stock market valuations of the four majors and the other banks –which have market to book ratios well below unity. Whether those numbers indicate excessive profitability and market power of the major banks is returned to shortly. But first, it is worthwhile to examine how bank shareholders have fared recently, what rate of return shareholders require from banks, and what accounting rate of return is consistent with that.

TABLE 1: Market to Book Ratios of Australian Banks; February 2012

Source: http://www.investsmart.com.au (15 February 2012)

How have Bank Shareholders Fared?

One way to determine whether bank shareholders have enjoyed excessive returns on their investments is to compare their returns to those on the stock market more generally. Figure 1 does that for the period since early 2007 using rolling quarterly rates of return (in order to smooth the graphs). The solid line is the return on the S&P/ASX 200 Accumulation Index (an index of returns on the top 200 stocks which incorporates both capital gains and dividends). The dashed line is the (equally weighted) average return on the four majors (again incorporating both capital gains and dividends).

Figure 1 suggests that returns to bank shareholders have, over the period since just before the start of the Global Financial Crisis, been relatively similar to those on the ASX 200.

Figure 1: Bank and ASX 200 returns*

* The figure displays the average monthly rate of return over the preceding three months.

An alternative method of examining the returns to bank shareholders is to use the market model, relating monthly bank equity returns against returns on the market index (ASX 200). Results of such regressions (in which returns are measured in excess of a risk free interest rate proxy) are given in Table 2. There are two main features of those results. First, the regression intercept (α), which can be interpreted as measuring abnormal returns, is insignificantly different from zero in all cases. Second, the betas for all banks are around unity, which the Capital Asset Pricing Model (CAPM) implies that shareholder required returns would be approximately the same as the required return on the overall market.

Table 2: Market Model Results

This table gives results of estimating rit-rft = α+β(rmt-rft) where rit is the monthly return on stock i in month t, rmt is the monthly return on the market (ASX200) in month t and rft is the return on a 30 day bank bill for that month. Figures in parentheses are t statistics for a test of the null hypothesis that the parameter is significantly different from zero. Monthly data from February 2007 till November 2011 is used.

Required Shareholder Returns on Bank Equity and Accounting Returns

The required return is generally defined as that rate of return which compensates the investor for systematic (non-diversifiable) risk, and can be estimated using an asset pricing model such as the Capital Asset Pricing Model (CAPM). It is also often described as an expected rate of return, in the sense that market equilibrium requires that the share price adjusts until the expected future cash flows from the investment mean that the expected return equals the required return. (If the expected return was below the required return, investors would sell shares, pushing the price down and the expected return up).

Applying the CAPM is complicated by Australia’s dividend imputation tax system, because a significant component of returns to shareholders takes the form of franked dividends. However, it is well established that the effect of this complication on the CAPM is primarily to require that shareholder returns be measured by “grossing up” the cash dividend component of returns for the value of attached franking credits. While there is much debate about the average value of franking credits, they are certainly fully valued by domestic investors such as superannuation funds. For simplicity and, I would argue, appropriately in this case, the following analysis will assume full valuation – although that will no doubt be challenged by some.

Using a theory such as the CAPM, it can be argued that investors in bank shares currently require a ball park rate of return (including franking credits) of around 11-12 per cent. This ball park estimate is based on a risk free rate of 5-6 per cent, a market risk premium of 6 per cent and a beta for bank stocks of around 1.

How does that match up with accounting rates of return on (book value) of equity such as the 19.2 per cent reported by CBA, or the 15 per cent rate more generally thought of as being achievable by the majors in the post-GFC world?

The average market/book ratio for the major banks is in the vicinity of 1.5, suggesting (as outlined above) that investors believe that banks can generate a higher return on the equity funds available to them to use than that required by shareholders. Does this mean that a 15 per cent accounting return on equity is consistent with the shareholder required rate of return on the market value of equity or around 10-11 per cent p.a.?

Quite possibly! However, the accounting return on equity is an after-company-tax rate of return, and the dividends provided to shareholders as part of their return include valuable imputation credits. The arithmetic is a thus a bit messy. But it goes as follows and is set out in Table 3.

Suppose the book value of equity is $100 and the market value is $150. Suppose that the accounting return on equity is 15 per cent (ie profit after tax of $15) of which 80 per cent is distributed as franked dividends giving a $12 franked dividend which grosses up to a $17.14 dividend before personal tax. To that must be added the effect of the $3 retained earnings on the share price which can be expected to create a capital gain. Assuming that the retained earnings are fully reflected in the share price, there is a $3 capital gain, giving a total grossed up shareholder return of $20.14 which, on a market value of equity of $150, is a fully grossed up, pre-investor tax, rate of return of 13 per cent. (Also shown for information is the after tax return for a superfund for which the full valuation of franking credits implied in the grossing up is realistic).

Table 3: Relating accounting and shareholder returns – an example

This ball-park calculation suggest that a 15 per cent accounting return on (book value of) equity is at least, or more than, adequate to provide shareholders with their required rate of return of 10-11 per cent on the (higher) market value of equity. And for superfunds, the tax benefits from receiving franking credits mean that this is a very pleasant after-tax rate of return.

Thus a 15 per cent accounting return on equity (which excludes franking credits) looks easily sufficient to meet investor expectations and maintain share prices (although precise calculations are more complex – and this should certainly not be taken as investment advice!).

Of course, the calculation is not quite this simple. Some part of earnings is paid out as franked dividends and franking credits have zero value for some (overseas) investors. While retained earnings increase the bank’s capital base and should generate capital gains for the shareholders via an appreciation of the share price, there are many other influences upon share prices including expectations of future performance.

Approaching the question from another direction, the cash dividend yields of the major banks have been in the region of 6.5 to 8 per cent in recent years, with not much in the way of capital gains (and losses in some cases). Since a fully franked 8 per cent dividend grosses up to around 11 per cent, these numbers are roughly consistent with recent accounting returns being at least sufficient to meet shareholder required returns.

The Market/Book Value Problem and Competition

But even if the major banks were only just generating the returns that their shareholders demand, the question remains of why investors are willing to bid bank share prices up to a multiple (well) in excess of unity. As outlined earlier, this suggests that banks are able to earn abnormal returns on the financial resources (book value of equity) available to them. Why is it that the banks can achieve this?

One possible answer can be found from examining bank pricing practices and the nature of competition in banking/financial markets. Banks obviously price loans and other financial products to reflect both their operating costs and their cost of funds – one component of which is their cost of equity funds. Stated alternatively, pricing is done to try and achieve the target rate of return on equity. Thus, all of the majors will be pricing to achieve an accounting return on (book value of) equity of around 15 per cent or more. That type of return is thought to be required to keep shareholders satisfied with the resulting returns on the market value of their equity investment in the bank.

Major bank CEOs and management thus perceive themselves as engaged in fierce competition with other banks, because all are constrained in their pricing by similar 15 per cent (or higher) accounting return targets. Higher return targets imply (ceteris paribus) higher product prices which will see them undercut by the others and lose business (unless they are more efficient and have lower operating costs than their competitors). Pricing is constrained on the downside by the target accounting return – which is needed to keep share prices from falling.

But this self imposed constraint only applies to the four majors, because of their elevated market to book ratios. Any new competitor not suffering such a “handicap” and starting with a market to book ratio of unity, would be able to target an accounting return equal to that demanded by shareholders (of around 10 – 11 per cent on the ballpark calculations done earlier), and undercut the major bank prices. Indeed, for the non-majors, as shown in Table 1, their market to book ratios below unity should give them a competitive edge in this regard – other things constant.

Of course, other things undoubtedly are not constant. Smaller banks or new entrants may face higher deposit or debt funding costs (or higher required returns of shareholders). That may reflect market realities or perceptions of implicit government guarantees for banks which are “too big to fail”. Scale, such as the four majors have, may enable them to operate with lower operating costs. And potential economies of scope, due to the pervasiveness of the majors’ activities across the entire financial sector, may also bring operating cost or revenue benefits. The higher market to book ratios of the majors may thus reflect a franchise value built up over time which generates such operating cost advantages.

The dilemma which policy makers must face is to ascertain why the majors have elevated market to book ratios. Is it because they have operational or funding cost advantages over other existing or potential competitors – such that lower return aspirations of the latter would be offset by lower operational efficiency and thus bring no net pricing benefits to customers?

If so then, with one caveat, the only rationale for policy intervention would seem to be if those cost advantages reflect distortions in the system – which suggests policy prescriptions directed towards removing such distortions. (Arguably, banning mortgage exit fees and policies aimed at making it easier for customers to switch banks fall into this category, as would be measures to remove any perceptions of implicit guarantees for large banks enabling them to achieve lower funding costs).

The caveat arises because we have reached the current situation because the evolution of operating/funding cost efficiencies over time was not fully reflected in lower customer prices via competition, but rather in higher stock market prices reflecting the resulting higher accounting profits. It might then be argued that “forcing” lower product prices or returns to shareholders (such as by special taxation) would rectify that historical lack of competition. However, it would be at the expense of driving down bank share prices and imposing substantial losses on current banks shareholders (who are not necessarily the ones who benefited from the historical experience).

An alternative explanation for the high market to book ratios may be that there are barriers to entry which enable banks to make excess returns on the book value of their equity (even in the absence of cost advantages) and support a higher stock market valuation. One such barriers to entry could arise from the wide scope of bank activities across the whole financial sector, and a consequent ability to temporarily cross-subsidize particular market segments and prevent new entrants (even those suffering no cost disadvantage in that particular activity) from profitable entry? While the banks will, no doubt argue that they have not engaged in such practices, for a potential entrant the possibility that they may do so, can be a sufficient deterrent.

Conclusion

The analysis of this paper suggests that profitability of the major Australian banks, which many have claimed to be excessive, may be marginally higher than required to provide bank shareholders with a fair, required, return on their shareholdings. Underpinning this conclusion is the fact that the market valuation of bank equity far exceeds its book value for the four majors, requiring product pricing to be based on target accounting profit rates which appear unreasonably high to the outside observer.

But that, by no means, is the end of the story. Why are market to book ratios for the major banks well in excess of unity – or is this a “normal” state of affairs in banking? Is it because barriers to entry prevent effective competition from others not suffering such a “handicap” and who would thus be able to price products off a lower target accounting rate of profit? Or is it because the majors have inherent competitive advantages which have emerged over time and become reflected in higher share prices rather than in lower product prices? If so, to what extent do those advantages reflect inherent efficiency advantages versus market distortions which policy actions might target? And why didn’t competitive forces lead to the alternative outcome of more of the efficiency gains being passed on to customers in the form of lower product prices rather than finding reflection in higher bank share prices?

While the analysis of this paper suggests that returns may be somewhat higher than consistent with fierce competition, the important message is that by focusing on accounting returns the debate may be looking in the wrong place. Instead, more attention should be paid to why market to book ratios for the major banks are (and have been for some time) at levels well in excess of unity.

This FRDP was prepared by Kevin Davis, Research Director, Australian Centre for Financial Studies.
info@australiancentre.com.au

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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

Rates of wrath: understanding the Big Four’s actions on interest rates

Posted on February 15, 2012
Filed Under ACFS Commentary, Banking, Financial Institutions and Markets, Funds Management & Superannuation, Media Watch | Leave a Comment

Published in The Conversation, 15 February 2012

Last week, the Reserve Bank defied market expectations to announce the 4.25% cash rate would remain unchanged. But the surprise decision by Australia’s Big Four banks to act independently of the Reserve Bank and raise their standard variable interest rate- even as they announce record profits – has caused much ire among customers and Treasurer Wayne Swan. Are these interest rate hikes justified?

Professor Kevin Davis, Research Director for the Australian Centre for Financial Studies argues that although the banks are looking to protect their profits, the rising cost of funding – not to mention structural challenges in the sector – are driving the increases…

I think for the moment, what one can say, is that given the state of nervousness in international capital markets, the cost of raising funds has probably gone up. But at the moment, the banks also are in a situation where they’re rolling over a lot of the borrowing that they did during the global financial crisis under the federal government’s guarantee.

Could you elaborate on that guarantee?

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Higher Bank Capital: What’s Wrong with That?

Posted on January 30, 2012
Filed Under ACFS Commentary, Banking, Financial Institutions and Markets, Funds Management & Superannuation, Publications | Leave a Comment

Published in AFR, Social dimension to bank capital ratios, 30 January 2012

Suggestions from the IMF for Australian banks to increase their capital have elicited the usual negative response from that sector. Unnecessary, unfair, undesirable (for economic growth) are the sorts of reactions one gets used to hearing. But really, what does the social cost/benefit ratio look like?

It is important to realise that, in essence, bank capital requirements are no more than restrictions on the funding mix used by a bank. Higher capital requirements mean more use of equity and less of deposits and debt to fund a given level of lending and investments. Why might regulators want more capital, and why do bankers oppose this?

The call for higher capital is based on the fact that shareholders then bear more of the risk associated with bank activities, with their equity investment providing a buffer to protect depositors and debt holders from losses. That is good for financial stability and for taxpayers (if governments compensate depositors when banks fail), and the call is premised on a view that bankers will choose a level of capital which is too low on a social cost-benefit analysis.

Bankers economize on equity capital funding because of the view that deposits and debt funding is cheaper. Using other people’s money to make profits for shareholders is the name of the game, and the more of others’ money and less of shareholder money the better.

But are deposits and debt cheaper, and if so why? At face value the interest cost looks lower than the rate of return demanded by shareholders, but that is only part of the story. Increasing leverage (deposits and debt relative to equity) increases the risk (variability of returns) faced by shareholders causing them to demand a higher rate of return.

Taking this implicit cost of higher leverage into account, there should be no reduction in the average cost of funding unless there are some other relevant market imperfections (as Nobel prize-winning economists Modigliani and Miller pointed out many years ago). And, of course, there are such imperfections which are worth examining in more detail.

One is that depositors and debtors, who also face greater risk (from bank failure) of increased leverage, do not adequately increase the interest rates they demand from banks to compensate for that risk. And that will be the case if they believe that governments will protect them from losses, either explicitly via arrangements such as the Financial Claims Scheme, or implicitly by bailing out failing banks.

Thus banks, acting in the interests of shareholders, have a private incentive for higher leverage than is socially optimal because of an implicit taxpayer subsidy.

But maybe current regulatory capital requirements mean that Australian bank leverage is sufficiently constrained, such that risk of failure is so small as to be negligible and the taxpayer subsidy of minimal or no import. That may be so, but then the question arises of what is the cost of a higher capital ratio which decreases leverage, shareholder risk, and the required return of shareholders.

Not much is the answer, particularly under the Australian dividend imputation tax system where debt (deposit) financing has no (or little) tax advantage. The average cost of bank funds may increase by 5 to 10 basis points for each 1 percentage point increase in equity capital/assets – or not at all if shareholders act as proponents of efficient financial markets theory should suggest and reduce their required rates of return.

Of course, any higher bank funding costs mean higher costs for borrowers – but this can be offset by Reserve Bank interest rate policy. The main risk would be that banks respond to higher requirements not by raising new equity capital, but by reducing the scale and risk-weighting of their balance sheets.

The current unsettled global financial climate may be an inopportune time for banks to raise equity. But offsetting this is the ongoing wall of money flowing into Australian superfunds, including self managed super funds, with much of that looking to be invested in (particularly blue chip) Australian equities.

Whether higher bank capital ratios than current are needed or desirable can be debated, but that debate (like those over other regulatory changes) needs more attention paid to social cost/benefit analysis than has occurred to date.

This Commentary is written by Professor Kevin Davis, Research Director of the Australian Centre for Financial Studies.

info@australiancentre.com.au

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Finance Sector Employment on a Slippery Slope

Posted on January 18, 2012
Filed Under ACFS Commentary, Banking, Financial Institutions and Markets, Funds Management & Superannuation, Insurance, Publications | Leave a Comment

Published in AFR, 17 January 2012

Despite their consistently good profitability and cost/income ratios which KPMG’s annual performance survey indicates are relatively favourable compared to their international peers, the announcements of staff reductions by the major Australian banks should probably not come as a surprise.

Three interrelated factors are driving bank attempts to cut labour costs. While one is perhaps cyclical, the others appear longer term in nature, and the interesting question is whether this will herald a downsizing of financial sector employment and activity as a whole, or a shift in its composition away from banks.

For historical context, total financial sector employment was a relatively constant share of total employment during the “noughties”, at around 3.7 per cent. This was despite the ratio of financial institution assets to GDP increasing from 2.5 to 3.5 over the decade and the finance sector’s share of value added (GDP) increasing from just under 9 to over 10 per cent.

In the 1990s, the employment share dropped from 4.7 per cent to 3.7 per cent, while assets/GDP increased from 1.7 to 2.5 times and share of value added increased from around 8 to around 9 per cent.

So, over the past decade, a rapidly expanding financial sector has not increased its share of total employment, and in the previous decade financial sector growth saw a declining share of total employment. If technological change has meant that high growth has just sustained sector employment, a slowing of growth seems likely to lead to reduced employment.

Thus, the first factor driving employment cutbacks in banking is the marked decline in banking sector growth rates following the Global Financial Crisis. Credit growth (including securitisation) has fallen from an average of 14.4 per cent p.a. in the four years prior to June 2008 to 2.9 per cent p.a. in the two years to November 2011.

Higher growth on the deposit side of bank balance sheets offset that effect for a while with M3 growth rate averaging 17.8 per cent p.a. in the two years to June 2009, as depositors returned to the major banks during the unsettled times and as banks tried to replace offshore funding with local deposits. But over the two years to November 2011 that growth rate dropped to an average of 7.4 per cent p.a.

Bank operational structures based on anticipation of ongoing high growth rates obviously needed reassessment.

A second factor is regulation. Bank CEOs have pointed to an increased cost burden from recent regulatory changes, and it is hard to dispute that these must involve some increase in costs. But any employment effect is primarily indirect as attempts by banks to pass on those costs reduce customer demand for their financial services. And it seems more likely that the slowdown in credit and monetary growth reflects the effects of economic conditions and uncertainty on customer demand for financial services than increased costs of regulation.

Moreover, any regulatory induced decline in banking may be offset by growth elsewhere in the financial sector, eventually providing employment opportunities elsewhere for bank ex-employees. Even if banks still maintain their share of intermediation, they may find that regulatory changes make it preferable to adopt a production process which relies more on outsourcing some activities. Mortgage broking comes to mind, although offshoring of some other activities will not help newly unemployed bankers.

Ongoing technological innovation is, of course, the third relevant factor. In the late 1980s and early 1990s the major banks, responding to deregulation, advances in technology, and a massive decline in profitability which threatened the survival of some, reduced branches and employment and earned the wrath of the Australian public. Technological advances are again causing a reassessment of labour requirements, with ever increasing growth of internet banking and “apps” which enable customers to interact with their banks on a virtual basis.

But in an environment where banks remain relatively profitable and financial sector pay remains absurdly high, look forward to a resurgence of the “banks are bastards” grumbling, which the banks had worked hard to get rid of over the last decade.

This Commentary is written by Professor Kevin Davis, Research Director of the Australian Centre for Financial Studies.

info@australiancentre.com.au

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The World in Crisis: Insights from Six Shadow Financial Regulatory Committees

Posted on December 9, 2011
Filed Under ANZSFRC, Banking, Financial Institutions and Markets, Event News, Funds Management & Superannuation, Insurance, Policy, Publications | Leave a Comment

The six Shadow Financial Regulatory Committees (SFRC) of Asia, Australia – New Zealand, Europe, Japan, Latin America and the United States have together published an online book, “The World in Crisis: Insights from Six Shadow Financial Regulatory Committees“. This book aims to inform financial policy makers around the world and other players in the global financial marketplace. The insights ideally would be helpful in preparing for or avoiding future financial crises.

In different chapters, members of the SFRC provide different regional perspectives on the Global Financial Crisis and Financial Regulation. The Committees discuss how the crisis evolved in each of their countries or region, lessons learned, reform measures adopted or not adopted to date and propose ways in which cross-country coordination of financial regulatory policies may help prevent future crises, or at least minimise their severity.

The book begins with an Executive Summary of the chapters, followed by a statement adopted by the six Shadow Committees at a joint meeting in Washington, D.C. on October 22 – 24, 2011 on the current economic and financial crisis in the Eurozone countries, applying relevant lessons from the individual chapters. The Australia-NZ Shadow Committee chapter was prepared by Profs Christine Brown (Monash University), Prof Kevin Davis (Australian Centre for Financial Studies and University of Melbourne), Prof Mervyn Lewis (University of  South Australia) and Prof David Mayes (University of Auckland).

At the joint meeting in Washington, D.C. , the six committees discussed the impact of the financial crisis on countries in their regions, relevant lessons and policies to adopt. Presenters and Commenters include:

• ASLI DEMIRGUC-KUNT, World Bank
  
• LUC LAEVEN, International Monetary Fund
• JEREMY GOH, Asian Shadow Financial Regulatory Committee
• HARALD A. BENINK, Europe Shadow Financial Regulatory Committee 
• MASAYA SAKURAGAWA, Japanese Shadow Financial Regulatory Committee 
• LILIANA ROJAS-SUAREZ, Latin America Shadow Financial Regulatory Committee 
• GEORGE G. KAUFMAN, US Shadow Financial Regulatory Committee
• KEVIN DAVIS, Australia-New Zealand Shadow Financial Regulatory Committee

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More about the Australia – New Zealand Shadow Financial Regulatory Committee