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

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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 Vickers Report – Implications for Australia

Posted on September 30, 2011
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FRDP 2011-04
September 27, 2011

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

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

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

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

Retail Ring-fencing

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

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

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

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

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

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

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

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

Capital Requirements and Loss Absorbency

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

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

Failure Management Powers

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

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

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

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

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

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

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Deposit Insurance – Getting the Financial Claims Scheme Settled

Posted on June 8, 2011
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Insurance, Policy, Publications | Leave a Comment

FRDP 2011-03
June 5, 2011

In this Australian Centre for Financial Studies Financial Regulation Discussion Paper, Professor Kevin Davis reviews the proposed changes to the Financial Claims Scheme which were released in May 2011. He argues that the absence of an ex-ante risk based insurance fee is justified given the “closed resolution” nature of the scheme, and the priority given to APRA in the unlikely event that the scheme is activated. However, the existence of the scheme arguably generates competitive benefits for ADIs, relative to other non-ADIs competing for retail funds, due to perceptions of greater safety. Whether such benefits are offset by costs to ADIs from prudential regulation, or whether some fee is warranted on competitive neutrality grounds is an unanswered question.

The only surprise in the proposed changes to the Financial Claims Scheme (FCS) is why the Government took so long to reach, and announce, those plans. The existing cap of $1 million had to be reviewed by October 2011, and procrastination has done little other than add the slight complexity of how to deal with term deposits which run over that date.

Most of the suggestions by the Council of Financial Regulators for changes to the FCS are relatively straightforward and uncontroversial. But the proposed size of the cap and the financing of the scheme will no doubt evoke debate.

The straightforward changes include the following.

First, deposits in foreign branches of Australian banks are not covered by the scheme. International practice varies on this score, but the recent Icelandic experience cautions against countries taking on such exposures. More generally, international regulatory pressures seem likely to lead to most international expansion being by way of separately capitalized subsidiaries (covered by the host country deposit insurance scheme). In that case, deposit insurance arrangements for foreign branches become a non-issue.

Second, coverage will not apply to foreign currency deposits. Individuals holding such deposits are presumably not unsophisticated investors whom the scheme is designed to protect.

Third, foreign bank branches will not be covered, unlike Australian subsidiaries of foreign banks which are incorporated, separately capitalized and supervised by APRA). Since their licenses are premised on them not dealing with typical retail customers (they are not permitted to accept deposit accounts with initial balances of less than $250,000), exclusion from a scheme which involves a cap on insured deposits of no greater than that amount is again, a non-issue.

Fourth, since the insured cap is meant to apply to total deposits of an individual at one bank, a coverage issue arises when an agent (such as a trustee) operates one account on behalf of a number of individuals. The proposals, sensibly, advocate “looking through” the account to identify the ultimate owners, with the proposed cap applying to each.

The first issue which will generate debate relates to the proposed size of the cap. Perhaps the most surprising aspect of the debate will be the absence of proposals by banks and other ADIs to lower the cap on insured deposits below the $100,000 to $250,000 range suggested by the Council of Financial Regulators.

My how times change! When the FCS was originally mooted with a suggested cap of $50,000, the banks lobbied hard to have the cap reduced to $20,000. In the event, the Global Financial Crisis (GFC) intervened and the scheme was introduced with a cap of $1 million. At $50,000, almost all retail depositors are fully covered, but the GFC has led to a general increase in coverage levels internationally, and the proposed range is not inconsistent with that found elsewhere.

Smaller institutions, such as credit unions, can be expected to lobby for retention of the $1 million cap. Explicit government protection removes some of the competitive disadvantage they feel they face from the perceived implicit government protection which, it can be argued, the large banks gain from their size. Since no up front fees are proposed as part of the scheme, the larger the cap the better from their perspective.

The issue of fees will no doubt generate some debate. An ex-post funding approach is to be maintained, whereby levies on other ADIs would be made should APRA pay out depositors of a failed ADI and not recoup those funds from the realization of the failed ADI’s assets.

Some will argue that ex-post funding of the scheme is inappropriate, due to moral hazard concerns, and that an ex-ante risk-based fee scheme should be used. These arguments have limited weight given the specific nature of the scheme.

First, the moral hazard concern is that depositor protection reduces depositor monitoring of bank risk taking and enables excessive risk taking by ADIs without the penalty of needing to pay higher deposit interest rates reflecting that risk.

Really! The notion that retail depositors have the expertise and ability to assess the riskiness of even small ADIs is laughable. Even sophisticated analysts who might provide such information to depositors do not have a good track record in this regard. Risk-based capital requirements and APRA supervision (and its flexibility to adjust capital (and liquidity) requirements for individual ADIs) are one reason to think that moral hazard concerns are not a major issue. Another is that market discipline by wholesale providers of funds to banks, who are not covered by the scheme, is unaffected by the nature of the deposit insurance arrangements. Arrangements which create moral hazard need to be avoided, but this is not one of them. In fact, it can be argued that since the alternative to an explicit, limited cap, insurance scheme is depositor perceptions of a complete implicit government guarantee, such a scheme reduces moral hazard.

The main effects of protection are to reduce uninformed runs and panics, and enable ADIs to raise funds at “risk-free” interest rates. Hence this is clearly of benefit to those ADIs covered by the scheme, and to which we shall return shortly.

The second concern – that an ex-ante risk-based fee scheme is needed – ignores how the FCS operates.

First, it is a closed resolution scheme, meaning that it only comes into operation when APRA applies to wind up an ADI or, where under the revised proposals, a statutory manager has been appointed and all hope lost of an alternative to winding-up).

Who believes that APRA and the Government will ever let a bank or other ADI, fail in that way, rather than finding some method of open resolution for troubled institutions such as a take-over or merger? In other words, the FCS book of procedures is highly unlikely to ever be taken off the shelf and the FCS activated.

Second, even if the scheme is activated, it is extremely unlikely that ex-post levies on other institutions will be necessary. The reason is that, upon failure, APRA pays out insured depositors and then stands at the very front of the queue for compensation from the liquidation of the failed ADI’s assets. It is the uninsured deposits and other claimants who lose. Only if total assets were not enough to cover the insured deposits would APRA need to impose a levy.

In general, this is extremely unlikely – although it obviously depends on the size of the cap and the structure of the ADI’s balance sheet. If all deposits were insured (ie. an unlimited cap) and there were no other creditors, then APRA could face a shortfall. But that is clearly not the case with larger banks who have substantial other funding sources. A modest cap ($100,000 – 250,000) would likely ensure that smaller ADIs have a buffer of uninsured deposits which bear the losses.

(It might be argued that not giving APRA priority in liquidation would increase APRA’s incentive to resolve troubled institutions before a liquidation situation is reached. In practice, the reputational cost to APRA of not monitoring ADI capital positions and acting rapidly enough to prevent a liquidation situation would appear to make the priority issue one of second-order importance).   

So, a risk-based ex-ante fee has little to justify it. But there is, arguably, a case for some form of charge as a requirement of competitive neutrality between ADIs and other institutions seeking to raise funds from retail customers. Because the FCS provides an aura of government protection for retail deposits not available to other financial institutions, ADIs benefit in two ways. One is the reduced likelihood of depositor runs which enables them to undertake greater liquidity creation than would otherwise be the case (ie. by using short term deposits to make long term loans while holding lower levels of liquid assets). The second benefit is the ability to raise retail funds at lower interest cost than their non-ADI competitors.

Banks and other ADIs will no doubt argue that they do already pay via capital and  liquidity requirements and through other regulation and supervision imposts. That may be so, but whether it is on balance adequate to offset the competitive advantages of explicit and implicit government protection is far from obvious. Whether the cap should be set at the proposed lower end of $100,000 or the upper end of $250,000 should perhaps be considered primarily in the context of how much it distorts competition in the market for retail funds between ADIs and other non-prudentially regulated institutions.

On the other hand, if individuals perceive that their deposits in ADIs have an implicit government guarantee regardless of their size, the size of the cap is largely irrelevant. It will be interesting to see if researchers can answer that question about perceptions by analysis of the behavior of depositors with $1 million or more over the last few years.

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

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Basel III Liquidity Options

Posted on June 2, 2011
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Policy, Publications | Leave a Comment

FRDP 2011-02
May 28, 2011

In this ACFS Discussion Paper, Professor Kevin Davis examines the new Basel Liquidity Requirements announced at the end of 2010, focusing primarily on the liquidity coverage ratio (LCR) requirement. The underlying philosophy of the approach can be questioned, partly because it aims to deal with both systemic stress and individual bank stress using the one policy instrument. The “Australian solution” to the shortage of high quality liquid assets (HQLA), involving a fee based liquidity facility at the Reserve Bank, also raises a number of tricky questions about determination of an appropriate fee and may require a review of system wide liquidity management arrangements.  While some details remain to be determined, and the implementation date is relatively long distant, the impact on Australian banks and the financial market is likely to be substantial.

It is generally accepted that the forthcoming introduction of liquidity requirements as part of Basel III^[1] poses significant issues for Australian banks. In particular, there is a shortage of government debt available to be held to enable compliance with the Liquidity Coverage Ratio (LCR) requirement. The proposed “Australian solution” to this problem changes the approach to ensuring liquidity crises are avoided in a subtle, but significant, way, and may have broader implications for system-wide cash management arrangements. The Net Stable Funding Ratio (NSFR) requirement also has the potential to affect the structural development of Australian financial markets, given the current high reliance on overseas wholesale debt markets.

The Basel III LCR and NSFR requirements have been introduced as one response to the Global Financial Crisis experience in which banks, worldwide, experienced liquidity crises. Holdings of marketable private sector securities turned out to be not very marketable, and lines of credit and short term funding dried up. A vicious cycle of asset sales to meet funding shortages led to asset price declines, inducing collateral and margin calls and further funding problems.

That experience demonstrates the third of the problems associated with liquidity. The first problem is that liquidity is hard to define, although most analysts would point to a liquid asset as being one which can be converted into cash (the ultimate liquid asset) quickly and without risk of significant loss of market value. Second, it is even harder to measure. And third, it is likely to disappear just when it is needed most. It is not an inherent, immutable property of a financial asset, but one subject to the fallacy of composition. An asset may be liquid for any individual holder, but not if all holders are attempting to use that property simultaneously.

The Basel Committee^[2] has defined bank liquidity as follows. “Liquidity is the ability of a bank to fund increases in assets and meet obligations as they come due, without incurring unacceptable losses.” Such liquidity risk arises from the key role of banks as liquidity providers by funding longer term assets with shorter term (often at call) liabilities.

Their approach has been to announce the gradual introduction of two minimum requirements, one aimed at short-term crisis situations and the other focused on longer term funding.^[3] Although not strongly emphasized, the former focuses primarily on system wide liquidity crises (reflected in the use of a stressed scenario involving “a combined idiosyncratic and market-wide shock” (bcbs188, para 17) and the latter on individual bank difficulties involving “an extended firm-specific stress scenario” (bcbs188, para 125).

The LCR Requirement

The LCR requires banks to hold an amount of high quality liquid assets (HQLA) sufficient to enable the bank to cope with fund outflows over a one month stress period. The scenario envisaged for cash outflows draws on the experience of the Global Financial Crisis, and assigns varying “run-off” factors to different classes of funding, allows for limited inflows of funds (such as from contractual repayments on loans), and assumes limited outflows of funds associated with the need to maintain some level of lending and credit extensions. Given the complexity of bank operations, including collateralized funding, off-balance sheet activities and derivatives transactions, there is a long list of categories of transactions for which quantitative assumptions about run-off factors to derive the denominator of the LCR must be made.

Because avoiding asset price fire-sale declines is critical, only assets whose price is not sensitive to credit risk concerns are suitable for inclusion in HQLA (the numerator of LCR). The Basel Committee adopts a two tier approach to the LCR with level one assets (essentially sovereign debt and Central Bank liabilities) being required to account for at least 60 per cent of HQLA. Level 2 assets can include highly rated (AA- or better) corporate (non financial institution) and covered bonds and some other assets (with a 15 per cent haircut to market value applied).

The Basel Committee also suggests that HQLA should be eligible for use as collateral in accessing Central Bank liquidity facilities. Because of the system-wide stress scenario used, securities issued by other banks or financial institutions are not included in HQLA because these would be likely to be facing losses in market value.

Ultimately, these criteria for eligibility mean that Australian government and semi-government debt have been designated by the Australian authorities as the only currently available assets meeting the LCR.^[4] While the Reserve Bank accepts residential mortgage backed securities as collateral for repurchase agreements, these are issued by other financial institutions. Similarly, despite a large Kangaroo Bond market (AUD securities issued in Australia by foreign entities), the depth of the secondary market in these securities, and demonstrated resilience, is deemed inadequate. While the Federal Government has recently announced plans to allow limited issuance of covered bonds, it will (hopefully) be some time before there is any evidence of how prices of such securities will cope in a time of stress (and their consequent suitability as level 2 HQLA).

The Australian dilemma is that, even with a shift of the government budget into deficit for some foreseeable future, past years of surpluses mean that there is unlikely to be sufficient Federal or State government debt to meet bank LCR demands. While, in aggregate, there may be enough debt on issue, the demands of other fixed interest investors (both domestic and foreign) mean that there will be strong competition – pushing government yields down. Good for the government, but not for the holders!

The response has been to obtain Basel approval for the “Australian solution” (also relevant for a few other countries in good fiscal shape). This involves banks being able to meet their LCR “gap” by inclusion of liquidity facilities which they obtain, for a “fair” fee from the RBA.

An Assessment of the LCR Requirement

The approach adopted places the onus for liquidity insurance upon the banking sector and private financial markets. The LCR approach does not envisage the banking system relying (at least initially) upon the safety valve of RBA liquidity provision via repurchase agreements etc. The logic of the approach can be questioned, in so far as it applies to system wide crisis scenarios rather than individual bank difficulties.

Consider a situation in which a liquidity crisis occurs and banks respond by selling their holdings of government securities. Such widespread action will push the prices of those securities down and their yields up, which is unlikely to be a desirable outcome in such a situation from the perspective of the RBA. Consequently, there is likely to be RBA operations in the cash market to inject liquidity by purchasing government debt or by repurchase agreements based on those or other eligible securities.

Consequently, the merits of an approach which assumes that the market can ensure enough liquidity in a crisis situation seems contradictory to the likely outcome, when the only ultimate provider of liquidity – the Central Bank – is likely to have to act. To the extent that this is the case, the exclusion of other repo-eligible securities from the LCR calculation can be questioned.

To the extent that the LCR is aimed at ensuring individual bank liquidity adequacy in a time of individual stress, there are also some questions which should be posed. First, are requirements based on a system-wide stress scenario appropriate? Second, the exclusion of a range of private sector assets from the calculation seems less warranted since their values would be little impacted by sales by one bank only.

The dilemma here is that the LCR appears to be one instrument aimed at achieving two objectives – one being individual bank liquidity adequacy in a single-name stress situation and the other being system wide liquidity adequacy in a generalized crisis scenario. A long standing tenet of policy formulation is that at least as many instruments are required as there are objectives if those objectives are to be fully met, rather than being constrained by a trade-off.

A number of other important issues arise from the planned implementation of the LCR.

Deposit Insurance Coverage:
The stress scenario gives a very low “run-off” rate to insured deposits. The more is insured deposit funding, the lower will be the hypothetical scenario cash outflow and thus the lower required HQLA holdings. The higher is the “cap” decided upon for the Financial Claims Scheme (currently $1 million and to be re-set by October 2011) the higher will be the proportion of deposits which fall into this category.

The Australian solution:
There is a fundamental difference in the underlying philosophy implied by the solution to a shortage of HQLA of allowing banks to fill a LCR gap through contracted liquidity facilities at the RBA. Specifically, it allows for liquidity requirements to be met partially by having in place arrangements for tapping this RBA liquidity safety valve – rather than requiring liquidity protection to be purely by way of bank sales of liquid assets into the private markets.

The ultimate, aggregate, outcome may not be too different. If instead, in the absence of that facility, all banks are unloading government securities in a crisis and pushing prices down and yields up, the RBA may be compelled to step into the market as a buyer to meet its interest rate targets.^[5] Aggregate liquidity would be increased, as would have been the case where the liquidity facility approach applied. While the adjustment process may be different, it is not apparent that the outcome would be different to a situation where repo-eligible securities are allowed to be counted to meet the LCR.

Where an individual bank faces a “name” crisis, it may be able to sell non HQLA assets without creating “fire sale” conditions. Consequently, the need for that bank to tap the liquidity facility is likely to be reduced, and the likelihood of RBA liquidity injection is reduced. But nevertheless, there is a fundamental change away from requiring basic liquidity protection solely by private provision.

This raises two possible alternatives. One is that other private sector securities which are “repo-eligible” at the RBA could be included in LCR eligible assets. The Basel Committee provides for the option for “level 2” assets to be included with a minimum 15 per cent haircut, and that haircut could be increased if it was thought appropriate to allow some available assets (mortgage backed securities, Kangaroo bonds) to count as level 2 assets.

Another option is that banks could build up their holdings of Exchange Settlement Accounts at the RBA – because these also count towards the LCR. Currently the RBA pays interest on these at 25 basis points below the target cash rate, and the banks minimize ESA balances accordingly. This raises the question of the pricing of the proposed liquidity facility.

Pricing of the RBA liquidity facility

The Australian solution requires that a fee be set for the liquidity facility which is “fair” – in the sense that there is no benefit/cost from using the facility (and holding eligible non-HQLA assets as potential collateral) relative to holding additional HQLA to meet the LCR requirement. There are two fundamental problems here. One is that the counterfactual involves setting a fee which is related to the credit-risk adjusted yield of additional holdings of level 1 and 2 HQLA, when there are none of the latter for which a yield is available.

The second problem is that a fundamental simultaneity problem exists, as follows. The reason for the safety valve facility is that the cost to banks of acquiring HQLA beyond some level is seen as prohibitive, given the stock available. As banks attempt to increase their holdings of government debt, their demand will drive down its yield relative to other investments. Wherever the liquidity facility fee is set will affect the relative use of the liquidity requirement versus holding HQLA, with the latter in turn affecting the cost to banks of using HQLA. The Figure below illustrates. The opportunity cost to banks of holding more government debt (the additional risk adjusted yield foregone on alternative private debt) is shown as increasing in their holdings of HQLA (because the higher bank demand for government debt drives down its relative yield). If the liquidity facility fee is set at Fee_a, HQLA holdings will be at HQLA_a, if it is set at Fee_b the holdings will be at HQLA_b etc. Thus there is no unique fee level.

Exchange Settlement Account Arrangements and the Liquidity Facility Fee

A further complicating feature arises from the ability of banks to use Exchange Settlement Account (ESA) balances to meet the LCR requirement. Currently the RBA pays 25 basis points below the cash rate, and banks manage their liquidity to keep minimal ESA holdings (lending surplus funds to other banks overnight at the cash rate). Conceivably, and ignoring the simultaneity discussed above, it may not be possible for the RBA to always charge a sufficiently low fee for its liquidity facility so as to make that more attractive than building up ESA balances.

Consider, for example, the situation where a bank holds repo-eligible RMBS to support the liquidity facility.  Because there is a haircut given to level 2 assets of at least 15 per cent, $100 of HQLA would require (say) $120 of holdings of level 2 assets. The fee for the liquidity facility should thus be for a facility of $120 and would reduce the net return on the $120 of repo-eligible assets backing that to of a government bond rate equivalent. The consideration for the bank is whether it would prefer to hold $120 of assets earning (net of the liquidity facility fee) the government bond rate compared to the alternative of $100 in its ESA account earning the cash rate less 25 basis points and another $20 in higher yielding private sector assets. The slope of the yield curve (long term v short term rates) and size of credit spreads (for private sector securities over government rates) are relevant factors in this calculation.

While these arrangements remain to be determined, if there is a build up of bank ESA balances (rather than holding other assets), the RBA’s cash rate target would see it acquiring additional assets from the banks (such as government securities) and potentially aggravating the shortage of HQLA.

The implication is that the whole structure of arrangements for system liquidity management may need to be reexamined.

[1] Basel Committee on Banking Supervision Basel III: International framework for liquidity risk measurement, standards and monitoring,  December 2010, http://www.bis.org/publ/bcbs188.pdf

[2] Basel Committee on Banking Supervision, Principles for Sound Liquidity Risk Management and Supervision, September 2008, http://www.bis.org/publ/bcbs144.htm

[3] After an observation period commencing in 2011, the LCR would apply from 1 January 2015 and the NSF from 1 January 2018.

[4]APRA “APRA clarifies implementation of global liquidity standards in Australia” Media Release 11-03, 28 February 2011.  http://www.apra.gov.au/media-releases/11_03.cfm

[5] Even if the crisis is a “flight to quality” with non-banks increasing their demand for government debt in exchange for bank deposits, the consequent liquidity adjustments of banks may create a need for RBA injection of liquidity.

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

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Off-Market Share Repurchases: Policies Wanted!

Posted on March 4, 2011
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Policy, Publications | Leave a Comment

FRDP 2011 – 01
March 3, 2011

In this ACFS Discussion Paper, Professor Kevin Davis notes a resurgence of interest in (and controversy about) off-market share repurchases and asks what has happened to changes proposed in 2009 to the tax treatment of such transactions. Of two major proposed changes, one has significant merit and warrants introduction, while the merits and benefits of the other is less obvious.

Off-market share repurchases (buy-backs) have been a significant form of corporate capital management in Australia in recent years. Between 1996 and 2008 there were over 80 such buybacks which returned around $27 billion of cash to participating shareholders. While there was little activity during 2009 and 2010, there are expectations of considerable use of buybacks during 2011, with BHP having announced a $5 billion buyback in February, and Woolworths having completed a $700 million buyback in October 2010.

These transactions are not without their critics, with the main issue of contention being whether they involve equitable treatment of shareholders (and an associated question of whether they are consistent with legal requirements for such treatment). The reason for these concerns lies in the way such transactions are structured enabling substantial tax benefits to be passed to shareholders who participate in the buyback. While that appears to disadvantage non-participating shareholders, competition for these tax benefits leads to the buyback price determined in the tender process being below the current market share price, which is a benefit to non-participants.

In May 2009, a Board of Taxation study of off-market repurchases(1)  was released by the then Assistant Treasurer, with an announcement that the Government planned to introduce legislation to implement the six recommendations of the study. Two of those recommendations were particularly significant, and would have substantially changed the way in which such transactions are conducted – and most likely have reduced their attractiveness to companies and shareholders as a way of distributing surplus cash and franking credits.

A Treasury discussion paper(2) outlining possible legislative changes was released on June 1, 2009, however, no legislative action has yet occurred on this front and buybacks are still operating under the old arrangements.

At least one of two major changes proposed then has merit, and should be implemented as soon as possible, while the other is more contentious.

Off-market buybacks are conducted as tender offers in which the payment made by the company comprises a small amount of capital repayment with the remainder taking the form of a franked dividend. Tax rulings mean that participants in the buyback thus get substantial tax benefits from a capital loss (their purchase price less the small capital repayment component) and from dividend franking credits attached to the dividend component.

Consequently, such buybacks occur at less than the current market price of the shares through competition in the tender for the associated tax benefits arising from selling into the tender. They are particularly attractive to shareholders on zero or low income tax rates (such as superannuation funds), and there is much attention paid to the prospect of such buybacks in the financial advice industry. For shareholders on high marginal tax rates, participation is not worthwhile. (While the capital loss for tax purposes is valuable, there is additional tax to be paid on franked dividends, which makes selling at a below-market price unattractive).

This tax-based discrimination against shareholders on high tax rates has led to concerns about equitable treatment of shareholders and the consistency of such buybacks with requirements that companies should treat all shareholders equally. In effect, the argument is that valuable franking credits are being syphoned to one group of shareholders to the detriment of others.

The shortcoming of this argument is that non-participating shareholders benefit from the below-market price at which shares are repurchased from participants. Thus, both participants and non-participants benefit at the expense of the taxpayer from the realisation, rather than deferral of tax benefits available to the company and its shareholders.

This prompts two questions, answers to both of which would have been affected by the lost tax changes. First, why is there this unusual tax treatment allowing participants substantial capital losses for tax purposes? Second, are the benefits equitably shared between participating and non-participating shareholders?

One of the proposed tax changes was to remove the ability of participating shareholders to claim a tax loss for tax purposes. That would have substantially reduced the appeal of off-market buybacks and led to much lower repurchase price discounts to market price for those which occurred.

Is that an appropriate change? Arguably not. The existing tax treatment can be thought of as equivalent to a partial wind-up of the company involving return of capital (which should not be taxed) and retained earnings (and associated franking credits). Even though the current shareholder may not have contributed capital, having bought shares on-market from previous holders at a higher price than the original issue price, those individuals would have paid capital gains tax on receipts – some part of which correspond to the return of capital in the buyback. But that interpretation is open to challenge and this question warrants greater analysis and discussion.

The second proposed change was to remove the 14 per cent maximum discount to current market price which the ATO effectively imposes on buyback prices. Almost all recent buybacks are constrained by that maximum discount, as is obvious by the substantial scaling back of applications.

Recent research(3) indicates that without the constraint the average discount would have been around 21 per cent. Non-participating shareholders would thus have been better off – because shares were bought back at lower prices.

The 14 per cent discount limit (seemingly plucked out of the air by the ATO) thus means that the distribution of the total tax benefits is biased towards participants in the buyback. Even though these are low tax rate investors, many of them are self managed superannuation funds of well endowed investors.

Removing the 14 per cent discount limit thus is an obvious policy change which should be resurrected from wherever it is languishing. The other proposal (to preclude capital loss tax claims) is in a different category, and warrants further debate. Of course, if it were to be implemented, the 14 per cent limit would, because of the reduced attractiveness of buybacks, most likely become irrelevant.

With the resuscitation of corporate interests in off-market buybacks, it is important to clarify the tax arrangements sooner rather than later, and resolve debates about equitable treatment of shareholders which will otherwise resurface.

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

(1) The Board of Taxation The Tax Treatment of  Off-Market Share Buybacks, June 2008
http://www.taxboard.gov.au/content/content.aspx?doc=reviews_and_consultations/off_market_share_buybacks/default.htm&pageid=007
(2) The Treasury, Discussion Paper: Improving the taxation treatment of off-market share buybacks
http://www.treasury.gov.au/documents/1550/PDF/Discussion_Paper_off_market_share_buybacks.pdf
(3) Christine Brown and Kevin Davis Tax Heterogeneity and Stock Supply Elasticity: Evidence from Australian Off-Market Repurchases.

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What is “Fair” Taxation of Credit Unions?

Posted on December 2, 2010
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Media Release, Policy | 1 Comment

Treasurer Wayne Swan has indicated his interest in creating a fifth pillar in the financial sector based around credit unions and building societies to increase competition with banks. A pertinent issue arises – the appropriate taxation treatment of mutual financial institutions such as credit unions.

Until the early 1990s credit unions were not subject to company tax – and are tax-free in many overseas countries. Professor Davis remarks that “If nothing else, taxation reduces the ability of credit unions to accumulate capital from retained earnings (which is their principal source of capital given their mutual status) and which is necessary for them to expand their activities while still meeting APRA’s prudential minimum capital requirements”.

The appropriate tax treatment of credit unions is unclear, but there are arguments that suggest that the current tax treatment is biased against credit unions. Professor Davis explains, 

“the situation is complex because owner/members of credit unions receive the benefits of the communally owned capital base accumulated from past activities of the credit union. They do not contribute equity capital directly, and are unable to receive dividends or capital gains on their ownership stake. The social and financial capital built up over the years by credit unions is a valuable resource and the question of whether it is currently subject to appropriate and fair tax treatment warrants further investigation”.

FRDP – 2010-06
December 2, 2010

Effective competition is enhanced by a level playing field. And efficiency of the financial system requires that the tax system should not distort the flow of funds or pricing decisions between different financial institutions (except perhaps where social motives intervene as in the case of superannuation).

Whether the Australian tax system penalizes some types of financial institutions operating in the banking sector and thus impedes their ability to provide better competition with banks is a complex question of current interest. Specifically, mutual financial institutions such as credit unions and some building societies appear to be disadvantaged because they are subject to corporate tax but, unlike banks, are unable (because they are mutuals) to pass the resulting franking credits onto shareholders.

This suggestion of adverse tax treatment warrants much deeper analysis, but the argument appears to have some validity – particularly if credit union members are primarily from lower income groups whose personal marginal tax rate is less than the corporate tax rate of (currently) thirty per cent.

The issue arises because owners of mutual financial institutions are the customers, each of whom has a non-transferable, redeemable, share of nominal value (e.g. $1) on which dividends cannot be paid. Consequently earnings (profit, or surplus – as it used to be called before the accountants insisted on changing the nomenclature) of the credit union are retained in the institution, accumulating to form its capital base which protects deposits of current and future members from loss.

The member-owner-shareholders thus do not receive dividends or capital gains on the capital base which is their ownership stake. That stake is, in effect, ceded to future members when they leave the credit union.

Until the early 1990’s Australian credit unions were not subject to company tax. Although no formal inquiry into the financial system nor into the tax system had recommended it, taxation of credit unions was introduced (with initially some concessions for small credit unions). Why that change was thought to be desirable is unclear, although a widespread lack of understanding of its implications for mutuals in a dividend imputation tax system no doubt helped the cause of those pushing it in the cause of equitable tax treatment. Credit unions had not helped themselves either with expansion of common bonds (ie relaxing membership criteria) making them look much more like banks and causing the differential tax treatment to look anomalous.

And such tax treatment of financial mutuals is in distinct contrast to that found in many overseas countries. In the USA, for example, credit unions are not subject to company tax – and because that country operates a classical tax system, this actually provides credit unions with a tax advantage over banks.

If nothing else, the introduction of taxation has slowed the growth of credit unions. Under the Basel Capital Accord and APRA’s Prudential Standards, they are required to maintain a minimum level of capital of eight per cent of risk-weighed assets. Consequently, to grow they must increase their capital base – and, with some small exceptions, their mutual status means that this can only be done through retention of earnings. Taxation of earnings reduces the amount which remains to add to the capital base and underpin growth.

But more important are the questions of whether the tax treatment is fair and conducive to efficient financial investment. Answering both of these questions is complicated because the owner’s equity in credit unions was not contributed in any pro-rata sense by the current owner-members, but from retained earnings from dealings with past members. So, fairness to current owners (who can easily leave) is not necessarily a relevant criterion.

Similarly, because the capital base (equity) is “inherited”, there is not the same imperative to generate a market rate of return on it, as there is for the banks with publicly traded shares. Indeed, credit union managers face a delicate trade-off in that generating higher retained earnings to enable faster future growth comes at the expense of charging current member-borrowers higher interest rates and paying lower interest rates to member-depositors.

For an economist focused solely on the market system and efficiency, the question warranting an answer is whether the tax system distorts the prices which different types of institutions are willing to deal at in the market place. Are there tax-induced differentials between banks and credit unions in the loan and deposit rates they are willing to quote? That, however, neglects the social dimension and, arguably, an externality in the form of the financial and social capital which is generated by the mutual structure with members willing to participate in such institutions and pass on benefits to future generations.

Without detailed analysis and debate about those complexities, a simpler approach is warranted to shed some light on the issue. One way of doing so is to ask the question of whether the total tax paid on the income stream generated by a mutual is the same as that for a hypothetical bank of the same size. The answer is, “it depends”, but there are some grounds for believing that the tax burden for mutuals is higher because of the intricacies of the dividend imputation tax system.

Why might corporate taxation under a dividend imputation system create a competitive disadvantage for mutuals? The essential reason is that dividend imputation means that company tax is essentially “washed out” of the system by dividend payments having franking tax credits attached to them. But mutuals are owned collectively by their members and cannot make dividend payments on their shareholder equity (accumulated over time from retained earnings) and so the company tax paid is not “washed out”. Mutuals pay company tax and accumulate franking credits which cannot be distributed. Their situation is akin to requiring that banks could only pay unfranked dividends to their shareholders, even though the company tax they have paid has generated franking credit balances. Such a requirement would, no doubt, be seen as unfair and inequitable, and could be expected to lead to banks reducing dividends and rewarding shareholders via higher capital gains associated with retention of earnings. While credit unions do (must) retain earnings, current shareholders get no return in the form of capital gain, with the effect of earnings retention being the “social capital” generated.

It may be argued that this situation simply involves a difference in the point of the income stream at which taxation is effectively levied. In the case of a bank, tax is ultimately levied on profits in the hands of the shareholders, with company tax being essentially a pre-payment of personal investor-level tax. In the case of the mutual, tax is levied at the company level, because profits are not distributed. Thus, the overall taxation of bank income is ultimately at a rate equal to the shareholder’s individual tax rate – which given the dominance of superannuation funds as investors perhaps averages in the region of 15 per cent. But for credit unions it is at the company tax rate of 30 per cent.

If credit unions were able, in some way, to distribute franking credits, the situation would change – although it must be remembered that receipt of franking credits is also accompanied by imputed income for tax purposes. Consider, for example, the situation where the mutual had paid $3 of company tax (at rate tc = 0.3) on an income of $10, and had retained, undistributable, income of $7. In principle, if that $7 income could be distributed to members on a personal tax rate of tp, the grossed up taxable income would be $7/(1-tc) = $10 and the member would have a tax bill of $tp.10 but a tax credit of $tc.10 for tax payable of $(tp-tc).10, and total (company and personal) tax paid of $tp.10.

If credit union members have marginal tax rates (tp) less than the company tax rate, they benefit from this outcome (but do not if their personal tax rate is higher). But only the franking credits and imputed income (and not the retained earnings) might be distributed – although what level of imputed income would be involved is problematic. (In the example above, imputed income of $3 was added to the $7 cash dividend received. Whether a mechanism for distributing $3 of franking credits without a cash dividend (payout of retained earnings) would require imputing income of $3 or $10 or some number in between would need to be considered). Distribution of franking credits and imputing income equal to the pre-tax earnings on which company tax was paid (ie $10 taxable income and $3 tax credit in the example) would appear to be beneficial, and equitable vis a vis the banks (with large institutional shareholders on low tax rates) if only those members on low tax rates could elect to receive them (and who would thus receive a tax rebate). Indeed, to force franking credits and imputed income upon high tax rate members (without also distributing the retained earnings) would be unfair because of the tax liability created.

There does thus appear to be some case for considering mechanisms for allowing credit unions to distribute franking credits, and offsetting what appears to be a tax disadvantage vis a vis banks. But the issue is complex, warrants deeper analysis, and would require the design of specific financial instruments which credit unions could issue which would be attractive to low income members. Alternatively, we could return to the previous tax treatment where mutual institutions were not subject to company tax, recognizing their mutual, non-profit, status and potential social benefits from the existence of, and development of, such social capital. But that is also a contentious proposition which requires much deeper analysis.

Disclaimer: Kevin Davis is a Director of Melbourne University Credit Union as well as a shareholder in most Australian banks.

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

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Mortgages: Time to Re-Design

Posted on November 5, 2010
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Publications | 3 Comments

FRDP – 2010-05
November 4, 2010

Professor Kevin Davis, Research Director at the Australian Centre for Financial Studies proposes that it is time to re-think and re-design the way Australia does mortgages.

Australian housing mortgage contracts have a somewhat unique characteristic. Australian home-buyers sign a mortgage contract with banks which gives banks the right to change the loan interest rate whenever and to whatever they want.

This flexibility given to banks is of considerable value to them, but exposes borrowers to risks to which they arguably should not be exposed. If a bank faces an increase in its funding costs, this can be passed on to existing borrowers. That applies regardless of whether the increase in funding costs is something which affects all banks or only an individual bank – although competition may impose some constraints in that latter case.

At the current time, there is much debate about Australian banks increasing housing loan interest rates by more than Reserve Bank changes in the cash rate.  Figure 1 illustrates how the margin was roughly constant at 180 basis points prior to the onset of the Global Financial Crisis and had increased to 290 basis points in October 2010.

Underpinning this debate is the fact that there have been significant changes in bank funding costs, relative to the cash rate, such that these need to be reflected in loan interest rates if bank profitability is to be maintained. Regardless of whether bank profitability is too high or not, the question of whether both existing and new borrowers should bear the burden of such funding cost changes, or whether this should impinge upon bank profits is an important one.

Changing the form of mortgage contracts would defuse much of that current debate, and would work to allocate interest rate funding risk more appropriately between bank customers and shareholders (and management).

The standard variable rate mortgage loan in Australia has long had the characteristic that borrowers place themselves at the mercy of lenders with regard to future interest rates they will have to pay. Foreigners find this truly amazing, being more used to either fixed rate or adjustable (indicator linked) rate loans. If Australian borrowers are sufficiently naïve to give this power to banks, perhaps they cannot expect to be treated in any other way.

Historically, Australians acceded to such contracts because housing loan interest rates were controlled by governments, and because they had virtually no bargaining power when confronting an oligopoly of large banks. We should not go back to government interest rate controls, but governments could force banks to adopt different loan contracts which would be socially beneficial.

While there has been much innovation in Australian mortgage markets(1), including some use of fixed rate and adjustable rate mortgages, these do not appear to have become predominant. Unfortunately, there are no publicly available official statistics which provide detailed information on the interest rate characteristics of Australian housing loans which would enable an assessment of developments in this regard.

The alternative to a “variable-at-the-bank’s-discretion” floating rate loan would be a loan in which the interest rate is tied at some fixed margin (set at the outset of the loan) over a relevant indicator lending rate. In such a loan, the borrower is still exposed to movements in the general level of market interest rates, but not to other discretionary changes by the bank.

Australian banks have little incentive to introduce such loans. The current mortgage structure makes their risk management job much, easier. As well as movements in general market interest rates being passed onto the home borrower, for them to bear this risk, banks are also able to pass on the consequences and risks of any errors they make in their funding and interest rate risk management choices. A bank which is funding housing loans in a way which subsequently becomes relatively expensive, or bets the wrong way on interest rate movements, can simply increase the rate it charges to existing borrowers.

While such funding (or interest rate risk management) errors will affect the bank’s ability to compete for new borrowers, existing borrowers have limited ability to avoid wearing the resulting costs. Paying out an existing loan to shift to another lender is a costly exercise, and less appealing when all that is on offer is more of the same from a limited number of major players. Also, the banks offer “special rates” to new borrowers involving discounts on the standard variable rate lasting for some number of years, which enables them to compete for new borrowers while not adversely affecting the return on existing loans.

If instead, adjustable rate mortgages (a fixed margin over an indicator rate such as the official cash rate) were adopted, the situation would be markedly different. New borrowers may face a different margin to existing borrowers because the current cost of bank funding relative to the indicator rate has changed. They could make conscious decisions about the merits of taking a loan which locks in that margin (or taking out a fixed rate loan) and banks can (if they wish) structure their funding to avoid taking on interest rate risk.

Existing borrowers would be protected from changes in interest rates other than in the indicator rate which reflects market trends. They would not be exposed to risks arising from poor funding choices or poor interest rate risk management by their bankers.

Of course, there are many details involved in structuring loans this way. It may be too risky for banks to fix the margin for very long periods (because the structure of interest rates may change), suggesting that contracts involving a fixed margin for some period (and ability to exit to another lender at the end of that period) might be appropriate. Whether the cash rate or a wholesale market rate such as the Bank Bill Swap Rate is an appropriate indicator rate is also another design issue.

But regardless of those complexities, it is clear that the current, historically inherited, internationally anomalous, mortgage design we have is creating problems. And while some of those problems affect the banks, they are unlikely to collectively give up arrangements which enable them to pass on risks to customers. Those risks should preferably fall on management and shareholders, and that could be readily achieved by government leadership to bring Australian mortgage loan contracts into line with the reality of twenty-first century financial markets.

(1) See for example Guy Debelle “The State of the Mortgage Market”

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

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Why be Afraid of Higher Bank Capital Requirements?

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

FRDP – 2010-04

September 13, 2010

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

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

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

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

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

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

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

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

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

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

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

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

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

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

kevin.davis@australiancentre.com.au

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

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Leverage and Self Managed Superannuation Funds

Posted on August 10, 2010
Filed Under Financial Regulation Discussion Paper Series, Funds Management & Superannuation, Policy | Leave a Comment

FRDP – 2010-03
August 9, 2010

The Cooper Review (1) did not make recommendations to limit use of leverage by SMSFs but recommended that recent proposals relaxing constraints on usage be reviewed in two years. There are several reasons which, on balance it is argued, support the view that SMSFs should not be able to leverage investments, and that policy should be changed accordingly.

Self Managed Superannuation Funds (SMSFs) have, for some years, been able to invest in levered products such as instalment warrants, despite a general legislative prohibition on borrowing by superannuation funds. Instalment warrants package together in a single financial product an investment in a listed stock with a no-recourse loan (of perhaps 50 per cent of the stock value) from the warrant provider. The warrant provider purchases the stock in trust for the investor, using the initial instalment contribution of the investor and the loan amount. Because the loan is no-recourse, the maximum loss to investors should they not make the required loan repayment (the “final” instalment) is the initial instalment amount. In that event, the warrant provider bears any loss due to the stock value being less than the final instalment amount, while otherwise the investor pays the final instalment and acquires ownership of the stock.

The attraction to investors of such products is the opportunity to leverage investments without risk to other wealth holdings (for which benefit a price is paid via the fees and interest paid to the warrant provider) and to exploit tax “arbitrage” opportunities. Some SMSFs have utilised investment structures which have enabled them to make instalment warrant type levered investments in property, by investing funds in a separate trust which purchases property using non-recourse loans. The Government’s March 2010 proposals(2) for changes to tax treatment of instalment warrants would effectively remove some anomalies in the tax legislation regarding treatment of ownership and taxation for such products and make use of such products simpler. The Cooper Review recommends that this issue should be reviewed in two years time and that providers of such products should be required to provide improved data on usage to enable better understanding of this market segment.

There are a number of arguments as to why use of instalment warrant products by SMSFs is not socially optimal and thus should not be permitted.

First, use of instalment warrants increases the risk being taken by the SMSF. While choice of a risk profile of investments is at the option of the SMSF trustees, it is not obvious that use of financial products which increase risk beyond some level is consistent with the policy objectives which justify concessional tax treatment of superannuation.

Second, because companies whose stocks are incorporated into instalment warrants borrow to finance their assets, those stocks are already levered investments on the underlying assets. Investment via an instalment warrant thus involves a doubling up of leverage.

Third, the tax deductibility of interest is permitted when a loan is taken out for investment in an asset which is expected to produce taxable income. One attraction of leverage, such as via instalment warrants, is the opportunity for “tax arbitrage” when some part of investment returns takes the form of capital gains which are subject to a lower tax rate(3). In the case of SMSFs, the investment is made to generate income which is already concessionally taxed (in addition to any advantageous treatment of capital gains in general). Whether tax deductibility of interest on loans taken out to generate concessionally taxed income is a socially appropriate or optimal policy is open to debate.

Fourth, one consequence of allowing SMSFs to invest in such products is to give incentives for financial services firms to create such products to market to SMSFs. And in general, complexity of product structure can become substantial. It is arguable whether trustees of SMSFs are able to adequately assess the risks and expected returns of such products, such that any tax benefits ultimately end up accruing to the providers of such products via excessive fee levels.

Fifth, it should be recognised that some proportion of the population will attempt to “rort” the system, while many others will be unable to understand its complexities. The former can be seen through attempts by SMSF trustees to structure property investments with a limited recourse loan from a third party – but where the trustee provides a personal guarantee to the lender. The latter is observable from the stream of requests to financial advisers about whether particular investment structures are feasible. Providing opportunities for leveraged investments contributes to both problems, and an optimal policy may be to simply ban such products rather than trying to police non-compliance with the requirements.

Finally, policy settings such as maximum contribution limits (and the now removed reasonable benefit limits) indicate a policy view that some upper limit on tax concessions provided through the superannuation system to individuals should apply. Allowing SMSFs to leverage up their concessionally taxed investments is at variance with that view.

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

(1.) http://www.supersystemreview.gov.au/
(2.) http://www.treasury.gov.au/contentitem.asp?NavId=037&ContentID=1724
(3.) There is also a more subtle tax arbitrage effect arising from the inappropriate legislative treatment of some part of fees paid (which are essentially an option fee payment) as loan interest. See Christine Brown and Kevin Davis “Taxing Capital Protected Equity Products” Agenda, 12, 3, 2005, 239-252

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Deregulating Retail Bond Issuance

Posted on August 2, 2010
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Funds Management & Superannuation, Policy | Leave a Comment

FRDP – 2010-02
August 2, 2010

ASIC’s relaxation of information/disclosure requirements for retail bond issuance are warranted, but successful development of the retail bond market may require further steps to facilitate efficient issuance methods and investor demand.

The retail (and wholesale) market for corporate bonds in Australia has been largely non-existent, despite the growing volume of potential investors such as Self Managed Super Funds. Whether this has reflected inherent market economies of alternative corporate funding arrangements or regulatory impediments is open to debate, but relaxation of excessive regulatory constraints is to be welcomed.

Following responses to its December 2009 consultation paper CP126 , ASIC released Regulatory Guide 213 “Facilitating Debt Raising” in May 2010 setting out simpler issuance requirements for “vanilla” corporate bonds which are to be listed on the ASX and sold to retail investors.

“Vanilla” bonds are defined as unsubordinated bonds with a defined term of 10 years or less, paying interest at regular dates at either a fixed or a floating rate (at a fixed margin to a market indicator rate), with principal repaid at maturity. Issues must be for $50 million or more to achieve secondary market liquidity for investors. Required disclosures include key features of the bond (term, interest rate, payment dates etc), key financial information such as gearing, interest cover, working capital ratio, senior debt outstanding, plus information about the effects of the transaction on the company. Detailed corporate financial data is not required, provided that it is available via continuous disclosure requirements.

The issuance requirements introduce a simplified “vanilla bond” prospectus which can be used by listed companies which are eligible to issue a transaction-specific prospectus for new issues of listed (continuously quoted) equities. There is also provision for a two part prospectus approach in which a first-part prospectus with a life of two years can be issued, enabling the company to make a number of separate bond issues during that time each requiring a second-part prospectus detailing only the bond characteristics such as interest rate, term, etc. For these latter documents, relief is granted from the exposure requirement (usually that 14 days public exposure of the document is required before funds can be raised).

In effect, the rationale for these changes is that, other than transaction-related information, investors should not need more information to assess the investment risks of “vanilla” bonds than they do for shares. Since both are claims on the company’s assets and cash flows, albeit with different cash flow characteristics and control rights, this has considerable merit for which support can be found in finance theory.

An important distinction in practice, however, is that a market valuation of shares is already available, whereas there is no market valuation of yet-to-be-issued bonds. Most investors, who are unable to derive a fair bond price (yield) from first principles using share price data and company financial accounts, require some other source of valuation information. In particular they will want to know the appropriate credit spread (risk premium) for the issuer over government bond rates. Ratings agencies can provide comparative information if the bond issue is rated (although they may not always get the rating “right”), and investors have ready access to market determined yields on bonds of similar rating.

Regulatory Guide 213 is silent on the need for a rating, but the ASX listing rules for debt (Chapter 1, section 1.8) require a rating of at least investment grade. While this provides useful information, for most retail investors decisions to invest in new bond issues will be significantly influenced by issuing procedures and the advice and information associated with those processes. Regulatory Guide 123 is also largely silent on this issue, other than the requirement that “vanilla” bonds must be sold at a price common to all investors.

Standard bond issuance procedures operate much like those for an Initial Public Offering of shares, with the issuing company hiring the services of an investment bank to underwrite, market, and distribute the bonds to potential investors. This can be a relatively high cost exercise, particularly if retail investors are the target, and may inhibit development of the market. And the ability of investors to assess whether the issue price (yield) is “fair” remains questionable, raising issues of incentives of parties in the transaction. Dividing an issue into a wholesale component where a “bookbuild” through institutional investors generates an issue price which is then applied for the retail component is one way of addressing this issue. But there are others methods of price discovery and distribution potentially available.

Recognising that bonds, like equities, are ultimately claims on the company’s assets suggests that.issuance of “vanilla” bonds by way of a renounceable rights issue to shareholders might be a feasible approach. Any mispricing of bonds is then offset by equivalent gains or losses on the share price. Investors (such as institutions) not wishing to hold such securities could offer their rights on the exchange and price discovery would occur through the rights trading.

While issuance costs would be low, a pro rata bond-rights allocation may mean that significant trading of rights is required for small shareholders to build a suitable scale investment, while institutional shareholders not interested in such investments may be substantial sellers. An alternative may be to allow companies to make a (non pro rata) “placement” of renounceable bond-rights to a particular group of (or all) shareholders. Provided that the issue size was limited relative to market capitalization (as occurs for equity placements) and that the issue price was pitched at (or near) fair value, there is probably less risk of inter-shareholder value transfers than currently exists from the ability of companies to make placements of shares.

An alternative approach would be a placement of bonds to a financial institution which would then on-sell the securities to retail (or other) investors via the stock market (as currently occurs with listed warrant products created by investment banks), relying on financial advisers etc to alert investors to the availability and value of such securities. Whether this low cost issuance method would generate adequate price discovery and ensure fair pricing for retail investors is open to question.

But if a retail bond market is to be encouraged, it is likely to take more than changes to disclosure, and serious examination is warranted of whether alternative efficient issuance and distribution mechanisms are also inhibited by regulation.

(1) http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/cp126.pdf/$file/cp126.pdf
(2) http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/rg213.pdf/$file/rg213.pdf
(3) http://www.asx.com.au/ListingRules/chapters/Chapter01.pdf
(4) For example, arrangements for a recent AMP Note issue are described at http://media.corporate-ir.net/media_files/irol/21/219073/asx/3_11b.pdf (section 2.1.5).

This FRDP was prepared by Kevin Davis, Professor of Finance, University of Melbourne, and Research Director, Australian Centre for Financial Studies.
kevin.davis@australiancentre.com.au
Ph: 0409 970 559

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Taxing the Banks

Posted on July 23, 2010
Filed Under Banking, Financial Institutions and Markets, Financial Regulation Discussion Paper Series, Policy | Leave a Comment

FRDP 2010-01 
July 12, 2010

In the wake of the Global Financial Crisis, there is widespread international consideration of proposals to impose specific taxes (levies) on banks (and some other financial institutions). The UK has already done so in the budget of 22 June 2010 and the French and German Governments have also announced their intentions to impose some form of bank balance sheet levy.

While some see such an impost as an ex post charge for the costs incurred by governments and national economies for excessive risk taking by banks which led to the GFC, most support is based on a forward looking view. Thus the IMF argues that “[e]ven countries that provided little or no support to their financial sectors during the recent crisis should consider forward-looking contribution schemes.”(1)

But there is not unanimous support for such an approach, as reflected in the recent communiqué of the G20 leaders Toronto Summit declaration.

“We agreed the financial sector should make a fair and substantial contribution towards paying for any burdens associated with government interventions, where they occur, to repair the financial system or fund resolution, and reduce risks from the financial system. We recognized that there are a range of policy approaches to this end. Some countries are pursuing a financial levy. Other countries are pursuing different approaches.” (2)

This reflects the fact that other strategies such as increased risk-based capital requirements are an alternative to taxation of banks in terms of their potential effects on risk-taking. There is also relatively little evidence on what effects such taxes would have, and how best to structure them.

The UK levy (to operate from January 2011) is to be set at an initial rate of 0.04 per cent, eventually rising to 0.07 per cent, of a bank’s aggregate liabilities excluding tier 1 capital (equity), insured retail deposits, repo funding backed by sovereign debt, and any retail insurance policy liabilities. There is also a reduced levy rate for long-term wholesale liabilities, reflecting the intention of the levy to encourage adoption of funding arrangements less exposed to instability. In this regard, it would have interactive effects with Basel II proposals for a Net Stable Funding Ratio requirement.

In the US, proposals for a levy funded Systemic Dissolution Fund as part of the Dodd-Franks Wall Street Reform and Consumer Protection Act were dropped in late June compromise negotiations in favour of expanded resolution powers for the FDIC, although President Obama apparently favours a “bank tax”.

There is no apparent Australian Government support for any introduction of a bank-specific tax, with much rhetoric flowing from the industry about Australian banks not having needed Government support – with this weakening arguments for any imposition. And given the recent experiences with minerals taxation, the Government is unlikely to want to rush into any other tax proposal specific to a major industry such as banking.

But there are at least three reasons why this matter should be seriously examined in Australia.

One can be found in the IMF quote referenced above – such taxes have a forward looking basis. They aim to induce behaviour less likely to create systemic crises and also partially internalize the externalities created by systemically important banks in this regard. Financial and economic theory is struggling to catch up and adequately explain the evidence of abundant financial instability we have seen over the years, but the conventional wisdom now seems to be that banking and financial systems are exposed to instability and systemically important banks play a major role in creating that exposure.

A second reason is that it is simply not true to say that Australian banks were not subject to substantial government support during the GFC. An initial blanket guarantee of bank liabilities, was followed by the wholesale funding guarantee scheme. And while the latter involved guarantee fees, those fees were substantially lower than those charged by other governments and even further below the risk premium assessed and required by the financial markets at the time. Yes, the Australian government received a fee for taking on risk, but the fee was well below what could have been charged (and alternative funding costs faced by the banks) and in that way was a subsidy to banks and their shareholders.

Third, it is now accepted that “Too Big To Fail” is the modus operandi of governments and financial regulators when dealing with systemically important financial institutions. While that does not include all banks in Australia, it is hard to escape the conclusion that TBTF operates for at least the four majors. The IMF has estimated the net effect of the TBTF policy as a subsidy of funding costs for such institutions in the order of 20 basis points.(3) A tax of equivalent magnitude would thus seem justifiable – in the form of a “user-pays” charge.

The preceding arguments do not necessarily imply that a “big bank tax” is appropriate for Australia. It may be that financial stability concerns can be adequately addressed through other regulatory initiatives (such as capital adequacy requirements). But they do suggest that such proposals should not be dismissed out of hand, and warrant further investigation (including of likely consequences). At the very least, if such levies/taxes become widespread internationally (as appears likely) justification of their non-imposition will require Australia to be able to demonstrate, in the spirit of international collaboration and fairness, that there are sound reasons for not doing so.

(1)http://www.imf.org/external/np/g20/pdf/062710b.pdf

(2)http://www.g20.org/Documents/g20_declaration_en.pdf

(3)http://www.imf.org/external/np/g20/pdf/062710b.pdf

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

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