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

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

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

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

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

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

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

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

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

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

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

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

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

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

info@australiancentre.com.au

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

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

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

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

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

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

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

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

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

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

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

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

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

info@australiancentre.com.au

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Professor Deborah Ralston, Director of the Centre stated that “research into Australian equities has been hindered by a limited historic digital record.  ANZT and ACFS have noted these limitations and have joined in seeking to remedy the deficiency.  The AED aims to extend the historic record of Australian equities back in time to the early 1900s so that the database will provide a broader and deeper set of equity fundamental and market aggregate information over a greater range of time than is presently available.  ANZT and ACFS have been supported in the project by RMIT University providing research support and Sirca providing a web platform for the database.  The project is a three year staged program of development and is now passing its midway point – a sufficient point to start sharing the benefits of the database more widely.”.

The database expands the publicly available digital equities data by over 150% and will further double in size by the completion of the program in the next 12 months.  The AED presently provides monthly data on almost 6,000 companies across the present 63 years of records collected.  The AED details major trading and fundamental data items including recorded earnings and dividend information, number of shares on issue, share turnover, equity nominal value, net tangible assets per share and price range data.  The database captures all capital change information and has been used to generate return and risk estimates at equity, portfolio and market level, together with all feasible ratios and performance indices. The AED has been extensively tested for accuracy, consistency and comparability so that it is now ready for user testing and application.

“The AED is a unique financial analysis strategy tool. Constructed from publicly available monthly stock exchange journal reports of the Melbourne Stock Exchange and, post-1972, the Australian Stock Exchange, the database enables longer term evaluation of investment and portfolio formation strategies relating equities to both historic and current trading and economic environment.  The AED is seen as potentially of value to a wide range of interested parties, such as the financial services industry; academia; media; private wealth and investment individuals; economists / market analysts.” Prof Deborah Ralston said.

Professor Ralston added that “ACFS has concentrated on development of the database with only limited research analysis undertaken.  However, even the analysis to date has found numerous market insights and suggested a number of significant equity performance indicators.  Some very high returns have been achieved in preliminary simulation tests.”

The database will initially be available through consultation with ACFS.  It is planned that increased direct access to the database will be made available at completion of full development of the program.

About the Australian Centre for Financial Studies
The Australian Centre for Financial Studies facilitates industry-relevant and rigorous research and consulting, thought leadership and independent commentary.  Drawing on expertise from academia, industry and government, the Centre promotes excellence in financial services.

The Centre specialises in leading edge finance and investment research, aiming to boost the global credentials of Australia’s finance industry; bridging the gap between research and industry and supporting  Australia and Melbourne as an international centre for finance practice, research and education.

The Centre provides access to and links between academics, finance practitioners and government and draws on expertise and experience from across these groups, to facilitate and disseminate knowledge creation and transfer throughout the greater finance community via its various activities.

The Australian Centre for Financial Studies (previously known as the Melbourne Centre for Financial Studies) is a not-for-profit consortium of Monash University, the University of Melbourne, RMIT University and Finsia having commenced in 2005 with seed funding from the Victorian Government.  Across the consortium partners ACFS has links with over 100 finance academics and over 200 postgraduate students engaged in finance research.

About ANZ Trustees
ANZ Trustees is a leading trustee company with expertise in philanthropy, wealth management and wealth transfer. Our expertise assists individuals, families, companies and charities to preserve and grow their wealth into the future. ANZ Trustees’ services include wills and estate planning, managing family and charitable trusts and foundations and investment and personal financial management.

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Media contact details:

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

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

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

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

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

Click image to watch video on C-SPAN video library

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More about the Australia – New Zealand Shadow Financial Regulatory Committee

As Reserve Bank of Australia board members gather today to ponder Australia’s cash rate, financial markets are having a bet each way the RBA will cut rates amid the release of data reflecting a softening in key non-mining sectors of the Australian economy, but more favourable inflation figures. But these days, Australian home owners can no longer rely on their banks to pass on the joy. So The Conversation asked: should banks be compelled to pass on interest rate cuts – yes or no?

Kevin Davis, Research Director for the Australian Centre for Financial Studies, and Professor of Finance at the University of Melbourne says no.

No, because…

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Westpac chief executive Gail Kelly this week warned about Australian banks are vulnerable to “the contagion effect” of Europe’s ongoing financial woes, after the Commonwealth Bank of Australia delayed a Euro-denominated fund raising issue.

Professor Kevin Davis, Research Director at the Australian Centre for Financial Studies explains contagion and what could be in store for Australian banks.

What was it that the CBA planned to do and why is the significance of delaying it?

The CBA planned to do a covered bond issue in Europe – that’s a new facility available to Australian banks that is different from “traditional” securitisation and which is commonly used in Europe and is quite attractive to European investors. It’s only been available to Australian banks for a couple of months.

But one of the issues the banks are facing is the unsettled state of financial markets, particularly in Europe, with investors wary about lending funds to banks – even when they are secured against very good assets like the Australian mortgages involved here.

Although Australian banks have had a fairly large presence as borrowers in Europe, I think everybody is looked at suspiciously at any new security issues into the market the moment. Even though Australia’s four major banks are among only nine banks in the world that have AA ratings, when you get into a situation of general uncertainty, as you saw during the global financial crisis, markets just dry up. Investors aren’t confident about the safety of any assets….

So what does this lack of confidence mean for Australian banks?

Are we likely to see the same sort of credit crunch experienced in 2008-2009?

Is the term contagion alarmist or reasonable? And what does contagion actually mean?

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• Scale not necessarily delivering economies
• Institutional funds need to be more competitive

The extraordinary growth in self-managed super funds to June 2011 has potentially limited the growth of assets within superannuation institutions and will continue to do so, according to research conducted by KPMG and The Australian Centre for Financial Studies (ACFS).

The report: Superannuation trends and implications examines performance and challenges in the Australian superannuation sector from 2000 – 2011, a period marked by the impact of the global financial crisis and government changes to administration delivery and member choice¹.

KPMG and ACFS found the growth of the self-managed super fund segment since 2000, and the ageing Australian population, provide the greatest threat to the future of superannuation institutions.   The self-managed fund segment increased by 461 percent and the industry funds segment by 410 percent, against a more somber growth in retail funds of 177 percent, and public sector funds, 100 percent².

“Many superannuation institutions face increased rollovers to self-managed superannuation funds and increased benefit payments at the same time their contribution inflows slow. This perfect storm potentially threatens their future viability,” said Sean Hill, head of KPMG’s superannuation group.

Institutional funds are struggling to reduce member costs despite the phenomenal growth in the average size of superannuation institutions in recent years.  “As superannuation funds increase in size, trustees should be able to exploit economies of scale and reduce costs.  However, only in 2009 did costs per member decrease, before rising slightly the following year,” said Professor Deborah Ralston, Director ACFS.

The report found that superannuation institutions that fail to adapt and respond to changing landscape face the prospect of negative funds flow, diminishing assets and terminal decline.

“Superannuation institutions need to recognise that their growth strategy, which may have been successful over the last decade, may no longer be appropriate,” Sean Hill said.

“They must review the competitiveness of their offering, particularly with regard to fees and cost, consider alternatives to organic growth and, formulate a strategy and transition plan specifically in relation to the upcoming Stronger Super reforms,” he added.

KPMG and ACFS cite the attractiveness of the self-managed super fund segment to members as the single greatest challenge to institutional funds.  “The popularity of self-managed funds could potentially lead to the decline in institutional funds as more members transfer benefits and contributions to self-managed funds.  As their assets diminish, superannuation institutions’ operating costs per member will increase, thereby perpetuating a vicious cycle,” Professor Ralston said.

The growth options for superannuation institutions are limited but achievable provided they can reduce costs per member. “This may be achieved through an increased focus on operational efficiency, or by merging with a larger, more efficient institution,” Mr Hill said.

1. A KPMG-ACFS Monograph, Superannuation trends and implications, September 2011
2. Growth measured by the change in nominal assets.

Download Full Report from KPMG website

Further information:
Professor Deborah Ralston
Director, ACFS
03 96661010
Deborah.ralston@australiancentre.com.au

Mr Sean Hill
Partner, KPMG
03 9288 6948
seanhill@kpmg.com.au

• Melbourne Mercer Global Pension Index expands to include 16 countries and 50% of the world population
• Netherlands continues to top ranking
• Australia jumps back up to 2nd from 4th

Australia’s retirement income system has jumped up the ranks in a global comparison of pension systems. However, it still needs significant reform to help Australians secure enough retirement savings and to financially support an ageing population according to the 2011 Melbourne Mercer Global Pension Index.

According to the Melbourne Mercer Global Pension Index many of the world’s retirement systems are under significant stress and even the world’s most advanced retirement income systems require ongoing reform to ensure they’re robust enough to support a rapidly ageing population.

Australia has regained its ranking as second in the world, after dropping to fourth in 2010.  Netherlands holds its position as number one with Switzerland making up the top three.

There is no perfect retirement income system according to the index.  No country received an A grade, and 10 countries received either a C (major risks or shortcomings) or a D (major weaknesses and omissions).  But this index can provide valuable lessons and insights into how countries are grappling with the economic and social challenges of an ageing population.

Mercer Senior Partner and author of the report, David Knox, said, in these uncertain economic and political times the risk of governments not being able to financially support their ageing population is becoming more of a reality unless some significant pension reform is made now.

“The best pension systems adopt a multi-pillar approach to spread these long term risks between governments, employers and individuals. It also forms the basis of the analysis undertaken in this report. Such an approach is also particularly relevant in periods of economic uncertainty, as we are now facing,” he said.

Australia’s index value increased from 72.9 in 2010 to 75.0 in 2011 due primarily to a real increase in the size of the age pension and higher net household saving rate, but fell short of being the best in the world due to lower levels of adequacy.

“Australia is very much in reach of becoming the first in the world to receive an A-Grade score if we can address the issue of adequacy by raising the level of compulsory savings via superannuation and continue reforms to reduce costs,” said Dr Knox.

“Our superannuation system is in the middle of significant reform, some of which is likely to boost our score in the index in the future but our current B-Grade is an important reminder that our world-class retirement savings system is in danger of failing us unless we take action now,” he said.

The overall index value for the Australian system could be increased by:

• Raising the level of mandatory contributions to improve the level of benefits whilst also increasing the level of household savings;
• Introducing a requirement that part of the retirement benefit must be taken as an income stream;
• Increasing the labour force participation rate amongst older workers;
• Increasing the pension age as life expectancy continues to increase; and
• Reducing the costs of the system by encouraging greater efficiency.

The Index is in its third year and has grown from 11 to 16 countries, now covering over half of the world’s population.  It objectively looks at both the publicly funded and private components of a system as well as personal assets and savings outside the pension system.  It is produced by Mercer and the Australian Centre for Financial Studies and funded by the Victorian State Government.  It is based on more than 40 indicators grouped into three sub-indices: adequacy, sustainability and integrity.

Dr Knox said, “Each country has to consider its own social, economic, political, cultural and historical circumstances, but despite the differences in the history and development of each country’s system there are some common challenges around the world.”

Common global challenges include:

• Increasing the state pension age and/or retirement age to reflect increasing life expectancy, both now and in the future, and thereby reduce the level of costs of the publicly financed pension pillar;
• Promoting higher labour force participation at older ages including the provision of phased retirement;
• Encouraging or requiring higher levels of private saving, both within and beyond the pension system, to reduce the future dependence on the public pension;
• Increasing the coverage of employees and/or the self-employed in the private pension system, recognising that many individuals will not save for the future without an element of compulsion or automatic enrolment; and
• Reducing the leakage of funds from the retirement savings system prior to retirement thereby ensuring the funds saved, often with the associated taxation support, are used for the provision of retirement income.

Professor Deborah Ralston, Director of the Australian Centre for Financial Studies said the Melbourne Mercer Global Pension Index remains critical for governments, industry and academia with an ageing population a top priority for government’s the world over.

“Once again, this third edition of the Melbourne Mercer Global Pension Index highlights the areas of policy debate in pensions around the world.  The on-going difficulty of developing systems that provide an adequate level of retirement income and yet maintain sustainability, especially in countries with an ageing population, warrants further research and discussion world wide.  We hope the Index will make a contribution to that end.”

Results by Overall Index Value

About the Australian Centre for Financial Studies
The Australian Centre for Financial Studies (ACFS) is a not-for-profit consortium of Monash University, RMIT University, the University of Melbourne and Finsia (Financial Services Institute of Australasia) which was established in 2005 with seed funding from the Victorian Government. Funding for ACFS is also derived from corporate sponsorship and through research partnerships.
The mission of the ACFS is to build links between academics, practitioners and government in the finance community to enhance research, practice, education and the reputation of Australia’s financial institutions and universities, and of Australia as a financial centre.
For more information, visit www.australiancentre.com.au

About Mercer
Mercer is a global leader in human resource consulting, outsourcing and investment services. Mercer works with clients to solve their most complex benefit and human capital issues, designing and helping manage health, retirement and other benefits. It is a leader in benefit outsourcing. Mercer’s investment services include investment consulting and multi-manager investment management. Mercer’s 20,000 employees are based in more than 40 countries. The company is a wholly owned subsidiary of Marsh & McLennan Companies, Inc., which lists its stock (ticker symbol: MMC) on the New York and Chicago stock exchanges.
For more information, visit www.mercer.com.au

FACT SHEET – METHODOLOGY

• The first Melbourne Mercer Global Pension Index was created in 2009 with 11 countries ranked.  There are now 16 countries in the index that represent a diversity of experience and pension systems and are reflective of the considerable range of approaches selected around the world.
• Each country is given a score between 0 and 100. The overall index value represents the weighted average of the three sub-indices – adequacy, sustainability and integrity.
• More than 40 indicators of desirable factors in all retirement income systems were used to score each country
• Weightings used for index value are:
  • 40% for the adequacy sub-index
  • 35% for the sustainability sub-index
  • 25% for the integrity sub-index.
• The countries that do well in adequacy have an above average base pension to relieve poverty; a good net replacement rate which allows for all the “compulsory” pillars and a system that requires the benefits to be taken as an income stream
• The countries that do well in sustainability have good pension coverage (normally through some form of compulsion or auto-enrolment); a high level of pension assets compared to GDP; a level of mandatory contributions, and a relatively low level of government debt.
• Several countries do well with integrity due to the presence of comprehensive regulation protecting members and a robust regulator.
• In 2011 a new chapter has been introduced called – The Gold Standard – which outlines how countries can achieve an A grade ranking.

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More information on www.globalpensionindex.com

Media Contact:
Professor Deborah Ralston – Director ACFS
+61 3 9666 1010 / +61 419 650318 /deborah.ralston@australiancentre.com.au

Laura Searle – Media Consultant to Mercer – Buchan
+61 3 9866 4722 / +61 (0) 450 403 321/  lsearle@buchanwe.com.au

Professor Kevin Davis, Research Director at the Australian Centre for Financial Studies explains the concept of “living wills” – a basic plan of how a bank could be pulled apart without damaging the broader industry.

What do living wills mean for banks?

One of the things that came out of the global financial crisis was general recognition that the powers of the regulators to resolve a troubled financial institution are not as good as they should be, so that when large banks get into difficulty we find there are all sorts of problems in them making a smooth and graceful exit from the industry……

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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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