The Australian Financial System Inquiry Report, delivered on Sunday, makes 44 recommendations which, if adopted, will change the way in which financial institutions in Australia do business – particularly at the big end of town.
We look at the suggested reforms, some of the likely outcomes, and the relevance for New Zealand.
An elite pedigree
The “Murray Inquiry”, named after its chair, David Murray, a former CEO of the Commonwealth Bank of Australia, has a lot to live up to as the Abbott Government has placed it in the tradition of two earlier inquiries, both of which were catalysts for major reform:
- the Campbell Inquiry in 1981 which led to the floating of the Australian dollar and the deregulation of the financial sector, and
- the Wallis Inquiry of 1997 which led to the establishment of APRA and to the recasting of ASIC into its current form.
The “blueprint” the Murray Report has come down with does not envisage change of anything like this scale but does reflect international thinking in the post GFC environment and is likely to be significant in its effect.
The Australian Government will consult with industry and the public before formally responding to the Inquiry. That consultation will run until 31 March 2015. But a number of the recommendations are not directed at the government as they come within the mandates of APRA and the Reserve Bank of Australia while those relating to tax have been referred directly to the Tax White Paper.
Key reform themes
The key characteristics that the Report identifies for an effective financial system are efficiency, resilience and fair treatment.
Here in New Zealand, these values are also reflected in the purpose of the Financial Markets Conduct Act (FMCA) to promote and facilitate the development of fair, efficient and transparent markets, in the new unfair contract terms regime under the Fair Trading Act and in the upcoming changes to consumer credit legislation (including the responsible lending code).
Another important theme informing the Inquiry’s recommendations is the need to increase the international competitiveness of the Australian financial sector. This applies particularly to the comments on tax distortions and is relevant to New Zealand in relation to the debate on the ongoing usefulness of the approved issuer levy scheme.
The Report reflects the international shift post GFC toward imposing higher capital requirements on the larger banks to remove any implicit government guarantee and so that they are more resilient against financial shocks without having to rely on taxpayer funded bail-outs.
The top 25%
Murray works from the premise that the four main Australian banks need to be “unquestionably strong”. To achieve this, he recommends that they should be ranked within the top quartile of internationally active banks in terms of capital. Estimates of what they would need to raise to meet this requirement over the medium term range are as high as A$35 billion to A$40 billion.
Moreover the Report expects this to be primarily in the form of equity or retained earnings to give the greatest level of protection against a bank failing and (presumably) to dispel further perceptions around any implicit guarantee.
Doubtless this will be a response to the recent APRA stress tests of the ‘Big Four’ which showed that, while they would all be above their minimum capital requirements even in the most extreme of scenarios, a number of them would breach their capital conversion triggers, thereby requiring their loss-absorbing regulatory capital to be converted into share capital.
It is also worth noting that the top 25% is a moving target as regulators in other jurisdictions impose stronger Basel III minimum requirements and requirements in excess of the Basel baselines. Only this week, for example, the US Federal Reserve announced a risk-based capital surcharge to be applied to the eight largest US banks which will penalise them for being too reliant on short-term funding.
Other recommendations to build resilience include:
- implementation of the Basel III leverage ratio (the “raw” test of capital without the impact of risk weighting assessments)
- introduction of a framework for minimum loss absorbing capital capacity in line with emerging international practice which, as announced at the G20 Summit, proposes a layer of “bail-in” securities that sit above the Tier 2 capital instruments already contemplated under the Basel III regime
- narrowing the difference between the IRB risk weightings on mortgages (estimated to be around 20%) and the standard risk weighting imposed by APRA on the smaller, regional banks to create a more level playing field and (probably) to take some of the heat out of the Melbourne and Sydney residential property markets, and
- requiring effective pre-positioning in planning for the use of powers in relation to effective crisis management or resolution regimes. These compare with New Zealand’s own statutory management regime and the work the RBNZ has done on open bank resolution (OBR).
Interestingly, the Report explicitly declines to recommend the bailing in of deposits. This contrasts with the New Zealand OBR policy where customer deposits are subject to the OBR “hair cut” and need to be pre-positioned in order to enable a bank to open as soon as possible after it is placed in statutory management.
Implications for the RBNZ
As international investor expectations continue to rise, a trend which the Murray Report will reinforce, the RBNZ may come under pressure to increase the quality and quantum of domestic capital requirements. In anticipation of this eventuality, New Zealand banks may choose to build up their retained earnings.
Regardless of whether the RBNZ moves, the New Zealand subsidiaries of the Big Four Australian banks may experience a “trickle-across” effect if the proposed minimum loss absorbing capital requirements are adopted in Australia, depending on how their parent group responds to the new minima.
The RBNZ has consistently stated that it does not consider the leverage ratio to be appropriate for the New Zealand market. Reasons offered include that it is “poorly targeted”, can give “a misleading picture of risk” and is rendered unnecessary by a robust and properly applied risk-based approach.
While it has been accepted for some time that New Zealand and Australia (and several other significant OECD countries) diverge on this issue, the Murray Report may put the spotlight back on this position and make New Zealand more of an outlier.
The proposals relating to the mortgage market may be of interest to the RBNZ as it considers how to use its macro-prudential tool kit to slow the increase in Auckland house prices, including the imposition of a minimum risk weighting on residential loans which would effectively require banks to hold more capital against residential lending.
The Report makes a number of recommendations for improving the operational efficiency of Australia’s superannuation system, commenting that:
- a “lack of strong price-based competition” means the benefits of scale are not being fully realised
- one of the design features contributing to inefficiency is the proliferation of multiple accounts, and
- superannuation assets are not being efficiently converted into retirement incomes.
The recommendations which will likely be of particular interest in the KiwiSaver context include:
- automatically allocating new workforce entrants to default funds in ‘MySuper’ products chosen by the government after a competitive tender process (with each such person having only one ‘high-performing’ account, portable across new jobs until they choose another fund)
- requiring trustees to pre-select for each member’s retirement a ‘comprehensive income product’ (with minimum features which include a regular and stable income stream, longevity risk management and flexibility ) and to communicate this selection to the member, with drawdowns then commencing on the member’s instruction (but allowing members to actively choose to take their benefits in another way), and
- requiring superannuation funds to provide retirement income projections on member statements from defined contribution schemes (using ASIC regulatory guidance) to improve member engagement.
The first of these recommendations will have a familiar ring in New Zealand (aside from there being a high-performance, rather than conservatism and risk management, focus when choosing default funds).
The second recommendation is also very topical. Product providers and commentators in New Zealand are devoting steadily more attention to the ‘decumulation phase’ of KiwiSaver and to mitigating longevity risk in retirement.
The third recommendation reflects research indicating that giving consumers retirement income projections improves their engagement with saving for retirement and their ability to make informed decisions about retirement saving.
The recommendation that the Australian Government accelerates proposals for crowd funding and, following that, peer to peer lending in order to give SMEs additional funding options reflects recent advances in the New Zealand market under the FMCA.
Development of such a market in Australia is likely to create a broader market in New Zealand and potentially provide more of a challenge to the traditional funding models.
The Report considers that further work is needed to lower interchange fees and to put more prescriptive limits on credit card surcharges. These are issues in New Zealand too, with the Commerce Commission deciding recently not to take action against Air New Zealand in relation to its credit card surcharging policy.
However the Report’s recommendations could increase public pressure for a further review in this area given the general unpopularity of these fees and charges.
The Murray Inquiry is concerned that the current system is deficient in a number of respects. These include:
- the “cultural approach” that banks take to treating customers fairly and the consequential pressure that places on the regulatory framework and regulator, and
- the heavy reliance placed on disclosure, financial advice and financial literacy as sources of consumer protection given the limited effectiveness of these tools.
The Report recommends a securities regime built around targeted and principles-based product design and distribution obligations in which product issuers would be required to identify target and non-target markets, stress test products to see how consumers would be affected in different circumstances, and consumer-test marketing materials to ensure that they are clear and easy to understand.
New Zealand has already made progress in this regard. The FMCA has effected a significant move toward regulating conduct, as compared to the previously narrow focus on disclosure, and the Financial Markets Authority is emphasising the centrality of good governance and putting customers first.
The Report also makes recommendations on a range of ad hoc matters.
Of interest in the New Zealand framework is the recommendation that there be reduced disclosure requirements for large listed corporates issuing “simple” bonds to retail investors. The Inquiry proposes the use of terms sheets and a cleansing notice.
Hopefully this will result in greater alignment with the new reduced disclosure requirements for quoted financial products under the FMCA, and that it will pave the way for mutual recognition of such limited disclosure documents.
Also of note are:
- the support the Report gives Australian government proposals to extend the unfair contract terms protections to small businesses (these must be relevant to New Zealand given the large number of SMEs in the New Zealand economy), and
- the encouragement to the banking industry to develop standards on the use of non-monetary default covenants, including requiring sufficient notice of changes so that borrowers have reasonable time to obtain alternative funding. Any new standards introduced into Australia should feed into the review due next year of the New Zealand Bankers’ Association Code of Banking.
A summer read?
At over 350 pages, and having taken account of nearly 7,000 submissions, the Report contains a wealth of information, and a detailed commentary on the current state of the Australian financial market.
That makes it a useful document which deserves to be read. But it doesn’t necessarily make for good holiday reading!