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Banks may need to set aside rainy-day capital

‘System robust’: Financial Systems Inquiry chairman David Murray. Photo: Nic WalkerA year ago when Joe Hockey appointed David Murray to lead a “root and branch” review of the financial system for the first time in 16 years, he raised the risk that governments always take on when they launch an inquiry without knowing where it will lead.

The Wallis report in 1996 had resulted in financial system architecture that worked: a specialist bank and insurance regulator, APRA, a specialist companies and markets regulator, ASIC, and a central bank that acted as the gatekeeper of the financial system and the economy.

Wallis wasn’t the only thing Australia had going for it during the 2007-09 global crisis. The government entered it with relatively low balance-sheet gearing, for example. Australia’s large stock of variable rate loans also allowed Reserve Bank interest rate cuts to flow into the economy quickly, something that did not occur in the United States, where a much larger stock of debt is fixed rate.

The consensus not just in Australia but around the world was, however, that Wallis passed the global-crisis stress test successfully, to the point where it became an exemplar.

There was no serious appetite for it to be dumped, and sighs of relief last July when the Murray inquiry’s interim report concluded that Australia’s regulatory architecture could be renovated and improved, but was at its heart “robust and effective”.

The Murray inquiry’s final report is expected to be released by the government on Sunday week, December 7, and the big banks expect it to recommend that they underpin their home lending books with more balance-sheet capital, to reflect the growing share of home loans on their lending books, the growing share of loans to investors in their home loan portfolios, and the risks they face if housing prices turn down sharply.

The banks have been fighting a rearguard action against the recommendation, which was foreshadowed in the interim report.

The household debt-to-income ratio had declined since the global crisis,  home loan repayments as a percentage of household income had fallen during the same period to the average since 1980, and sub-prime home loans that peaked at 14 per cent of total home lending in the United States before the global crisis got to only about 1 per cent in Australia, Westpac said in its response to the interim report, for example.

Large-bank non-performing loans were less than 2 per cent of total loans compared with more than 3 per cent in the US, almost 6 per cent in the United Kingdom and 8 per cent in the Euro area, it added.

A stress test conducted this year by APRA that assumed a horror scenario – a 4 per cent contraction in economic growth, unemployment of more than 13 per cent and a double-dip slide in house prices of more than 40 per cent – did, however, conclude that the banks could rack up losses of $170 billion during 5 years, about a third of them on home loans. If it took a hit of that magnitude, Australia’s banking system would not be fully functional, APRA’s chairman Wayne Byres said in a speech early this month.

Byres said the regulator was not forecasting that a slump of that ferocity would occur. The stress test was nevertheless “very deliberately designed” to expose vulnerabilities in the banking system, he said. That, and the fact that the banks are still reliant on overseas markets for funding, is likely to persuade Murray that extra “rainy-day” capital should be set aside.

As much as $53 billion could be needed, according to the Fitch credit rating agency. The big banks earn that much among them in about two years, however. Fitch says they are well positioned to raise the money internally, and would be given time by APRA to do so.

If it calls for the banks to build their capital buffers but endorses Wallis’s system architecture, the Murray report will be classed initially at least as being less influential than the Wallis report or the Campbell inquiry in 1979 that lit the fuse on financial deregulation.

What that would mean, however, is that Murray and his colleagues got it right. The system needs fine-tuning rather than a radical overhaul, and there will still be much in the final report worth taking up.

The interim report made it clear that superannuation would be a major focus, and noted that the regulation of superannuation had been focused more heavily on the accumulation phase than the retirement, or drawdown phase.

Some might say this is an obvious conclusion to reach after the examples of adviser misbehaviour and investor losses that have emerged since the global crisis occurred, but the obvious conclusion is in this case the right conclusion, and it will be very interesting to see where it lands.

It is hoped the final report will, for example, recommend that the gearing of self-managed superannuation for property purchases be banned, closing down an opportunity for self-interested alliances between property spruikers, lenders and financial advisers that should never have been allowed to open up.

The interim report also asked for feedback on whether genuinely independent advice needed to be more clearly distinguished, as it is in the UK, where advisers must tell their clients whether they are independent – able to recommend all products – or restricted, and able to recommend only some products. A similar recommendation here would be a body blow to the big banks and their tied planner networks.

It also asked whether ASIC should be given the power to prescribe marketing terminology for complex and risky products and, if necessary, temporarily ban them. ASIC’s equivalent in the UK, the Financial Conduct Authority, already has the power. ASIC wants it, and Murray may well strengthen its arm.

This story Administrator ready to work first appeared on Nanjing Night Net.

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