Michael Keating. The Financial System Inquiry. Part 1: Resilience of the Financial System.

I am reposting this important article in case you missed it during the holiday period.  John Menadue

With its budget stalled the Abbott Government has often appeared to be floundering and devoid of any long term economic plan or strategy. But this appearance may be deceptive. In fact the Abbott Government has established major inquiries into the financial system, federalism and taxation. Taken together these reports could provide the basis for a comprehensive package of major reforms for the Government to at least announce, even if not complete, before the next election. Ideally that reform package would also include a review leading to a better integration of policy for retirement incomes; where many of the relevant issues have already been touched on by the recently released report on the Financial System and by the Henry Tax review (released five years ago, but except for the ill-fated mining tax, largely ignored since).

In this comment I will discuss one of these building blocks – the report by the Financial System Inquiry (FSI) chaired by David Murray. The report considers two general themes – removing distortions to the funding of the Australian economy and allowing competition to drive efficiency – and it also has 38 recommendations covering five specific themes:

  • Strengthen the economy by making the financial system more resilient,
  • Lift the value of the superannuation system and retirement incomes,
  • Drive economic growth and productivity through settings that promote innovation,
  • Enhance confidence and trust by creating an environment in which financial firms treat customers fairly,
  • Enhance regulator independence and accountability, and minimise the need for future regulation.

In addition the FSI Report has another 6 recommendations covering some significant matters that do not fit neatly under the five themes above, and the Report has a number of observations (but not recommendations) about changes to the tax system, which the FSI believes should be considered as part of the process in train for reviewing the tax system.

Although the FSI Report has not received a lot of media attention it does seem to have been well received. Personally I think there is a good chance that the Government, after a period of consultation, will adopt many of the recommendations, although as I will identify there are a few recommendations that may be opposed by various interest groups.

In this posting I will comment on the recommendations which are intended to:

  • Make the financial system more resilient, and
  • Increase efficiency through improved competition

In two subsequent postings I will discuss

  • the proposed changes affecting superannuation, and
  • investor protection and some other related issues

In the space available it is not possible to cover all the report and all its recommendations, and so I will concentrate on what I consider to be the most important.

Resilience of the Financial System

The FSI found that historically Australia has maintained a strong and stable financial system. At its core is the banking system and its safety is of paramount importance. The Australian banking system is, however, very concentrated, unusually dependent on foreign capital inflows, and exposed to fluctuating terms of trade, so that the Australian banks need to be better positioned than most. Accordingly the FSI recommends setting capital ratios for the Australian banks so that they are in top quartile of internationally active banks, and this in a world where the international standards for capital ratios are being raised. There was some expectation that the major banks would oppose this recommendation, arguing that it would reduce bank dividends and/or increase bank margins thus damaging economic growth. But the report shows that such fears have been greatly over-stated[1], and since the release of the report, the major banks seem to have decided that a fight over this recommendation is not worth it, and they seem likely to agree.

Other key recommendations to improve the resilience of the banking system are:

  1. Increase the risk weighting for mortgages held by the big banks. At present the big banks are able to shrink their mortgage books to just 18 per cent of their real size for the purpose of calculating minimum capital levels, and the FSI has recommended that this risk weighting should be increased to between 25 and 30 per cent, with the exact decision to be made by the regulator, the Australian Prudential Regulatory Authority. This recommendation will also make the smaller regional banks more competitive because they can only risk weight their mortgages down to 39 per cent of their true value.
  2. Change the tax treatment of investor housing, which the FSI found presently ‘tends to encourage leveraged and speculative investment’, to the point where ‘Housing is a potential source of systemic risk for the financial system and the economy’. Accordingly the specific suggestion by the FSI is that the capital gains tax concessions for assets held longer than a year should be reviewed. In this context the FSI also recommends that superannuation funds should no longer be able to borrow to finance investments in property. This recommendation may prove particularly controversial with the owners of self-managed superannuation funds which have increased their borrowings by almost 18 times over the last five years from $497m in June 2009 to $8.7bn in June 2014. This leveraging up of these superannuation funds has not only made them more risky, but if they fail some of the risk is transferred to the taxpayer, as the owners of the funds then become eligible for the pension.

In my opinion all the recommendations to improve the resilience of the financial system should be supported. The Global Financial Crisis has reminded us very forcibly of the problems that arise when an institution is considered to be ‘too big to be allowed to fail’.  I agree with the FSI that its package of recommendations to improve the resiliency of the financial system ‘would make institutions less susceptible to shocks and the system less prone to crises. It would reduce the costs of crises when they do happen … and minimise the cost to taxpayers, Government and the broader economy from the [inevitable] risks in the financial system.’

Efficiency and Competition

The FSI found that the primary driver of efficiency in the financial system is competition, and overall the Inquiry considered that ‘competition is generally adequate’. The FSI was, however, properly critical of the lack of competition in the superannuation industry (see more in next posting), and personally I was disappointed that the FSI did not pursue competition in the banking industry with the same vigour as it applied to the superannuation industry. From a lay point of view, some of the banking margins (eg. foreign exchange transactions) look excessive, but this was not seriously examined in this review. However, another aspect of some of the recommendations already discussed is that they should improve competition. In particular, the recommendations regarding risk weighting of assets will help make the second tier banks more competitive and overall the FSI is probably correct that its recommendations will help small business in particular gain improved access to funding.

 

[1] The FSI calculated that increasing the capital ratios by one percentage point would increase average loan interest rates by less than 0.1 percentage point which could reduce GDP by 0.01-0.1 per cent. This seems a reasonable insurance cost against the potential losses from a financial crisis that challenged the solvency of the financial system. For example, on the basis of recent international experience, the FSI suggests that ‘the average financial crisis could see 900,000 additional Australians out of work, … [and] the average total cost of a crisis is around 63 per cent of annual, GDP, and the cost of a severe crisis is around 158 per cent of annual GDP’.

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