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Financial System Reform:Current Issues and Prospects

Professor Kevin Davis

University of MelbourneAustralian Centre for Financial Studies

Monash University

Outline

• The Changing Financial System• Causes

• Implications

• Specific Topics• Borrowing: costs and options

• Changing options and risks for retail Investors

• Superannuation and Retirement

• Taxation and the Financial Sector

• Consumer Outcomes and Financial Advice

• Technology and Innovation

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Drivers of Change•Global regulatory agenda – driven by northern

hemisphere concerns about financial stability (and bank culture)

•Domestic implementation of recommendations of Australian Financial System (Murray) Inquiry

• Fintech

• Zero-interest rate world

• Tax “debate”

Towards a zero-rate world?

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Towards a zero-rate world?

Consequences for: long term wealth accumulation an retirement;incentives for risk taking in search of yield

Bank Capital Requirements and Borrowing Costs

• Basel 3 and 4 regulatory changes• Much higher bank total capital requirements

• Some minor upward effect on bank cost of funds

• But increased bank safety, lower required return on equity, and less taxpayer risk of bail-outs

• Banks attempting to protect margins and roe’s by increasing loan interest rates

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Bank Capital and Borrowing Costs

• Higher capital requirements for major banks for residential mortgage loans

• Reduces their competitive advantage vis a vis others

• Particularly at low risk end of market

• In conjunction with overall capital requirement changes may cause majors to be less focused on mortgage lending

• Should lead to more differential pricing of old and new loans and more borrower “switching”

Bank Capital and Borrowing Costs

• Impetus to other forms of credit provision enabled by technology• Peer to peer lending – small unsecured loans

• Trade finance – e.g. Paypal merchant finance• Funds provided for repayment of a fixed amount (Loan plus fee) over unspecified time –

as an agreed percentage of revenues from merchant sales through paypal.

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Retail Investment Opportunities: Fixed Interest Markets

• Push for “simple corporate bonds” market aimed at retail investors• Provide alternative source of funding to bank loans for companies, and bond

market as a “spare tyre” in crisis

• Yield gain attractive in “near zero” interest rate world, but• Lack of investor diversification a major risk

• How to assess appropriate credit spread

• 2008 experience shows market price risk and illiquidity risk (even in absence of default)

Australian Corporate Bond Spreads

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Retail Investment Opportunities: Fixed Interest Markets• Peer to Peer Lending

• Many new entrants in Australia• Society One, ThinCats, Money Place etc

• Claim to make better use of technology for credit assessment, risk based pricing, loan management than banks

• In principle, retail investors can have large diversification across many small loans and better low risk returns than deposits &corporate bonds• US/UK experience not inconsistent with this

• But recent Chinese Ponzi scheme P2P case illustrates need for good regulation and oversight

Retail Investment Opportunities: Fixed Interest Markets• Bank Capital Requirements have spawned major market in bank

hybrids with “bail-in” provisions• If a “trigger event” occurs, securities convert to a fixed value of ordinary

shares• Trigger events are breach of specified capital ratio or APRA declaration of “non-viability”

• Assessing probability of bail-in and cost, if it occurs, all but impossible – value of shares received based on pre-announcement share price

• Some evidence that a risk premium applied by investors, but is it appropriate?

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Bail-in issue yields relative to alternatives

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Half-year

ANZ div yield

NAB div yield

CBA div yield

WBC div yield

BEN div yield

Average bail-in issueyield

3 yr term deposit startof half year

Retail Investment Markets: Equities and Managed Funds• Technology enabling significant change

• ASX – “M-funds” enabling investors to have investments in unlisted managed funds integrated with equity holdings through CHESS

• Exchange Traded Funds (ETFs)• Massive growth – enable low cost investments in portfolios which track

specified indices

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Taxation

• Tax “debate” a mess – white paper process has faltered. Issues under consideration include• Superannuation tax concessions

• Dividend Imputation

• Negative Gearing / Capital Gains Tax

• GST

• Structure of personal income tax scales

• Differential tax treatment of saving/investment types

• Outcome will affect future financial system structure

Super and Retirement

AFSI - Recognition of plethora of changes still working through system from MySuper and SuperStream. Issues under government consideration include

• Objectives of the superannuation system• Relevant to contribution rates and tax concessions

• Efficiency in the accumulation phase• Allocation of new members to default funds

• Retirement Products and managing longevity, investment, and sequencing risks• preselected CIPRs

• Also• Leverage and Superannuation

• Governance

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Innovation and Technology

Technology - fundamentally changing finance• Digital identities

• Data access and sharing • comprehensive credit reporting

• Payments system• interchange fees & surcharges

• participants

• Graduated, functional regulation• Peer to peer lenders

• Crowd sourced equity funding

• Technology neutral legislation

Consumer Outcomes

Disclosure, Education, Advice approach hasn’t worked

• Product issuer/distributor accountability

• ASIC product intervention powers

• Align interests of financial firms, advisers, consumers• Remuneration arrangements, penalties/banning

• Disclosure of ownership structures

• Adviser competency standards, registration

• Clarify/rename personal/general advice

• Innovative disclosures

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Regulatory Change:

TheLikely

Outcome?

Thank youQuestions?

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