Australian Financial System Research Articles

Has the Australian Prudential Regulation Authority Done Enough to Meet Its Legislated Objectives and Prepare Australia for the Next Financial Crisis?

This article examines APRA’s performance against its legislated objectives and the policy rationales and legal theories underlying the supervision of prudential regulation and promotion of financial system stability. The article will investigate the prudential framework in place and actions taken by APRA in the period beginning January 2014 to the end of June 2018, focusing on APRA’s oversight of residential property lending standards because the quality of these loans will be the single largest determinant of the future health of the Australian financial system. The current study’s findings and broader evidence suggest that APRA’s responses to ongoing lax and risky home lending standards were ad hoc, conservative, and reactive.

Public policy: The first line of defence

The lack of effective competition and systemic misconduct in the Australian financial system has been the subject of recent examination and recommendations of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry and the Productivity Commission’s two inquiries into the efficiency and competitiveness of the superannuation system and competition in the Australian financial system. This is at a time when the Australian financial and superannuation systems represent $7.6 trillion in assets and account for over 9 per cent of the Australian economy, whilst their services and products impact the wellbeing of all Australians. In this paper three public policy areas are examined: why Australia’s financial system is today characterised by ineffective competition and unfair consumer outcomes, reflections on the institutional failures and system wide shortcomings revealed by the respective Commissions of inquiry, and considerations for how to arrive at the right future policy settings.

The Farce of Fake Regulation: Royal Commission Exposed Australia

The revelations from the Hayne Royal Commission (HRC, 2019), limited though they were by the terms of reference, have come as a shock to most people, including Australian politicians, officials, academics and the media. Their expressed shock indicates a high degree of ignorance about the Australian financial system. For decades, the public was led to believe that Australia has the best financial system in world, being one of the few countries to have avoided a recession in the global financial crisis (GFC). This complacent view was contradicted by the HRC and this fact needs to be understood and explained. The HRC Final Report lacks an explanation for its major finding that the regulators had failed to enforce the law. The report merely recommended the regulators be more active, when it did not discover why the regulators had been so passive in the past. This paper provides detailed explanations for the observed failure to regulate based on published research, new or old empirical evidence and industry insider experience.

From Campbell to Hayne: W[h]ither Australia? Australian financial regulation and supervision at a cross-roads

The Australian Government is in receipt of landmark advice: Heydon Royal Commission, Productivity Commission, and the Hayne Royal Commission. Each of them points to deep systemic and cyclical problems in the provision of financial products and financial services.Whilst the Hayne Royal Commission identified egregious behaviour in banks and large financial institutions, far greater economic damage has occurred in less well known sectors of the Australian financial system. Australian law regulating and supervising Non-Bank Financial Entities (NBFEs) has failed those it purports to protect: the vulnerable investing public. Systemic failure manifests in extraordinary loss of investor funds and nationwide economic damage. Without substantial law reform, this author predicts systemic deficiencies in regulation will remain, repeating their cyclical manifestations.Australia’s plight is not unique but no other nation with a sophisticated economy now suffers comparatively. Blame is being attached to the basic policy framework whereas in fact it is policy implementation and enforcement that has allowed systemic failures to manifest.Research demonstrates that inherent tensions between entrepreneurship and investor risk, optimal investor outcomes balanced with compliance, are not of themselves contradictory in a market based system, but they rely upon defining objectives, eliminating conflicts of objectives and conflicts of interest, significantly enhanced behavioural standards of market participants, and the de-politicisation of the regulatory environment. This analysis demonstrates that fiduciary principles are misunderstood, applied haphazardly, often ignored, and subservient to specific statutory and contractual provisions.Australia has a history of subsuming fiduciary principles behind statutory and contractual frameworks facilitating grudging disclosure and creeping corruption. Community expectations of what each market participant should do is often different from what they actually do.Hayne’s real message is the need to link law and morality, community norms and expectations with legal reality.

Restoring Confidence in Consumer Financial Protection Regulation in Australia: A Sisyphean Task?

Consumer financial protection and the integrity of the Australian financial system are critical to the Australian economy in many ways, including the provision of an effective banking system, and the security of Australia’s significant superannuation savings. This is especially the case in an environment where financial products have become more complex and difficult for consumers to understand. In recent years there have been several scandals in Australia’s financial sector that have undermined confidence in the financial system, and exposed regulatory failure. The authors argue that there needs to be a more effective oversight of the key regulators in the Australian financial system to maintain confidence in the system, and prevent capture of the regulators by the financial services industry. The authors contend that the recommendation of the Financial System Inquiry for the establishment of an Assessment Board to provide continuous oversight of the financial regulators is an effective solution to the poor regulatory outcomes encountered in Australia in recent years. The consequences of not having such oversight are likely to be more financial scandals, and further instability in the financial system. These deficiencies must be addressed as a matter of urgency.

Restoring Confidence in Consumer Financial Protection Regulation in Australia: A Sisyphean Task?

Consumer financial protection and the integrity of the Australian financial system are critical to the Australian economy in many ways, including the provision of an effective banking system, and the security of Australia’s significant superannuation savings. This is especially the case in an environment where financial products have become more complex and difficult for consumers to understand. In recent years there have been several scandals in Australia’s financial sector that have undermined confidence in the financial system, and exposed regulatory failure. The authors argue that there needs to be a more effective oversight of the key regulators in the Australian financial system to maintain confidence in the system, and prevent capture of the regulators by the financial services industry. The authors argue that the recommendation of the Financial System Inquiry that there be an Assessment Board to provide continuous oversight of the financial regulators is an effective solution to the poor regulatory outcomes encountered in Australia in recent years. The consequences of not having such oversight are likely to be more financial scandals, and further instability in the financial system. The authors argue that the time to address these deficiencies is now.

Financial Product Design, Retail Investor Sophistication and Issuer Incentives: A Case Study

AbstractMany financial products and securities marketed to retail investors involve design features that can make it difficult to understand the risk and return characteristics involved. This paper examines one such security, Convertible Preference Step Up Units (CPUs), issued in Australia by the US Masters Residential Property Fund (URF) at the end of 2017. It argues that an apparently relatively simple design masks significant complexity which would make risk assessment and fair pricing well beyond the capabilities of retail investors. Despite that, analysis of the security design and disclosure documents suggests that it would not fall foul of the financial product banning powers recommended for the Australian Securities and Investment Commission by the 2014 Australian Financial System Inquiry and in draft legislation as at mid 2018. This highlights the difficulties for effective financial consumer protection resulting from the mismatch between financial literacy levels and financial product design.

The Campbell Committee and the origins of ‘deregulation’ in Australia

ABSTRACTThe 1981 Australian Financial System Inquiry, known as the Campbell Committee, is widely seen as the start of the reform movement of the 1980s and 1990s. Accounts of its origins have been dominated by a debate about which policy actor can take credit. This paper utilises cabinet and Reserve Bank archives to reassess the origins of the Campbell Committee. The inquiry had its origins in an earlier attempt by the Whitlam government to take federal control of the regulation for non-bank financial institutions and the building society crisis of the mid-1970s. In its response to these political and economic challenges we can identify the moment in which the Fraser cabinet turned towards market-based reform. The political decisions made in the context of crisis set the path for regulatory change in subsequent decades, particularly in the area of prudential regulation, where we have seen regulatory consolidation and expansion rather than ‘deregulation’.

Financial Integration in the Asia-Pacific: Fact and Fiction

Australia’s financial connectedness with the Asia-Pacific region lags behind its deepening economic, diplomatic and cultural ties with the region, according to this report by the Australian Centre for Financial Studies. The report finds that while the Asia-Pacific region represents roughly two-thirds of Australia’s global trading relationships, it still accounts for less than one-third of Australia’s financial relationships. Australia’s financial services exports and two-way investment profile remain oriented toward the ‘traditional’ trading partners of the United States, United Kingdom and New Zealand, even as four of Australia’s top five trading partners now lie in the Asia-Pacific. The report points out that financial services is the largest single industrial segment of the Australian economy, a major employer and the largest source of corporate tax revenue. The industry is also a major exporter – of a magnitude not often understood in the community. The value of Australia’s exports of financial services is in fact larger than the value of its tourism exports, and more than double the value of its education exports. High barriers to services trade and cross-border investment in Asia may be inhibiting Australian firms and investors from growing their connections with the region. This is likely to shift in 2015 with the gradual opening of China’s capital account; the realisation of a regionally-integrated ASEAN Economic Community; and the conclusion of three recent free trade agreements with China, Japan and South Korea. “All of these events will change the way in which the Australian financial system interacts with a rising Asia,” according to Amy Auster. A key finding of the report is that many aspects of financial integration are not well-researched or understood. The benefits and costs of financial integration have not been closely examined, and the data on trade in financial services is poor. Policymakers, regulators and practitioners lack a strong evidence base from which to make decisions of vital importance to the entire economy. Authors: Amy Auster, Deputy Director, and Martin Foo, Research Officer, of the Australian Centre for Financial Studies

Update on the Aussie Securitization Market

Securitization has been recognized as an important form of funding for the Australian financial system. Reflecting recovery from the financial crisis, the Australian securitization market had an active year in terms of new issuance in 2014. The large majority of transactions were in Australian dollars, reflecting good domestic demand and a preparedness by some international investors to invest in AUD. The Aussie residential mortgage-backed securities (RMBS) market has been performing well, reflecting a strong credit culture in Australia, regulatory underpinning of underwriting standards, and the full-recourse nature of Australian mortgages. Sponsors of RMBS in Australia are typically the ongoing servicers of the mortgage assets, which provides implicit “skin in the game” where the lender/servicer has a direct economic interest in the performance of the securitized mortgages. The securitization industry is hoping that the banking regulator, the Australian Prudential Regulatory Authority (ARPA), will allow banks to use master trust structures and also to use date-based calls to issue bullet and scheduled amortization notes to international investors in non-AUD denominations with the objective of expanding the investor base and bringing global investors back to the Australian securitization market. The regulator is also looking to simplify securitization. The direction is for structures primarily to have just two credit tranches and to avoid resecuritizations and synthetic securitizations. <b>TOPICS:</b>Developed, technical analysis

Its Time to Replace Toxic Governance with Good Governance

The Australian financial system is exposed to the same toxic governance practices that caused the financial crisis in 2008. The US Government’s 2011 commission of inquiry into the crisis concluded that a “key cause” was “dramatic failures of corporate governance and risk management”. However, the Australian Prudential Regulatory Authority enforces US practices that become particularly toxic with Australia law. A shared source of toxicity arises from corporate constitutions providing directors with absolute power to corrupt themselves, their firm, and in the case of prudentially regulated institutions, the financial system and so the real economy. The solution is to amend constitutions to separate the power to govern from the power to manage while engaging with stakeholder constituencies to empower them to become co-regulators. A fundamental problem is that regulators, governance rating agencies and experts who formulate governance codes have not identified the objectives of good governance and so do not know where to head. Parliament is required to give direction. Good governance requires organizations to act ethically and fairly while minimizing harms, inequities, costs and risks on society by improving their self-governance. Self-governance is found in nature to allow creatures with little intelligence to reproduce in dynamic, complex unknowable environments. The paper describes how the laws of nature can be used to design the constitutions of organizations to follow the compelling success of simple creatures. The paper concludes that a Parliamentary inquiry is required to rectify the commitment by regulators, governance codes, and practitioners and their professional bodies to toxic governance.

Implications of the Global Financial Crisis: Submission to the Australian Financial System Inquiry

The global financial crisis has provided clear evidence that the global financial system, including that of Australia, is founded on flawed economic theories. There is no scientific justification for sophisticated risk management, complex institutional structures or intrusive regulation. Australian financial system reforms should simplify corporate structures by restoring Glass-Steagall type separation, discourage anti-competitive conglomeration, reduce system leverage and prohibit over-the-counter derivatives in regulated institutions, decrease secrecy of complex institutional regulation, and increase consumer protection through transparent disclosure of regulatory data.

Should the FSI revisit the philosophy of financial services regulation?

The Australian government's Financial System Inquiry (FSI) is charged with, among other things, refreshing the “philosophy, principles and objectives underpinning the development of a well-functioning financial system”. However, the FSI's Interim Report gives little indication that a fundamental rethink of the dominant “conduct and disclosure” approach to financial services regulation, derived from principles of capital markets regulation, is on the cards. While that approach remains a sound basis for regulating securities issuers and participants in capital markets, it is not clear that it provides the right framework for regulating fiduciary intermediaries in the wealth management sector, or providers of consumer financial products and services.

Australia's Financial System Inquiry: some preliminary observations

The Australian Government's Financial System Inquiry is due to release an Interim Report in July. This short article briefly reviews the 270 public submissions it has received so far and offers some observations on their content and the process to date.

Culture and the future of financial regulation: how to embed restraint in the interests of systemic stability

This paper examines the challenges associated with setting or recalibrating “the philosophy, principles and objectives underpinning the development of a well-functioning financial system”, a core term of reference for the Australian Financial System Inquiry. The current philosophy is informed by an emphasis on structure, leaving it to market participants to self-police through a combination of rules and principles. It is informed by a high degree of trust in market ordering and acceptance of conflicts of interest as long as they are managed, thereby delivering beneficial outcomes. Specialisation and expertise are deemed to ensure that risk-taking takes place in fair, orderly and transparent markets. The global financial crisis has severely tested that assumption. As in other markets, trust in the integrity of financial markets and their participants has evaporated. The key policy question is whether the operation of the financial system is, in the vernacular, “fair dinkum”, according to or deviating from Australian belief in fairness. The paper explores the defects in the regulatory paradigm through each of the key themes: (i) balancing competition, innovation, efficiency, stability and consumer protection; (ii) how financial risk is allocated and systemic risk is managed; (iii) assessing the effectiveness and need for financial regulation, including its impact on costs, flexibility, innovation, industry and among users; and (iv) the role of government; and the role, objectives, funding and performance of financial regulators including an international comparison. The evaluation demonstrates profound limitations with the current paradigm. We argue that culture is a critical driver of behaviour. It can justify, embed or restrain action but ought to do so in light of institutional purpose. Unless the underpinning philosophy defines duties and responsibilities as well as rights, and links this to a framework that place culture at its core, we risk failing to learn from history. This would be both tragedy and farce.

Fiscal shocks and the real exchange rate: evidence from an outpost of textbook open-economy macroeconomics

Recent empirical research into the macroeconomic effects of fiscal policy shocks has generated a ‘puzzle’. Both Keynesian and Real Business Cycle models predict that a fiscal expansion will lead to a real exchange rate appreciation. However, in almost all the individual countries that have been studied, positive shocks to government spending cause the real exchange rate to depreciate. Recent theoretical work suggests that this unexpected result might reflect incomplete international financial market integration. The country where the incomplete markets assumption is least plausible is New Zealand, because of its integration into the Australian financial system. We show that in New Zealand there is no puzzle, and the standard textbook result still holds. Our counter-factual results are consistent with the argument that the puzzle is to be explained by an absence of complete international financial market integration in most parts of the world.

Banks, Capital Markets and Australian Economic Development

This paper traces the evolution of the Australian financial system from 1788 to the current day showing how institutions have evolved to meet the changing needs of the economy. Governors in the earliest periods struggled with an inappropriate legal and regulatory structure; and the economy suffered from major fluctuations in financial flows. By the later part of the nineteenth century the institutional and legal structure was more stable but the system was shocked in the 1880s and '90s by an asset price bubble (fed by financial exuberance and large capital inflows) which burst and provoked a depression. This experience was similar to the current global financial crisis. While the 1890s crisis was a private sector failure, Australia's 1930s experience was caused by a major build-up in public debt, largely borrowed offshore, which could not be serviced. The private financial institutions had few problems. The subsequent period from 1940 through to 1980 then saw heavy repression of finance. This helped pay down government debt at the expense of private savers, but proved unsustainable as finance moved around the regulatory net and controls became progressively less effective. The breakdown of the global system of fixed exchange rates made Australia's position untenable. The financial system was liberalized during the eighties, re-opening the economy to large capital inflows and forcing it to adjust to a fluctuating exchange rate. So far the experiment has worked well. The system appears to be stronger, more diversified, and more resilient than in the past.

The productivity and performance of Australia’s major banks since deregulation

The aim of this study is to present some measures of the performance of banks operating in Australia since the deregulation of the Australian financial system in early 1980s; including the periods of financial market instability (the early 1990s and mid to late 2000s). In undertaking this measurement two approaches will be used. The first simply applies standard financial indicators. The second approach applies data envelopment analysis (DEA), to determine Malmquist indices of the levels of and the changes in the efficiency and productivity of Australian banks. The empirical results demonstrate the effect of deregulation and periodic financial crisis’s on the performance of individual banks, and the major part of the Australian banking sector. Overall the productivity performance of the Australian banks tended to improve considerably in those periods of strongest economic growth (i.e. the mid 1980s and 2000s).

Making Sense of the GFC: Where did it Come from and what do we do Now?

The collapse of the global financial system following the events of September 2008 was unprecedented in its global reach and the response elicited from governments. The Global Financial Crisis has called into question the basic assumption of Efficient Markets Theory that traded financial instruments will always have a market price – indicating that capital markets as well as depository institutions can suffer liquidity crises or ‘runs’ due to asymmetric information. This paper traces the causes and implications of the GFC, focusing especially on the Australian financial system and its regulation. Attention is drawn to the need to review financial sector regulation in light of the GFC in order to rebalance the mix between competition and regulation in financial markets. But the paper also notes the danger of over‐regulation with its potential to stifle innovation and constrain the risk‐allocation function of financial markets.

Interest Rate and Foreign Exchange Risk Exposures of Australian Banks: A Note

The abolition of most government controls over the Australian financial system in the 1980s, the advent of a flexible exchange rate regime in 1983 and the globalisation of the financial system in the 1990s have created new opportunities for Australian banks but exposed them to new sources of risk. This study estimates systematic risk exposure of publicly listed Australian banks with respect to market, interest rate and foreign exchange rate using a GARCH-in-Mean model. Not surprisingly, the results suggest that nearly all banks exhibit varying degrees of market risk exposure. However, stock returns of large banks are highly sensitive to interest rate changes, while most small banks are almost immune to both interest and exchange rate changes.