Financial System Inquiry: Final Report Delivered

Monday 8 December 2014 @ 12.00 p.m. | Corporate & Regulatory | Taxation | Trade & Commerce

On Sunday 7 December 2014, the ABC reported that Financial System Inquiry Chairman Mr David Murray (the former Commonwealth Bank chief executive) and the Federal Treasurer Joe Hockey, had released the final report of the Government commissioned, Financial System Inquiry (FSI). A report which as the ABC points out the Treasurer was:

"keen to emphasise . . . was completely independent from the Government" or in the Treasurers words was: ". . . a report to the Government, . . . not a Government report."

Overview of the FSI Report

In its "Executive Summary" the report states that it responds to:

". . . the objective in the Inquiry’s Terms of Reference to best position Australia’s financial system to meet Australia’s evolving needs and support economic growth. It offers a blueprint for an efficient and resilient financial system over the next 10 to 20 years, characterised by the fair treatment of users".

The report states that it makes 44 recommendations intended to serve as "a blueprint for the financial system over the next decade".

The reports recommendations are said by the report to focus on two general themes:

  1. funding Australia’s economy and
  2. boosting competition;

Five specific areas of attention are identified in the report as being:

  • resilience;
  • superannuation and retirement incomes;
  • innovation;
  • consumer outcomes and
  • the regulatory system.

Some Key Findings of the FSI Report

Amount of capital held by Banks to Cover Potential Loan Losses

As the ABC reports, one of the FSI reports key findings is that Australia's major banks are positioned ". . . only middle of the road by international standards in the amount of capital they hold to cover potential loan losses".

According to FSI Chairman Mr Murray the FSI report had reflected on the lessons of the global financial crisis GFC, and found that even a more modest banking crisis than the GFC would cost 900,000 Australian jobs. Given changed circumstances since the GFC and the fact that future GFC like events will happen the FSI according to Mr Murray, as reported by the ABC, wants ". . . the taxpayers off the hook as far as possible". To this end the FSI estimates that a realistic internationally comparable estimate of the big four banks' capital levels would be anywhere between 10-11.6 percent, while 12.2 percent would be needed to make it into the top quarter of banks in terms of capital held to cover potential loan losses.

If adopted by the Australian Prudential Regulation Authority (APRA), such a measure would effect profitability and shareholders as it would mean tens of billions of dollars in extra shareholder funds would need to be raised by the big four banks, some estimates being as much as $60 billion.

Notably, this recommendation is reported as contrary to the research commissioned by the Australian Bankers' Association (ABA) which placed Australia's banks in the top quarter of financial institutions globally.

Lifting Risk Weights on Mortgages

At present our five largest financial institutions are able to use their own internal models to evaluate the risk of their mortgages and then set aside what they see as an appropriate amount of capital to cover those losses. The FSI has found using APRA's figures that the five major financial institutions only set aside capital provisions to cover an average of 18 percent of their mortgage lending, versus an average of 39 percent for regional banks, mutual banks and credit unions. This is a situation allowing the majors financial institutions to require less shareholder funding to cover potential mortgage losses and have more for use as debt funding, which is considerably cheaper and gives them a significant cost advantage over smaller players. To counter this the FSI proposes putting a minimum floor on "internally generated risk weights" a measure interpreted as also being an inference by the FSI that the five major financial institutions "may not be sufficiently protecting themselves against the risks of a widespread housing downturn".

In this respect the effect of negative gearing got a special mention as the ABC reports with the FSI final report noting in an appendix:

". . . that negative gearing had been largely responsible for a risky run-up in housing investment in preference to other forms of saving, although it will be up to the Government's tax review to examine this issue in detail".

Ban Superannuation fund borrowing

An area of risk where the FSI recommended action was from its finding of a rapid build up in debt by superannuation funds since the restriction on borrowing had been lifted, the report finding that in the past five years, superannuation fund borrowings had increased by 18 fold, from $500 million at June 2009 to $9 billion in June 2014. An increase which was seen as small relative to the overall financial system, but which could be a problem for financial stability in future if present rates of growth continued.

Comments on the Report

The Conversation in an interesting overview of the report seeks the opinion of several commentators/academics in response to the FSI final report and there comments as presented appear to range from "as expected and not to controversial" to "could have done more and did not cover everything", examples are:

Professor Stephen King, (Professor at the Department of Economics, Monash University) who  says that the FIS report is "solid and predictable" and goes on to say:

"But that does not mean it is not important. It sets a clear path forward for the federal government to improve the Australian financial system. Its main recommendations deserve bilateral support in parliament."

Mr Michael Peters, (Lecturer at the University of NSW Business School) who says:

"From the outset the inquiry had its sceptics. Absent from the panel was any representation from the mutual banks, credit unions, co-operatives, customers, employees, unions, small business or ordinary Australians who rely on an accessible and affordable financial system. . . . The question was justly asked “what is the purpose of the inquiry?”

Next Steps

On the FIS website these next steps are indicated to be as follows:

  • the Federal Government will consult on the Inquiry’s recommendations before making decisions and as part of this is calling for written submissions from all stakeholders, including industry and members of the public; then
  • where the FSI report recommendations are under the responsibility of financial regulators such as APRA, ASIC and the RBA, the Government is looking to those regulators to consider recommendations relating to their legislative mandate and looking for submissions; and finally;
  • FSI report recommendations and observations on tax issues are to be considered under the Tax White Paper process and submissions on tax issues are requested to be directed to that process (details to be announced shortly).

The closing date for submissions is posted as Tuesday, 31 March 2015.

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