FSI Report Highlights Flaws in the Australian Financial System

Brace yourself for a week of frenetic news and headlines on the ‘Murray Inquiry’.

Or at least the next few days — I don’t think the news cycle lasts as long as a week anymore, even for something as important as fundamental financial system reform.

Yesterday, the government released ‘The Financial System Inquiry Final Report(FSI) to the public…all 350 pages of it. Chaired by former Commonwealth Bank head David Murray, the report contains 40-odd recommendations for reforming and strengthening the financial system.

That’s the key point though. These are merely recommendations. It’s up to the government to implement them now, which will be the challenge.

There’s a lot to take in, but at first glance the report looks like a good one, in that it encourages genuine reform and strengthening of the financial system. It tries to put a leash around the big banks, and calls for changes to an inefficient tax system, something I’ve been banging on about for ages.

Its recommendations will no doubt ruffle some feathers, and you can bet that the big banks’ lobbyists are already banging down Joe Hockey’s door, telling him what a calamity it will be for the nation if the government enforces the changes.

That’s because the FSI had the temerity to say that the big banks have too much market power and are taking too much risk. It recommends they increase their tier one equity ratios by 1.4%, which would see the big banks have to raise around $20 billion in additional capital. That figure is courtesy of the Financial Review, but I heard on ABC radio this morning that it could be as high as $60 billion once all recommendations are taken into account.

The additional equity is in part because the big banks will also have to increase the amount of capital they set aside when making mortgage loans. Currently, the big banks only assume 18 cents in every dollar of mortgage loans is ‘at risk’…and they only set capital aside against that 18 cents.

This compares to the smaller banks, that apply a current risk weighting of 39 cents in the dollar. The new recommendations attempt to level the playing field, so the big banks lose their advantage over the second tier banks.

This attempt to break the concentration and dominance of the big four banks is undoubtedly good news for Australia’s financial system, and for longer-term economic stability. But as I said, the big banks won’t like it. It means lower future returns on equity and lower share prices.

The big bank advantage is best seen by a quick look at price-to-book values. This is the market value of a company divided by its book, or ‘equity’, value. For example, the Commonwealth Bank [ASX:CBA] trades on a price-to-book value of 2.6 times, while the Bendigo and Adelaide Bank [ASX:BEN] trades at just 1.2 times, a much lower multiple.

The difference reflects the higher profitability and dominance of the large banks. This is why the market values their ‘equity’ so much higher.

Expect that to slowly change, though. Should the report’s recommendations come into effect, big banks will get less profitable and the smaller banks more profitable as the industry’s profits spread more evenly throughout the system.

But if all the report’s recommendations are taken on, the banking sector’s pie may grow much more slowly in the future than what it has in the past. More on that in a moment.

In the short term, though, expect plenty of squawking from the big banks.

ANZ’s deputy CEO Graham Hodges did his job yesterday when asked to comment, telling the Financial Review that increasing the risk weights ‘appears at odds with Basel’s risk-based approach to regulation. It seems to discount the significant investment in achieving and maintaining an advanced risk-based model approach [models that are approved by the regulator] and ignores other factors that make the major banks more efficient.’ 

The idea that the big banks have better or more advanced risk models than other banks is absurd. In the event of a crisis, all banks are at risk and their risk models will prove useless.

The big banks are more ‘efficient’ because they have the benefit of riding on the government’s AAA rating. They have the implicit backing of the taxpayer, which protects their downside, while keeping all the upside to themselves.

This sweet deal is now at risk of ending. So expect a lot of lobbying to ensure that it doesn’t. The more lobbying and screeching there is, the greater the sign of the effectiveness of the reform suggestions.

The market doesn’t appear phased about things this morning though. In early trade, CBA is up more than BEN. Is the market discounting a long implementation process and a weak and impotent government? Or just an all-powerful lobby group that will water down the recommendations to ineffectiveness?

Whatever it is, pay no attention to the bankers’ claims. They just don’t want the gravy train to stop. I’ll do my best to shoot down their self-serving arguments in the weeks ahead. I’m for a less risky, more egalitarian financial system than benefits all Australians. The bankers are simply out for more gravy.

But it’s not just the big banks that won’t be happy with the FSI. The real estate industry and the army of rent seekers that benefit from ever rising house prices will be a little nervous as well. As I said, the more noses it puts out of joint, the better the recommendations are.

I’ll labor on this point because it’s an important one. The profits and benefits of growth in an economy flow through to different groups. Some of the rewards are deserved and some just flow through to groups because of regulatory flaws, which create a large sub-group of rent-seekers.

Overall, this is a disadvantage to an economy because it creates poor incentives, which lead to lower productivity and, over the long term (say decades), lower standards of living.

Australia is now about to enter a period of falling living standards, thanks in part to the issues described above….and this is exactly what the FSI is trying to remedy.

For example, the FSI highlighted a number of inefficient taxes that it wants the governments’ upcoming White Paper to address. Specifically (in terms of the effect on the property market), it’s looking at the capital gains discount and negative gearing:

Capital gains tax concessions for assets held longer than a year provide incentives to invest in assets for which anticipated capital gains are a larger component of returns. Reducing these concessions would lead to a more efficient allocation of funding in the economy.

For leveraged investments, the asymmetric tax treatment of borrowing costs incurred in purchasing assets (and other expenses) and capital gains, can result in a tax subsidy by raising the after-tax return above the pre-tax return. Investors can deduct expenses against total income at the individual’s full marginal tax rate. However, for assets held longer than a year, nominal capital gains, when realised, are effectively taxed at half the marginal rate. All else being equal, the increase in the after-tax return is larger for individuals on higher marginal tax rates.

The tax treatment of investor housing, in particular, tends to encourage leveraged and speculative investment. Since the Wallis Inquiry, higher housing debt has been accompanied by lenders having a greater exposure to mortgages. Housing is a potential source of systemic risk for the financial system and the economy.

If these changes do take place, it will remove a lot of the speculative activity in the property market. The banks, real estate agents, property spruikers, property speculators, professional landlords and myriad others won’t like the results it brings (lower profits).

And who would’ve thunk it? A former banker turning on his own? David Murray looks to have done a good job at highlighting the flaws in the Aussie financial system, and coming up with recommendations to improve the distribution of wealth throughout society in a more equitable manner than currently exists.

The problem, however, is that it’s up to the government to implement the changes. Maybe that’s why CBA is up nearly 1% in early trade today? The market is betting on more of the same.


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Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

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