Financial Stability Review – September 2007 Developments in the Financial System Infrastructure

Basel II

The Australian Prudential Regulation Authority's (APRA) revised prudential standards for authorised deposit-taking institutions (ADIs) based on Basel II are scheduled to come into effect on 1 January 2008. Most ADIs will use the standardised approaches, with only a small number of large banks having applied to become accredited by APRA to use the more advanced approaches. Announcements regarding which banks will receive accreditation for these advanced approaches from 1 January are expected in the near future.

The implementation of Basel II is expected to lead to a modest decline in the minimum amount of capital that ADIs are required to hold. This mainly reflects the reductions in regulatory capital requirements on most housing loans. Offsetting these reductions are the introduction of capital requirements for operational risk, and APRA's decision to use national discretion to introduce an explicit capital charge for interest-rate risk in the banking book for those ADIs using the advanced approaches. Further, in recognition that past experience in the housing loan market in Australia may not be a very good guide to future losses, APRA has set a minimum transitional ‘loss given default’ of 20 per cent for those banks using the advanced approaches for credit risk. It has also indicated that in 2008 any reduction in minimum regulatory capital for ADIs accredited to use the advanced approaches will be limited to 10 per cent of the capital that would have been required had current arrangements continued. This limit will be retained in 2009 pending a review based on experience.

While minimum capital requirements for the system as a whole are likely to decline a little, the combination of APRA's new capital requirements and changes to accounting standards is likely to lead to an improvement in the overall quality of capital, as some ADIs will need to hold a higher proportion of their total regulatory capital in the form of non-innovative Tier 1 capital.

As part of the implementation of Basel II, APRA is proposing to build on its existing processes of supervisory review to set a prudential capital requirement (PCR) for each ADI that must be met at all times. The PCR will be set at a level that is appropriate to each ADI's overall risk profile, with the minimum PCR being 8 per cent of risk-weighted assets.

The implementation of Basel II will also see further improvements in the already high level of disclosure by ADIs. All ADIs will be required to disclose a basic set of information on their capital adequacy, broadly similar to current reporting requirements, but with some additions in areas such as operational risk and securitisation. ADIs using the advanced approaches will be required to make extensive additional disclosures of quantitative and qualitative information (reported semi-annually and annually respectively). APRA may also vary the disclosure requirements for an ADI depending on its particular circumstances.

The implementation of Basel II has been a lengthy process. It has, however, provided strong incentives for ADIs to upgrade and improve their risk management systems, business models, capital strategies and disclosure frameworks.

The Regulatory Response to Property Company Collapses

Over the past 18 months, four property development companies in Australia have gone into receivership – Westpoint, Fincorp, Australian Capital Reserve and Bridgecorp. In total, around 20,000 investors in these companies are owed approximately $900 million. All four companies were mainly involved in residential property development.

The administrators of the failed companies are examining the options available to minimise the losses to investors. Options include selling existing assets and completing property developments that are already underway. Several Fincorp properties are in the process of being sold, and secured noteholders have been notified that they are likely to receive a return of around 50 cents in the dollar (unsecured noteholders are not expected to receive any return). Administrators for Australian Capital Reserve have estimated that investors will receive at least 60 cents in the dollar, while the administrators of Bridgecorp are yet to release information about likely returns. For Westpoint, returns to investors will vary across the different development projects, and in some cases are still unknown.

The Australian Securities and Investments Commission (ASIC) is investigating the failed companies and their directors for any wrongdoing and has proposed changes to market disclosure requirements. It has sought, and obtained, orders to freeze assets of the former directors of Fincorp and, in some cases, those of their spouses, pending further investigations into the disposal of assets. For Westpoint, ASIC is continuing to investigate possible criminal behaviour, with charges against some individuals already being laid. Westpoint's use of promissory notes with a face value of over $50,000 was an attempt to avoid certain provisions of the Corporations Act 2001 intended to provide some safeguards to retail investors. However, in 2006 the Supreme Court of Western Australia ruled that because the promissory notes were used to fund a managed investment scheme, they were subject to the Corporations Act.

These recent failures have focused attention on the issue of how well investors understand the risks involved in some debentures, particularly those issued by entities that are neither rated nor listed on the stock exchange. In total, unlisted and unrated debentures account for approximately $8 billion of the $34 billion in debentures currently on issue to retail investors and self-managed super funds. ASIC has recently released a consultation paper which proposes means of improving the quality of disclosure to retail investors in these debentures. Under the proposals, ASIC would establish a series of benchmarks with issuers being required to disclose whether they meet these benchmarks, and if not, why not.

The proposed benchmarks are as follows:

1. Issuers should have their debentures rated for credit risk by a recognised agency, and have that rating disclosed in the prospectus and in advertising.
2. Issuers should have a minimum of 20 per cent equity where funds are lent, directly or indirectly, to property developers.
3. Issuers should estimate their cash needs for the next three months and have cash on-hand to meet these needs.
4. Issuers lending money for property development should be required to maintain a maximum 70 per cent loan‑to‑valuation ratio, based on a valuation that assumes the development is completed, and 80 per cent on the basis of the latest market valuation.
5. Issuers should disclose details of loans they have extended, or expect to extend over the coming year.
6. Valuations should be fully disclosed. Development property assets should be valued on a cost, ‘as is’ and ‘as if complete’ basis, with all three disclosed.
7. Issuers should disclose how many loans they have made to related parties, or expect to make to related parties over the next 12 months, and what assessment and approval process they follow for such loans.
8. Issuers should disclose their approach to rollovers of debentures, including automatic rollovers.

ASIC also proposes that advertising for these products should not use words such as ‘secure’ and ‘safe’, and should disclose prominently that there is a risk that investors may lose some, or all, of their capital. It is envisaged that trustees, advisers, valuers and auditors would use these benchmarks to fulfil their responsibilities. For retail investors, ASIC also plans to produce an Investment Guide to help with understanding disclosure documents, and conduct an education campaign to improve investor understanding of investment principles, such as diversification.

The Reserve Bank supports the general approach being taken by ASIC as a way of assisting investors to make more soundly based investment decisions.

Non-operating Holding Companies

A number of ADIs are considering establishing non-operating holding companies (NOHCs). The likelihood of them doing so has increased following the removal in June 2007 of a number of regulatory and tax impediments which made it unattractive for some banks to convert to a NOHC structure. Around the same time, APRA released a discussion paper on changes to the prudential standards relating to capital adequacy, some of which finalised APRA's treatment of conglomerate groups containing one or more locally incorporated ADIs.

The changes relating to conglomerate groups have their origins in the Wallis Inquiry into the Australian financial system which recommended that non-operating holding company (NOHC) structures should be permitted in Australia. The Inquiry felt that such a structure would enhance the ability of a holding company to isolate risk within a subsidiary, as it would facilitate a legal separation that quarantined the assets and liabilities of the various entities, making creditors of a failed subsidiary unable to make claims on other parts of the group. It would also bring Australia into line with other countries where this type of structure is common.

Acting on the recommendation of the Inquiry, the Government revised the Banking Act 1959 to allow for NOHCs, and in 2002 APRA released its ADI policy framework for the operation of NOHCs. Key elements of the framework relate to capital adequacy and limits on exposures of the ADI to other parties within the NOHC. Minimum capital requirements could be applied not only to a NOHC, but also to a group headed by a NOHC. Non-financial businesses could, in principle, be part of a NOHC structure, though APRA has retained the power, under the Banking Act, to issue directions to a NOHC. APRA's policy also allowed for group ‘badging’, provided that it did not create the impression that a non-ADI member of the group was an ADI, or was guaranteed support by the ADI.

Currently, only two banks in Australia operate under a NOHC structure – BankWest (under HBOS Australia) and Member's Equity Bank.

Financial Compensation by Australian Financial Services Licensees

Retail clients of financial services licensees can suffer losses because of inappropriate advice, fraud or lack of disclosure by licensees, which include financial planners. Licensees are not required to have compensation arrangements in place despite the fact that retail clients can make claims for compensation directly against them. In some circumstances, licensees have not been able to meet all the claims and, as a result, retail clients have not received compensation even when they were entitled to it.

In response, new regulations have been passed by the Government requiring financial services licensees who provide services to retail clients to have in place adequate compensation arrangements, mainly via professional indemnity insurance, although certain APRA-regulated entities will be exempt from this requirement. Where professional indemnity insurance policies do not provide cover for all the situations required under the new regulation, the licensee will have to use its own financial resources to self-insure (with the approval of ASIC). Many licensees already have some form of insurance, as it has become a standard element of business best practice, along with being a condition of membership of the Financial Planning Association and the Australian Securities Exchange. The compensation requirements are not intended to cover product failure or general investment losses.

ASIC has released a consultation paper on how it proposes to implement the new regulations and ensure that the objectives of the revised compensation scheme are met. The comment period on the consultation paper closed on 14 September 2007.

Regulation of Mortgage Brokers

The regulation of mortgage brokers in Australia has been under consideration for some time. In part, this reflects concerns that a small number of brokers may have been associated with predatory lending practices and that their remuneration structures – predominantly high upfront and low trailing commissions – might have adverse consequences for both borrowers and lenders.

There is no national licensing or regulation of mortgage brokers. ASIC's licensing powers do not extend to brokers who only advise on credit products, as credit is not considered a ‘financial product’ for the purposes of the Corporations Act 2001. Mortgage brokers, therefore, are not obliged to have an Australian financial services licence. ASIC has the power to take action against brokers only in relation to misleading or deceptive conduct/advertising.

Instead, the provision of credit is covered by the states under the Uniform Consumer Credit Code (UCCC). However, as the UCCC does not regulate the provision of advice on credit, some states have introduced separate legislation to cover mortgage broker activities. This legislation focuses mainly on disclosure, with only Western Australia licensing mortgage brokers.

In late 2004, the Ministerial Council of Consumer Affairs (MCCA) – a working committee comprising the Federal Parliamentary Secretary to the Treasurer and state Ministers of Consumer Affairs – released a discussion paper with proposals for uniform state-based regulation of finance brokers. The proposals, which would apply to all finance brokers (other than those who only broker business loans to large firms or amounts over $2 million), include a licensing scheme, minimum competency requirements, full disclosure of fees and commissions, and participation in a dispute resolution scheme approved by ASIC. Recommendations by brokers would also have to meet quality standards, with brokers obliged to provide customers with a written explanation of their recommendations.

A draft bill based on the MCCA proposal is currently being prepared by NSW, with a view to this draft being used as a template for the other states. Given the delays in the process, however, a couple of states have proposed interim codes of conduct for finance brokers until the uniform legislation is implemented. The delays have also prompted the House Standing Committee on Economics, Finance and Public Administration to recommend that mortgage brokers be regulated under Commonwealth legislation. Either approach would result in a standardised framework for dealing with licensing, conduct and disclosure. The Reserve Bank supports calls for such a framework to be established as quickly as possible.

Credit Reporting

After extensive consultation, the Australian Law Reform Commission (ALRC) released a discussion paper in mid September reviewing the application of the Privacy Act 1988 to credit reporting. Credit reporting is the practice of providing information about an individual's credit worthiness to banks, finance companies and other credit providers through credit reporting agencies. The Privacy Act, among other things, limits the information that these agencies are permitted to keep and regulates the storing and provision of credit information. In Australia, there are three main credit reporting agencies – Veda Advantage (formerly Baycorp Advantage), Dun and Bradstreet, and the Tasmanian Collection Service. These agencies are privately owned, in contrast to some other countries where the agencies are publicly run.

Under the current model, an individual's credit file contains name, address, employer details and a record of credit applications made by the person in the past five years. It also includes information about defaults (payments overdue by 60 days or more) during the past five years, irrespective of whether the debt is subsequently repaid. Dishonoured cheques with a value of more than $100 are also recorded, as are bankruptcy orders and relevant court judgements.

The more comprehensive model proposed by the ALRC would include the information currently collected, plus selected details of loan accounts, such as when an account was opened and what credit limit was approved. In addition, the ALRC is proposing that individuals can report to a credit reporting agency that they have been the victim of identity theft, so that this information is available to any potential credit provider. The Commission did not support calls from some credit reporting agencies and credit providers for additional information, including payment histories and current balances, to be recorded.

The ALRC's proposals seek to balance the benefits of having a broader range of credit information available to lenders, against the potential cost to individual privacy, concerns about the accuracy of information, and the potential for the information to be misused. While, in principle, more information should improve the ability of a lender to assess whether a borrower will be able to repay the credit, the Commission was concerned about the accuracy of the data collected by credit reporting agencies, and how disputes over the information might be addressed. The ALRC's proposal includes a requirement that any credit provider who gives information about credit defaults to a credit reporting agency must belong to an approved external dispute resolution scheme.

The ALRC is seeking submissions on these proposals by 7 December 2007. The final report and recommendations are scheduled to be given to the Attorney-General by March 2008. The ALRC has suggested that after five years of operation, this approach to credit reporting should be reviewed.