Melbourne APEC Finance Quarterly

Issue 2, February 2008

Welcome to the newsletter of the Melbourne APEC Finance Centre.

MAFC at Monash University is a facility sponsored by the Victorian Government. Its mission is to promote Victoria's knowledge and expertise in financial services in the Asia-Pacific region through the provision of training, symposia and research.

In this second edition, we provide you with more executive level insights from leading industry participants. PricewaterhouseCoopers provide a status report on yet another major compliance challenge facing industries in Australia and globally – addressing Anti-Money Laundering legislation. The Melbourne Center for Financial Studies pose more thoughts about the continuing saga of the Sub Prime crisis, and the challenges this is presenting to international regulators. We also have an article from the Federal Government’s Department of Education, Employment and Workplace Relations highlighting the significant capacity Australia has now developed as a global center of excellence in providing tertiary and vocational education to overseas students. This national willingness to lend expertise to the world is also mirrored in capacity building programs provided by industry bodies and institutions such as our own – our Director Ken Waller comments in this edition about a symposium MAFC is organizing next month in Melbourne.

AML/CTF - THE STATE OF PLAY IN AUSTRALIA

Steve Ingram is Partner, Forensic Services at PricewaterhouseCoopers

Initially it may have taken some time to get off the ground, but the Anti-Money Laundering and Counter-Terrorism Financing (AML/CTF) Act is now a prominent business compliance issue for Australian organisations. Two key learnings for organisations whatever jurisdiction they operate in are:

1. A risk based approach is a double edged sword; and

2. Don’t sit on your hands, there is more to be done than most people think.

The Australian AML/CTF Act explained

The overarching aim of the Act is to identify, manage and mitigate the risk of money laundering and terrorism financing through Australia’s financial systems. It requires organisations to put risk based systems and controls in place, as well as systems to identify and verify their customers and staff. The Act targets services not businesses. Therefore, a wide range of organisations that provide one or more of the Acts 73 “designated services” are captured under the Act. Such organisations (known as “reporting entities”) must have established an AML/CTF program by 12 December 2007. Key elements of the Act, such as know your customer (KYC), transaction monitoring and correspondent banking relationships have been phased in over 24 months. Each phase has a conditional prosecution free period of 15 months; however the Regulator, the Australian Transaction Reports and Analysis Centre (AUSTRAC) may impose penalties and enforceable undertakings for non-compliance during this period where the designated service provider does not make a genuine effort to meet the requirements of Act.  

The Act has an additional “tranche” of legislation that will expand the definition of designated services to cover organisations such as real estate agents and professional services firms. As yet there is no confirmation as to when this might occur.  

Don’t sit on your hands

There is a temptation to treat AML/CTF as ‘just another compliance piece’. This is particularly dangerous in jurisdictions suffering “compliance fatigue” from other regulatory initiatives such as Sarbanes Oxley and Basel. The difference with AML/CTF is that it touches every product, every service and every employee of the reporting entity. It affects both front and back offices, and there is typically more work than you think to achieve timely compliance. Effective change management and senior management buy-in are essential. The governance role of the Board means that early engagement is critical – especially with budget issues. When we asked representatives from across the financial services industry whether they thought their workload was increasing as they learnt more about what was required to sufficiently maintain AML/CTF compliance, there was overwhelming agreement – particularly in the larger banks (see diagram below).

IS YOUR WORKLOAD INCREASING AS YOUR ORGANISATION'S UNDERSTANDING INCREASES?

A risk based approach is a double edged sword

A risk based approach means that an organisation can tailor its AML/CTF program according to their own specific circumstances. It has the benefits of flexibility and customisation and is non prescriptive. However it also requires an entity to understand and anticipate the risks of products, services, customer channels and jurisdictions. This involves more work than you would think. The downside of this has been a lack of clarity around the interpretation of key requirements and uncertainty in how AUSTRAC will approach their regulatory examinations. This issue was identified as most important to major Australian banks in our recent AML Workshops (see diagram below).

KEY ISSUES - DECEMBER 2007

Conclusion

In Australia, as in most jurisdictions there will be unintended consequences of any new legislation. We are working through a period of adjustment and refinement while those effects are identified and ironed out. This month will bring more draft rules to accompany the Act and assist in applying its requirements. Importantly, AUSTRAC continues to encourage industry consultation, helping the industry and the Regulator.

Approaching AML/CTF on a risk based, phased approach has given industry what they asked for, but it has also lead to some ambiguity and confusion. With the cost and effort that is required to meet regulations, we are also experiencing an uneven playing field. Some organisations express their intent to rely fully on non-prosecution periods while others strive for early compliance.

The key lessons to be learnt from the Australian experience are that preparation and clarity is the key to effective implementation of AML/CTF laws. Keep tools and processes simple and fit for the purpose of your business. Ensure key roles and responsibilities are allocated to staff with appropriate seniority and be ready for business unit resistance. And remember:

1. A risk based approach can be a double edged sword; and

2. Don’t sit on your hands, there is more to be done than first thought.

THE SUB-PRIME SAGA CONTINUES - WHAT FUTURE FOR FINANCIAL REGULATION?

Professor Kevin Davis is Director of the Melbourne Centre for Financial Studies

The global financial crisis has sparked calls for a reassessment of financial regulation, including the need for improved global coordination, given the international linkages and spillovers from the US sub-prime crisis demonstrated in recent months.

Notably, this is occurring at the very time new internationally agreed banking regulations (the Basel II Capital Accord) are being introduced by national regulators. While the events prompting recent financial mayhem occurred under Basel I, and partly reflect its weaknesses, an obvious question is whether the new Accord will inhibit future recurrences.

Can Basel II save the system?

Probably not – although some of the grosser transgressions of prudent banking practice involving some off-balance sheet activities might be prevented. For example, under Basel I banks avoided capital charges for 364 day back-up liquidity facilities to conduits and SIVs (Structured Investment Vehicles, which accessed short term commercial paper markets to fund longer term assets). Similarly, Basel 1 capital requirements provided incentives for banks to retain riskier tranches of securitizations on balance sheet, which the new Accord seeks to rectify through improved risk assessment.

But realistically, it would be unrealistic to place too much hope in the new Accord to resolve underlying problems in the financial system identified by recent events. There are two main reasons. One is weaknesses in the new Accord itself. The other is that many of the current problems emanate from outside the banking systems covered by the Accord.

On the latter score, the sub-prime crisis and its international ramifications stem as much from the role of non-bank mortgage originators and investment banks who sliced, diced, repackaged and sold credit exposures into world financial markets. Agency problems resulting from misaligned incentives are generally most severe when there are major information deficiencies, such as created by complex financial engineering. Not only have mortgage originators, not ultimately exposed to the credit risk created, had no incentive to act prudently, the sellers and distributors of securities have been able (sometimes perhaps unknowingly) to pass on excessive risks to under-informed investors.

Exposing the real risks

It is clear that a major challenge facing financial regulators in the modern world of complex financial instruments is ensuring adequate disclosure of risk (and perhaps its fair pricing!) – which even many creators of such instruments did not apparently understand. Market discipline (the third pillar of the new Accord) based on disclosure and financially literate investors is clearly a fragile pillar. It is also one which government bail-outs of financial markets (regardless of their short-term necessity) tend to undermine.

Also important is improved internal discipline in banks and other financiers. Willingness to provide finance to complex corporate business structures which lack of clarity regarding risks involved, (rather than eschew such possibilities and lose market share) has re-emerged, as memories of past experience and merits of not being a large player in some markets have faded.

Turning specifically to Basel II, international coordination is already a past dream, with the US retaining Basel I (and all its failings) for all but the very largest banks. But given the weaknesses exposed in the financial infrastructure which underpins Basel II, that may not be such a major issue after all.

Ratings agency and credit insurer roles

For, two important actors under the Basel II standardized approach (designed to apply to all but the largest international banks) are the ratings agencies and the credit insurers. Capital requirements on corporate loans would be linked to ratings given by approved ratings agencies, while credit enhancement of securities by highly rated insurers would also reduce capital requirements. Recent developments (of late ratings downgrades and questionable capital strength of credit insurers) have exposed significant fragility and potential conflicts in these areas warranting review.

But a major concern for prudential regulators emerging from the recent experiences is the degree of trust which can be placed in the internal risk management systems and practices of banks. Under Basel II, capital requirements for credit, market, and operational risk for approved large “sophisticated” banks are based on outputs from these internal models.

A flawed perspective

Market risk models have been long used with reasonable success, but are most fragile in crises when liquidity dries up and correlations converge towards one. Credit risk modeling is a constantly evolving art and sadly lacking in reliable historical data. The recent failures of models to get within “coo-ee” (an Australian expression for far away) of correct risk assessment of many complex products in which large banks are dealing, must give some cause for concern – and it would be interesting to see “back-testing” results released for public scrutiny.

And as for relying on internal models and practices for capital requirements for operational risk, which includes rogue trading, nous osons maintenant?

AUSTRALIAN EDUCATION: QUALITY GUARANTEE

Fiona Buffinton is Chief Executive Officer of Australian Education International

Australia is a leading English-speaking education destination, offering world-class programs from institutions with international reputations. In 2007, more than 350,000 enrolments were recorded from the Asian region. Students benefited from quality courses taught by experienced teachers, and enjoyed a lifestyle and culture that encourages personal growth, freedom and opportunity in a safe and clean environment.

Education services are a significant contributor to the Australian economy

The international education industry is Australia’s largest services export sector, contributing $11.7 billion to the Australian economy in 2006–07. Australia is the preferred choice for international students from many countries and is the third most popular English-speaking study destination.

In 2007, about 455,000 enrolments were recorded by students from more than 190 countries studying at educational institutions in Australia, including 5,000 funded under Australian Government scholarships. Another 100,000 were studying Australian courses at off-shore campuses or by correspondence.

Australia offers international students some 26,000 courses delivered by more than 1,200 universities, training colleges and schools. The three biggest sectors in terms of enrolments were higher education (around 178,000), vocational education and training (121,000) and English-language intensive courses (102,000).

Asia remains Australia’s main source of international students, with more than 75 per cent, but enrolments from the Middle East, South America and Africa have grown strongly. International students are attracted by the high standard of Australia’s education and training, its national qualifications framework, welcoming environment and diverse society.

The numbers

In 2007, according to Australian Education International, the greatest number of international student enrolments in Australia came from the following countries: China (107,071); India (63,604); Republic of Korea (34,674); Thailand (19,987); Malaysia (19,874); Hong Kong (19,742); Japan (16,077); Indonesia (14,919); Brazil (12,545) and the United States (11,822).

Australia has provided scholarships since the late 1940s

Australia has provided scholarships to enable students in the Asia–Pacific region to study in Australia since the late 1940s. Australian Scholarships brings together under one umbrella the Endeavour Awards, managed by the Department of Education, Employment and Workplace Relations and the Australian Development Scholarships and Australian Leadership Awards, managed by Australia’s international aid agency, AusAID. Through the Endeavour Awards, opportunities are also available to Australians to undertake research, study and professional development abroad.

Australia’s English-language schools provide a wide variety of training programs. These range from short courses to improve students’ English-language skills while visiting Australia as part of a holiday, to formal courses in preparation for accredited levels of English recognised by education and immigration authorities around the world.

English-language training in Australia is provided by specialised institutions. A national accreditation body (the National ELICOS Accreditation Scheme) sets standards for class sizes, teacher qualifications, teaching methods and curriculum.

In pursuit of quality

The quality of Australia’s education offering is assured through the development of robust and comprehensive national quality assurance frameworks covering qualifications, courses, governance, protection, teachers and institutions. The foundation is the Australian Qualifications Framework (AQF), which links Australian school, vocational and higher education qualifications into a simple structure of 15 education awards.

The AQF encourages choice, flexible delivery and lifelong learning. It simplifies international comparison and recognition and makes a major contribution to the high level of quality assurance Australia provides students. It is the world’s first of its type and is the subject of strong international attention. Over 20 Asian and European countries have requested briefings on the framework in the last few years.

Vocational education and training

The Australian vocational education and training (VET) system provides opportunities for a broad range of learning which is designed to meet the contemporary needs of industry. Training outcomes are developed by industry in consultation with government, creating job-ready graduates with the skills and knowledge to excel in their careers.

Students’ confidence in the quality of VET products is guaranteed by regulatory frameworks which incorporate the requirements of the AQF. Specifically, the National Training Framework provides national standards for registering and auditing of training providers and accrediting courses, and provides national standards for service delivery. These standards are applied by State and Territory governments to ensure that all institutions within this sector and the qualifications they issue are nationally consistent and recognised throughout Australia.

Australia's teachers

The quality of education delivery by Australian teachers is a key component of the quality assurance system. Students at Australian institutions are taught by highly qualified professionals.

Australian school teachers undergo a minimum of four years’ university training which includes compulsory classroom training. They also regularly participate in professional learning to further enhance their skills. English language teachers undergo a similar level of training and must have a degree and an approved English language teaching qualification.

Teachers of VET must have a government-approved certificate in assessment and training and relevant trade or industry qualifications. It is common for VET teachers to exceed these requirements. Australian university teachers have postgraduate qualifications or a higher degree and more than half have a doctorate.

International collaboration and excellence

The infrastructure in Australian education and training institutions is sophisticated and modern. Australia has a reputation for adopting new technologies more rapidly than many other countries. Research facilities in universities are cutting edge, with many research teams at the forefront of their specialisations. Many students have used universities’ sophisticated laboratories, computer centres and libraries to make major advances in business, industry and medical science that have had a profound impact on the lives of people around the world.

REPORT ON PENSIONS PLANS IN ASIA-PACIFIC ECONOMIES EXPOSES CHALLENGES AND OPPORTUNITIES

Ken Waller is Director of MAFC at Monash University

One of the key work components of the Melbourne APEC Finance Centre is to undertake research in emerging regulatory regimes for the supervision of superannuation and pension systems. Towards this the Centre commissioned Mercer to author a report ‘Private Retirement Plans in Selected APEC Economies’.

Seven economies, including Australia (which has total consolidated assets in the superannuation sector in excess of AUD 1.3 trillion), were examined. Retirement income arrangements, regulation and disclosure requirements are compared in the report, focussing on compulsory or voluntary privately managed funded schemes.

Evolving systems generate new pressures

Certain themes were identified during the research including the decline in traditional family-based support systems for old age financial security, pension product differentiation, more women entering the workforce, low levels of membership and ageing populations. Coupled with small but developing equities markets, and the fact that many governments prescribe investments of retirement plans and constrain investments in international markets, increasing pressure is being brought to bear on government agencies to reform their pension systems.

In considering regulatory matters, Mercer has applied the Draft OECD-IOPS Guidelines on the Licensing of Pension Entities - the first international standard - as a benchmark for assessing each country’s licensing requirements. Whilst many countries require a written governing document and a licence to establish a plan, the report notes that the absence of an accompanying business plan in many cases represents a major shortcoming in the regulation of providers of superannuation products. A matrix outlining respective country disclosure requirements is included in the report.

Some important questions ahead...

Future trends and gaps in capacity suggest that certain fundamental decisions need to be made in respect to developing private retirement plans. In many cases these are not being made and in order to encourage further development and expansion of private retirement plans, answers to matters relating to solvency, the tax treatment of contributions and changing retirement ages need to be taken.

These and other issues identified in this report underscore the dialogue being organised by MAFC this March in Melbourne. This event will bring together regulators, policy makers and academia from across Australia and the Asia-Pacific region to discuss and debate the road ahead for the development of private retirement plans and pensions regulation. For more information on the dialogue including the program and registration please click here.

The Melbourne APEC Finance Quarterly is edited & published by MAFC at Monash University.

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