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Melbourne APEC Finance Quarterly Issue 8, April 2010
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Welcome to the newsletter of the Melbourne APEC Finance Centre. In our 8th edition Professor Kevin Davis of the Melbourne Centre for Financial Studies examines differing points of view in relation to the Basel Committee's recommendations regarding proposed changes to bank liquidity requirements; Austrade has provided us with an overview of the salient features of Islamic Banking, drawn from their excellent publication Islamic Finance; former head of HSBC's Global Custody business Terry McCaughey argues why your banker should also be your custodian, and APEC Study Centre Director Ken Waller talks about why tax changes are not a panacea for the type of excessive risk taking we have seen from financial institutions. BANK LIQUIDITY AND FUNDING: REFORM AND REGULATIONKevin Davis is a Professor of Finance at The University of Melbourne and Research Director at the Melbourne Centre for Financial Studies
Concerns have been expressed about new liquidity requirements contemplated for Banks Australian banks have expressed disquiet about new liquidity requirements proposed by the Australian Prudential Regulation Authority (APRA) and by the Basel Committee. APRA had released a consultation paper about its proposals in September 2009 with an expected implementation date of around mid 2010, but announced in December that the implementation date would now be mid 2011 to better match that contained in the Basel Committee’s new proposal. The proposals involve two key requirements. The first is that, essentially, banks will have to hold more liquid assets such as Government debt. APRA proposed a more restricted definition of liquid assets to those which can be used in normal repo transactions with the Reserve Bank of Australia (such as Government Debt) and increasing the length of the time period used in assessing whether a bank can cope with adverse circumstances leading to deposit outflows. In the Basel consultation document this is referred to as a liquidity coverage (LC) ratio. The second requirement proposed by the Basel Committee involves a net stable funding (NSF) ratio. The standard will require banks to have some minimum proportion of long term stable funding over a one year horizon, based on an assessment of the liquidity of assets and contingent liabilities. The proposed requirements stem from issues which arose during the “GFC” These proposals address the failings in bank liquidity management which became apparent in the Global Financial Crisis. Modern bank liquidity management had moved away from holdings of central bank deposits (cash) and government securities. Instead, banks (both commercial and investment) held marketable private sector securities which they assumed could be sold into deep and liquid markets to raise cash if needed. They also relied extensively on short-term capital markets funding (liability management) to be able to raise new funds to meet outflows of deposits or other funds. These practices were particularly apparent for the off-balance-sheet activities of banks involving Structured Investment Vehicles (SIVs) and conduits, and in Investment Bank funding. The SIVs held medium-long term assets such as Collateralised Debt Obligations (CDOs) and other asset backed paper which was funded by rolling over short-term commercial paper. In the crisis, the markets for the assets froze (preventing their sale) and funding from commercial paper markets dried up. The bank sponsors of these vehicles were thus required to provide liquidity, stressing their own balance sheets. The investment banks took these practices to the limit, relying on short term funding through activities such as repurchase agreements (repos). Securities would be bought and financed by a repo involving sale and agreed future repurchase of those securities to a third party – effectively a short term loan secured by the securities involved. In the crisis, the repo counterparties (lenders) were unwilling to continue to extend credit, and made margin calls, forcing the investment banks to try and sell securities into a falling market. The new measures are designed to reduce both funding and asset price risks These above examples illustrate the dual liquidity problems facing banks of “funding” risk and “asset price” risk – risks which are highly intertwined. By requiring banks to meet an NSF ratio requirement, the Basel proposals are designed to limit the funding risk element. The LC ratio requirement should mean that asset price risk is reduced because the markets for the high quality government securities which banks will hold are less subject to the disruption experienced by the markets for private sector securities. Do Australian Banks have a valid argument to be excluded? The disquiet expressed by the Australian banks in response to such proposals is based on a number of factors. First, it is argued that the Australian banking sector did not experience the same liquidity crisis experienced elsewhere. And while that is true, it is also true that inter-bank liquidity tightened significantly, with all banks increasing their holdings of Exchange Settlement Accounts at the Reserve Bank very significantly. And while banks continued to lend to each other overnight at the target cash rate set by the RBA, spreads for longer term loans increased significantly. And finally, the RBA acted pro-actively and speedily to widen the range of private sector securities which it would accept in its repo transactions – thus increasing the secondary market liquidity of such assets and providing a liquidity safety valve. One consequence of that change was to encourage the major Australian banks to convert on-balance sheet loans into mortgage backed securities which were held on-balance sheet to make them eligible for use in repo transactions with the RBA. A second response has been to claim that a requirement that forces banks to hold a larger proportion of their assets in government securities will increase the cost of banking – because the returns on such assets are lower than those available on private sector lending. Banks would thus need to charge higher loan interest rates to customers to restore profitability. This argument is based on a blinkered perspective which assumes that the scale of bank balance sheets does not change when the requirement is introduced. It is a myopic view which ignores the system wide effects. To illustrate, consider the case where a bank buys government securities from a superannuation fund to bolster its liquidity holdings. Because bank deposits are the means of payment for society, the net outcome is that banks, in aggregate, have an increase in deposit liabilities (to the superannuation fund seller of securities) and an increase in government security asset holdings. Only if the cost of those additional deposit liabilities exceed the return on government securities does this involve a net cost to the banks. A third response has been that there are not enough government securities available to meet the liquidity requirements which the banks would face. There is some merit in that claim, with the Australian government bond market being very small due to years of government budget surpluses prior to the GFC. And even though the Federal Government budget has moved into deficit (due to the GFC effects on the real economy and the fiscal stimulus applied by the Government), there does not appear to be significant expansion of the available stock of government debt in prospect. Government guaranteed securities should be deemed as acceptable liquid asset holdings But there are many other possible securities available – although the LC requirement might need adapting to include them. Australian banks, for example, have issued very substantial amounts of bonds into domestic and international markets using the government guarantee facility. Such bonds, being government guaranteed, should be acceptable as liquid asset holdings (whereby one bank holds as an asset the government guaranteed bonds issued by another bank). Over, at least, the next few years this provides an additional source of liquid asset holdings. Longer term, the Kangaroo Bond market provides another possible source of high quality liquid assets, with overseas governments and multinational agencies issuing AUD bonds in Australia. NSF requirements may prompt a different banking intermediation model The other area where the liquidity requirements will have significant impact for Australian banks is in the NSF requirement. Australian banks rely extensively on offshore capital markets funding - although much of this is for longer term funds. Given the disruptions in international capital markets experienced in the GFC, there are concerns about the financial stability implications of this, and the banks themselves have attempted to reorient their funding more to domestic retail deposit markets. But the scope for much success there is limited. What may happen (and the future is always hazardous to predict) is that the Australian banks might move someway towards a different intermediation model. Currently, the major banks effectively fund Australia’s large and longstanding balance of payments current account deficit by borrowing offshore – and then lending on-balance sheet to Australian companies. Very few of those companies issue debt themselves in the international market – and much less so than in comparable countries internationally. For the large banks with significant securities origination, distribution and underwriting capacity, the option of generating fee income by taking Australian companies to the international debt markets to issue their own paper (rather than the current practice of the banks borrowing to on-lend) is one way of changing their funding mix. And if the credit rating or investor recognition of the Australian companies is inadequate, bank guarantees could be provided (for a fee) to make the securities more attractive to international investors. In conclusion, old liquidity concepts require re-examination. There are other risks in such a scenario – but the GFC has provided such a shock to the global financial system that the financing mechanisms of the recent decades warrant re-examination and new scenarios careful consideration.ISLAMIC FINANCE – AN OVERVIEWWith thanks to: Luhua Tang, Senior Industry Advisor, Austrade, Sydney
Global development of Islamic Finance Islamic finance is one of the fastest growing segments of the global financial services industry. Shariah-compliant financial assets have been growing at over 10 per cent per annum over the past 10 years. Measured by Shariah-compliant assets of financial institutions, the global Islamic finance industry is estimated at US$822 billion in 2009. Growth is being driven by the following factors:
Currently, the Middle East and South East Asia are the primary locations for Islamic capital. In particular, the United Arab Emirates, Bahrain and Malaysia are seen as the main centres of Islamic finance, with significant activity also taking place in the United Kingdom and more recently in Europe, Africa and Indonesia.
The demand for Islamic finance has not been matched by supply despite the rapid growth in the sector in recent years. An increase in supply is necessary to meet current and expected demand. What is Islamic Finance? Islamic finance is finance activity that is consistent with the principles of Islamic law or the Shariah. Islamic law is sourced from the text of the Quran, and the sayings and acts (the Sunnah) of the Prophet Mohammed. The Shariah provides guidance or principal rules that include coverage of a Muslim’s economic activity, such as property dealing and wealth creation. The Shariah explains in detail ethical concepts in use of money and capital, the relationship between risk and profit, and the social responsibilities of financial institutions. There are some key principles underlying the provision of Islamic finance, One key principle is the prohibition of interest (riba). In Islamic finance, rather than interest, a yield from the deployment of money or capital generally arises in the form of profit and loss sharing from an investment activity or a profit or fee from sale of asset or lease of asset. Other principles include the prohibition of uncertainty in contractual terms and conditions, prohibition of investment in or financing of banned products and services such as alcohol, gambling, pork and pornography, and a requirement that all financial transactions are underpinned by an identifiable tangible asset. Key Principles Underlying Islamic Finance
An Islamic bank wishing to conduct financial activity in compliance with the Shariah will look to a Shariah scholar for guidance. Shariah scholars may belong to a particular Islamic school of thought, and they may interpret Islamic law in varying ways, reflecting different Shariah regulatory frameworks. There are notable differences of such nature between the Gulf and South East Asia. For example, Shariah interpretation in Malaysia based on the Shafi’i school of law may allow a two-party sale and buy-back transaction for cash financing. However, scholars in other regions do not allow this practice. Financial institutions involved in Islamic finance will normally establish a Shariah supervisory board or committee (Shariah board or committee) which will determine if the institution’s financial products are Shariah-compliant. The board will oversee the institution’s financial product and service structures and will issue a fatwa or formal pronouncement on Shariah-compliance when the product or service is taken to market. In some countries with significant Muslim populations, Shariah-compliance is required by legislation (such as Sudan and Iran) while in others national legislation is silent on the matter (such as the UK and Singapore). While designed to meet the specific religious requirements of Muslim customers, Islamic banking and finance is not restricted to Muslims. Islamic financial transactions can be undertaken between Muslims and non-Muslims. An Islamic finance product can be attractive to non-Muslim investors for its commercial features as well as its underlying ethical and socially responsible character. Types of Islamic Financial Products and Services Islamic finance covers a range of financial services and markets similar to conventional finance, such as banking, capital markets, insurance, asset management and advisory services. Key Islamic financial products and services are as follows:
To illustrate some of the differences between Islamic banks and conventional banks, below is an outline of the treatment of common banking products – the residential mortgage and deposits – under Islamic law:
Types of Islamic Finance Delivery Models The main types of organisational structures or delivery models for the provision of Islamic finance products, in order of decreasing preference from a Shariah perspective, are:
This article comprises sections from a booklet titled “Islamic Finance” published by Austrade. The complete publication, which also includes details of reference sources and acknowledgements, is available from Austrade’s website at: http://www.austrade.gov.au/Landmark-Islamic-finance-publication-Ministerial/default.aspx WHY YOUR CUSTODIAN SHOULD PROBABLY BE YOUR BANKER Terry McCaughey is an Independent Non-Executive Director of the UK stockbroking firm Hargreave Hale Limited, and former head of HSBC's Global Custody business in London. He now lives in Australia.
Custody – an unglamorous business? The chair of a conference recently introduced a panel discussion on custody as the least glamorous side of the securities business. And as the moderator of that session I was reminded to think of those investors in Bernard Madoff’s ponzi scheme who lost a lot of their hard-earned savings and how they would have ranked glamour in their selection assessment to place their funds with him: and if I was to ask you who Bernie’s custodian was you probably wouldn’t care but I am sure you will be surprised to learn it was Bernie himself. Not surprising then that this farce went on for so long undetected and to the detriment of so many. What I would like to do in this brief article on one of the many aspects of the custody business is attempt to answer two very pertinent questions:
A strong organisation is needed to handle cash payments and securities movements An intrinsic part of the securities settlement process is the relationship between the security and the cash with which it is purchased and sold. These two activities customarily run on separate systems. Cash is processed through a bank’s payment system, whereas the security is processed on what is generally referred to as the SMAC system (securities movement and control system). The interaction of these two activities is monitored by your custodian whenever cash and securities are involved – sales, purchases and corporate actions such as dividends, right issues, interest collection, etc. These activities are therefore subject to the governance of the country’s clearing system and its relevant regulators and overseers. That alone should provide a high level of comfort. The next issue is the timely exchange of the security for the cash proceeds – commonly known as DVP or delivery versus payment. As this process is not entirely riskless it is probably better to have it occurring within the established infrastructure that the banking system has embedded itself in. In my experience I recall two major failures where the timely settlement of transactions still proceeded despite the demise of the counterparty, namely Barings in 1995 and Lehman Brothers in 2008. In the former, my organisation held several millions pounds of Barings’ bonds as collateral for a gilt loan. The bonds were substituted on request and no fallout occurred. In the other case Lehman’s was counterparty in a routine share purchase. As they were unable to deliver the stock the Exchange used the ‘hammer’ price - that is a long established market mechanism for determining one price for both sales and purchases in the event of non-delivery of the stock. Obviously the hammer price is unlikely to be the one to which you contracted, but it is within the daily trading range and subject to what is referred as market risk. In this case the purchaser of the stock was required to pay an extra £20,000. Not satisfactory but in the context of a £2,000,000 transaction an acceptable outcome given the alternative of a complete failure. The point is that in times of extreme market upheaval, it is probably best to be with a strong organisation in a well regulated infrastructure – and as the last three years have proven, your bank is the least likely to fail in such times because of the fear of systemic risk. The following “leagues table” evidences the major global players in the market.
Banks in bold offer a custody service in Australia (BNY Mellon with NAB) The custody business provides meaningful liquidity to a bank? To my second point – why would a bank want to undertake these activities? To answer this I want to refer to two very specific aspects of banking. The first is liquidity and the second is quality of earnings. We have just been through the most traumatic time certainly in my banking career of over 40 years. Sitting in a board meeting in London discussing how you might need to explain to your stock broking clients where their deposits have gone when another major city bank collapses that day is a pretty daunting experience. In the final outcome it didn’t happen and we survived but it was a very sobering experience. But why was the global banking system in such a state? It is often said that banks don’t collapse because of insolvency; it is rather a lack of liquidity. Although ultimately it may be proven that the bank was insolvent the market was unlikely to know that at the time. The main reason for the banking crisis of 2008 was that a collapse in confidence led to a withdrawal of limits and placings in the interbank market. And as banks generally tend to rely on short term funding requirements by lending to one another daily they do so through the interbank market. When this market ceased to provide the safety valve, a number of banks quickly became insolvent as they couldn’t realise their assets quickly enough to meet their liabilities. The custody business generally resides within a range of products often referred to within commercial banks as Transaction Banking. These products comprise payments processing, trade services and securities processing. Major players in the securities business hold large amounts of ‘float’. This comprises the value of transactions for which orders are being processed ahead of the despatch of the cash for settlement and second the amount of short term cash investors have in liquid form awaiting investment opportunities. These amounts can be substantial. My own bank in London often held in excess of £10 billion in ‘float’. It was the largest UK based custody bank and I would argue that few of these large banks, who were active in the securities market, suffered the same liquidity problems I referred to earlier. Custody income produces quality earnings My final point is quality of earnings. During the 1980/90’s a number of organisations including banks started using a method of accounting for internal purposes called MVA/EVA (Market Value Added/Economic Value Added). By making adjustments to GAAP accounting, banks are able to measure the economic benefit of various products - in this calculation the securities processing business features well. The calculations focus on three main areas:
In short – a good annuity income On all counts the securities business performs well. The business needs very little capital; risks have been documented over many years and it is generally an annuity income generating business providing a steady stream of regular and consistent revenue - just what the analysts love. But, of course, it doesn’t prevent banks from wandering into areas of risk, to wit, a major Australian Bank’s experience with Opus Prime, which probably led to its subsequent withdrawal from the business. But that is a matter of strategy and not directly related to the business itself. TAX PROPOSALS NOT THE SOLUTION FOR APEC IN RESTRAINING EXCESSIVE RISK TAKING IN FINANCIAL INSTITUTIONS Ken Waller is the Director of the Australian APEC Study Centre at RMIT.
The aftermath of the global financial crisis has prompted a plethora of proposals aimed at reducing risks in banking and in taming the excesses that some major internationally operating banks indulged in and which contributed to the crisis. Those excesses exacted a toll on taxpayers as governments, particularly in Europe and the US, used fiscal resources to bail out their banking systems. In attempts to placate taxpayers, affected governments are seeking to recover the costs they incurred in bail-outs and to take preventative measures to curtail future excesses and risk taking. Some measures which focus on greater disclosure of an institution’s risk exposure and appetite are likely to contribute to enhanced financial stability; other proposals of a taxation nature may do little to curb risk, may weaken prudent management in banking systems and add to the costs of banking. In this latter category could be included the suggestion raised last November by the UK to introduce a Tobin tax on financial transactions (first proposed by economist James Tobin in the 70’s to support aid to developing countries), and most recently by French and German authorities to implement a levy on banks’ balance sheets. A transactions tax would not only be difficult to implement – the Managing Director of the IMF has noted it could be avoided utilizing derivative products – but, in addition, it would do little if anything to rein in excessive risk taking. If implemented it could raise the cost of finance at a time when global investment and trade flows are seriously depleted as a consequence of the global financial crisis. Similarly, it is unclear what a levy raised on the level of a bank’s assets would do to limit excessive risk taking that could not be achieved by orthodox capital charges, assessed on the risk that particular asset classes carry, and which are already inherent in the Basel ll framework applying to internationally operating banks. Recommendations arising from G20 and the Financial Stability Board on the way in which governments and banking supervisors will reform banking supervision in the aftermath of the crisis will be of great relevance to APEC economies. Invariably recommendations will involve higher regulatory costs. For this reason, APEC economies will need to assess the value of specific prudential recommendations of standard setting bodies and determine the costs and benefits in adopting them. As well, APEC economies can be expected to exercise great care in responding to proposals from the European Union for an international agreement on bank taxation whose purpose would be rein in excessive risk taking by banks. It is worthwhile noting that the two North American APEC members, the US and Canada, have intimated that they will not implement transaction taxes on banks. It is reported that the US is considering a levy on banks’ balance sheets but focused on recovering bail out costs. The key policy issue in the current debate on new imposts on banks is the one of determining precisely what is the intended outcome of any specific tax or levy on the finance sector. A tax on the assets of banks would seem to have more to do with raising general revenue than of curbing excessive risk taking. The EU argues that a tax on bank assets should be internationally agreed but utilized for national purposes. International agreement would ameliorate EU concerns that any tax it raised on its banks would not disadvantage those banks in an internationally competitive market place. There is some support in the EU for the view that any tax should be based on the systemic risk that a bank poses for an economy. However, such an approach would involve real issues of judgment as to what constitutes a systemic risk in a particular institution. Determining the extent of systemic risk posed by an institution on an economy and therefore the level of impost it should bear to offset the risk would be particularly complex. Attempts to reach international agreement on these matters could be expected to further complicate the application of any such tax. (A more clearly defined approach to constrain undue risk taking and one already available to national financial supervisors is to raise capital charges or provisions against higher risk assets of bank and non-bank financial institutions). A tax which is intended to recoup the costs of bailout support provided to specific institutions could be expected to have strong political appeal. Arriving at such a policy after the event of a bail-out implies a judgment that the bail-out of a specific institution or institution at the time of the crisis was necessary to maintain systemic stability. In this circumstance, the tax could be seen as a direct policy action to recoup the burden carried in the crisis by tax payers. As this was apparently the case in the US and the UK then full cost recovery for the taxpayer would likely have wide community support. A question arises as to whether such a tax should be considered as being one-off in nature and to be eliminated once tax payer costs have been recouped. The down-side to this approach is the moral hazard that is implied by governments providing bail-out support in the event of the collapse of an institution or institutions. Arguably, this is not an approach that contributes to probity in banking behavior over the long-term. APEC policy makers and supervisors will need to consider whether they would see any reason to implement the kinds of taxes now being proposed to guard against future systemic failure. Proponents of a transactions tax have placed it in the context of a tax to support international development or to finance to developing economies to offset climate change. On a somewhat more philosophic level, the European Union has emphasized that measures to avoid excessive risk, take account of the importance of renewing the economic and social contract between financial institutions and the society they service and of ensuring that the public benefits in good times and is protected from risk. Regrettably, some of the taxation measures under discussion in the EC may do little to renew confidence in financial systems or to protect society from risk. They will almost certainly raise the costs of doing business. Risk taking is what banking and financial systems are about. Ultimately, responsibility for managing risk in a prudentially sound manner resides with the boards and managers of risk taking institutions. Well constructed incentives to perform this function effectively and reliably is a critical matter for the institutions themselves and for financial system supervisors and governments. Incentives should take into account acceptable levels of risk and the management of risk, sound governance practices and clear rewards for prudence and probity and, penalties when standards are not met. Reforms proposed by international standard setting bodies which have these objectives as their goal will serve APEC and the global community well. APEC policy makers and financial system supervisors would be wise not to let the taxation proposals from Europe get in the way of good banking and financial principles when they consider the region’s responses to reforms following the global financial crisis.
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