KGB Interview: David Murray
Chair of the Financial System Inquiry and former Commonwealth Bank chief executive David Murray tells Business Spectator's Alan Kohler, Robert Gottliebsen and Stephen Bartholomeusz:
-- How the capital adequacy system has changed since the days when he managed the Commonwealth Bank
-- Why Australia needs to overlay new international standards with additional capital requirements
-- What the banks can do to raise substantial amounts of additional capital
-- Why he still has confidence in APRA but thinks they should focus more on competition
-- There should be a graduated approach to allowing new entrants to access the payment system.
Alan Kohler: Well David, the inquiry was kind of borne out of firstly the GFC and sort of a decision to review the financial system after that and then in 2010 it was kind of borne out of opposition to the banks. There was a lot of bank bashing going on at the time. So, when you started this process, in your mind did you have the sense that you were kind of responding to a sense in the community, that something needed to be done about the big banks?
David Murray: No. Not really. I was always a fan of these reviews being done periodically because the system just changes shape over time and we found going round the world that behind the scenes many people were very supportive of this sort of process and I was a big, big fan of the Campbell inquiry and the discipline that it went through in trying to unscramble the system that it had to.
AK: Right. And in fact the response to your report in the last sort of 24 hours has also focused on the big banks and the capital changes you've made, so in a way the announcement of it and the response to the report itself has been focusing on the role of the big banks, but do you think that that's inappropriate?
DM: No. Well, it's okay. But I think the big banks were surprised by what we said in the interim report about the possibility of having higher capital and they went into a very public process then of getting a report done by PwC and essentially starting a difference of opinion with us from that point on and in the event we found that we still didn't agree with the position that they put forward, relative to our view that they should be unquestionably strong and positioned at the 75th percentile on capital against the global peers with whom they compete for capital.
Robert Gottliebsen: David, when you were managing the Commonwealth Bank, do you think extra capital was required then and if you answer, no, it wasn't, what's changed since you were the CEO that [it] now requires more capital?
DM: Well, the capital adequacy system, Robert, was different. We ran our own economic equity allocation system internally, but the risk weighting system was tougher than it is today. You know, we had a 50 per cent to home loans, nothing for bonds, but that's changed an awful lot with the IRB model and in general in the lead up to the crisis, banks increased their leverage around the world and that turned out to be quite an issue, so a lot has changed and we believe that Australia's circumstances demand a particular position for Australia's banks.
Stephen Bartholomeusz: David, as you'd be aware, very well aware, there's been an enormous amount of international effort that's gone into re-regulating banks in particular post crisis and the Basel Committee promulgated a huge range of new capital standards and liquidity standards. Why do you need to put an overlay over that?
DM: We looked at some studies, Steve, that had been done in other countries to try and figure out how you work the capital position relevant to the country's circumstances and it's something we would dearly have loved to have done, but it takes a long, long time to get right and we felt that those countries that were smaller and more exposed in their economic structures generally decided they needed higher capital ratios than the minimum set by the Basel system and we were in fact in a very similar position to that.
SB: But the issue for us, I suppose, in 2008 wasn't one of capital; it was one of access to wholesale debt markets. How does what you've recommended address that issue?
DM: Well, at that time we had the banking system in good shape from a solvency point of view, but Australia did not witness a spiralling down of asset prices as a consequence of the liquidity shock that occurred from outside, so what we've looked at is, were the circumstances to be different here, could we withstand that and how would the capital position have to look for the taxpayers to be a little more comfortable than they might otherwise be?
AK: Yeah, but I mean an argument can be made that Australia's banks are in the twenty-fifth percentile, something like that, of riskiness in the world, yet you're saying they should be at the seventy-fifth percentile of capital?
DM: Well, they are in that position if you believe that there's no concentration risk in the housing market and if you believe that you can't have a materially different outcome in that market from what was seen historically and experience around the world says that that doesn't happen, so if we've erred, we've erred on the side of protecting the taxpayer more.
RG: If the banks have to put substantial amounts of additional capital in, many people think that the only way to have maintained profits is to charge more for loans and less to deposits. Can it be done by technology or do the banks simply have to take lesser return on equity?
DM: Oh well, I think the opportunities from the digital world are enormous and we're only part way through the development of changes there, so I think there's an awful lot more they will do with technology and they've shown themselves to be quite adept at continuous improvement in their systems, so they could adjust prices, they could adjust their efficiency or they could adjust their payout ratios or they could just continue to accumulate capital from their net internal capital generation over time and experience has been that the regulators don't impose these new requirements in a hurry, so it could pan out in any number of ways, but we think the cost of the insurance to the taxpayer is very modest relative to the longer term protection it builds.
RG: Do you think the banks are paying too high dividends?
DM: In historical terms, Bob, it is high, the dividends, and the payout ratio. The net ratio is about 55 per cent. When I first looked at these things, it was uncommon for banks to be around 35 or 40. Now, there are good reasons for that in Australia. The imputation system supports it. There's nothing wrong with that. It makes it easier to raise more capital if they have to. But they are high payout ratios and the returns to equity are higher by global standards and even if those were to fall, the banks could still generate enough internal capital, net of dividends, to run with higher rates of credit growth in Australia than we have today.
SB: David, if the majors have to stay within that top quartile set by those banks of global systemic importance and if your proposals on raising the floor and the risk weightings for mortgages for the major banks are accepted, what does that say about your trust in APRA as a regulator because you're taking away from them two of the big levers in the system?
DM: Well, no, APRA's got a number of things to consider. We didn't have any reason not to have confidence in APRA, but the proposal that we've made for this regulatory assessment board is quite new. It allows experts in the industry to consider the extent to which the regulators have taken all the elements of their mandate into consideration in their policy stance over each year, so that the industry is actually going to be much better placed in consultation with that board to criticise, or not, whether the proposals take into account efficiency in the total system, competition and stability, so I think we've given them more teeth in the industry.
SB: I assume from the recommendations on risk weightings that you believe that APRA's placed more weight on stability than on competitiveness.
DM: I'm quite certain about that and yet their existing mandate includes competition, so we think there should be more emphasis across the system on competition.
RG: No.
AK: David, you mentioned before your risk weighting for real estate mortgages when you were running the CBA was 50 per cent, I think, and in the report you observed that it had come down to 18 and there is obviously a debate going on, or has been recently, between risk-weighted assets and the leverage ratio. Now, you seem to have had a bob each on that. You've recommended an increase in the risk weighting of mortgages, but also you are talking about a recommended leverage ratio I think of 3 to 5 per cent. Where do you stand on that? Do you think that risk weightings are appropriate and should be retained or should the banks go to a leverage ratio only?
DM: Well, the developments here have been unusual because it seems to have become necessary in considering what happened in the crisis for regulators to override in certain ways the risk weighting system. They were very concerned that in the lead up to the crisis the leverage ratios of banks had deteriorated quite noticeably and even in Australia now without implementing a leverage ratio, APRA already overrides the loss given default factor for residential mortgages, so we have this curious position that there has been declining confidence in the risk weighting system, but it will take a long, long time to reconsider that and the outcomes are different for different countries. Andrew Sheehan, on our international panel, authored a report in which they described some of the outcomes from the risk weighting system have been quite adverse to small- and medium-sized enterprises, to trade finance, infrastructure finance and one other area, longer-term lending by banks. So, I think it's important that that risk weighting system over a considerable period now be carefully reassessed and that the Basel committee is starting that process already, but the fact that it's had to be overridden is a complexity we have to live with and the reason for this is that as a capital importer, Australia can't duck international regulation, so I think it's important that we get in and try and influence it as best we can, but we can't duck it.
RG: Are you saying that the current system is starving the business community, particularly the small business community, for funds? And I note recommendation 33 where you're saying that small businesses need extra help to have fair contracts with large organisations. Is that a major part of what you have in mind?
DM: It's one component. The non-monetary default clauses in their loan contracts seem quite unfair in many respects. They seem to turn a small business loan into a hybrid of a principal and interest loan and a margin loan. That is, if in the opinion of the bank the security value falls, then there's a non-monetary default which causes a top up of security. Well, that's quite a draconian obligation for a business that, on the surface, has entered into a principal and interest loan, so there are some reasons to believe that that needs to be considered in terms of unfair contracts, but that could well be one of the ways in which the risk weighting system drives banks to reduce risk weights and that loss given default consequence of what I just described would do that without necessarily reducing prices.
SB: Yeah, but David, if you were still the CEO of one of the major banks and you saw your recommendations implemented, so the change in the risk weighting floor, increased capital, would you then look at where you lent and say well, maybe lending to businesses has actually just become more attractive?
DM: Yeah, look, I mean this sounds like hindsight stuff, but I would be concerned first that my balance sheet had 65 per cent residential mortgages in it. Then, with new technology, I'd be concerned to look at any part of the business where there's a significant difference between the quality, pricing and variation in quality between the front book and the back book, because these new technologies are going to exploit it. So I think I'd be inclined to question whether I've been going fast enough on deployment of new technology and probably whether I've been creative enough in my business model on not only small business but medium and larger businesses, so that I'm more prepared for the sort of competition that's going to come down the line.
RG: You know, if you were running a bank now and you saw a report like this, wouldn't you say okay, I'm not going to waste five years and do all this, I'll get in and do it in the next couple of years, so I can then say that my bank is clean? It's got all these recommendations and we're operating from there. Why wait around for five years? Why wouldn't you do it now?
DM: Well, it's a good point, Bob. If you go back pre-crisis and look at the difference between some banks that looked very, very similar in the market before the crisis, and yet during the crisis you could find one of them almost failed and one didn't go close, the banks that tend to do best in good times and bad are the ones that go for very high quality and don't get carried away too much with, you know, the last point of market share or the last point of return. And I think in the new technology world, and with the focus globally on regulation, that banks, including the work they do with their consumers, are going to benefit from that approach.
AK: David, we've talked a lot about capital today and that's been a lot of the focus since the report came out. But there was a lot in your report about consumers, about financial advice and about innovation. Do I take it from reading the report that the panel's in favour of the Future Of Financial Advice legislation that the Labor Party brought in and would therefore be against its repeal by the Coalition?
DM: No, no. I think, Alan, that would be the wrong reading of the report. We take a step further. We go a step further than FOFA because we argue that there should be product manufacturing and distribution obligations that deal with both the information available to consumers and advice where needed for those consumers. So, you know, the analogy is if I buy vitamin C pills, I get information on the label, but probably no advice; if I buy pseudoephedrine, I've got the information plus advice from the chemist; if I buy antibiotics, I've got a lot of advice from a doctor with a huge information imbalance between me and the doctor, and I've got a lot of information that comes with the antibiotic. So it's goes much further than FOFA. We agreed with the remuneration conflict aspect of FOFA. We didn't agree that mortgage brokers and stockbrokers should be excluded from the original FOFA and we had difficulty with this concept of general advice in the proposed changes to FOFA because there are products that can be sold without advice at all, and to label that general advice, the gist is it still is advice. That general advice question should maybe have been better put into context of information, you know, specialist information rather than general advice. So this idea of obligations on product manufacturers and distribution and distributors goes a lot further than FoFA.
AK: So, you reckon FoFA wasn't tough enough? That's why you're not in favour of it.
DM: No. It didn't fully cover what needed to be fixed in the system in our view, but it was one very important area.
SB: David, in this consumer area, you speak in the report about the cultural issues and they seem to come out of these vertically integrated financial houses, so I suppose bank-owned wealth managers…
AK: Such as CBA.
SB: No, we'll leave that aside. But bank-owned wealth managers. Did you consider even for a moment recommending the break up of the vertically integrated groups?
DM: We looked at that, but we thought the more important issue was this manufacturing and distribution and if that's attended to it should solve the problem, whether a firm is vertically integrated or not, and we didn't see the issue as being necessarily about vertical integration.
RG: David, would we solve a lot of problems if we let the Future Fund launch a public fund which is a mirror image of their existing fund? So, you'd get a low cost, aggressive superannuation fund that's managed well and with very little fees because the base fees have covered both Future Funds.
DM: Well, that's right, Bob, and it's kind of you to make nice remarks about the Future Fund, but look, I think the issue there is once government gets in the business of offering a fund, then you distort competition in the whole system, so it did occur to us that the Future Fund could do something, but we felt that it's not an area the government should enter into.
AK: You also spent a lot of time in the report talking about innovation and technology and it clearly is an important part of the considerations and the inquiry's work. But can you sum up what, briefly, where you got on that because it was hard to figure out what you were actually saying or recommending?
DM: Yeah, it is, and that and the payment system in particular are very complex areas. What we're saying, quite simply, is that for people who want to come into the market, including the payments system, the regulator should have a graduated approach. That is, they can allow people to enter on what basis of regulation and see how things develop and grow and, if necessary, ask them to conform with more regulation, whether it's under APRA or ASIC. This has the benefit of allowing innovation to get into the system more easily and for new business models to be deployed, both to help competition and to help efficiency. And some of the those business models, particularly the ones that involve supply chain management, such as Alibaba and others, usually have a payment system attached to them. But if you allow that payment system to operate and watch it for a time, it means that small businesses in particular can benefit from the new business model.
AK: Does that apply to peer-to-peer lending?
DM: Crowdfunding and peer to peer lending are in a similar category and we've made recommendations that follow through on some work done by CAMAC to see whether more can be done to allow those people to operate more freely.
SB: David, isn't that sort of graduated, we'll toughen up regulation if they get bigger approach, completely at odds with the Wallis Committee approach, which basically said if you've got people doing the same thing, regulate them in the same way?
DM: Well, APRA has started to do it already, Steve, and we just believe that this digital world is one of the biggest-ever changes in a generally applicable technology that crosses the whole system and we just want to get the most out of it we can. So the graduated framework puts in more formally what has been done in some areas, for example, dealing with prepaid cards and store value cards by APRA already, and we think it should be a model that's followed more generally.
SB: On cards, you looked at, as I think the Reserve Bank did some years ago, just simply banning interchange fees and instead have come up with proposals that would trim them. Why not just get rid of them?
DM: Well, you know, that was on the cards, but that system has moved along so far, and going back to the consumer we felt that the consumer can be tempted with all sorts of reward structures which don't fully take into account the cost on the other side of the interchange fees. So we looked more at the status quo except that we didn't see why you can surcharge at a very high rate for a transaction, for example, with a debit card that costs next to nothing. So we've suggested that be reduced to zero surcharging. For credit cards, the interchange fee effects that surcharge. We said there should be a cap rather than a reasonableness test. And for three-party schemes where there are bigger reward structures and higher costs, we said there should remain a reasonableness test. So, I think we've gone as far as we possibly can to take away unreasonable surcharging in the system.
AK: David, having been through this process and looked into the future of banking and wealth management in general, would you actually buy shares in the big four banks as we speak?
DM: Well yes, I would. I'd put them in a portfolio because they conduct what is close in an economy to an essential service and they are regulated in a way that it allows them to make a reasonable return on equity and pay a reasonable dividend. Our structure would make them less volatile than they have been in the past, so I think for part of a portfolio they represent a hybrid between an equity and a good fixed income product and that's valuable, particularly for pension portfolios. So I've always held the view that around the world, under the capital asset pricing model, the beta of banks is higher than it should be at about 1.2 given that the regulation is intended to make them more stable and that they serve a whole economy and they should have a beta more like one.
AK: I suppose I'm specifically wondering whether you think they're now going to be disrupted by the variety of innovations that you actually talk about.
DM: Well, that's possible, but I think, as you probably know from my own background, the answer to those issues within any business is to attack the problem and not let it fester if you're to remain competitive and keep your own brand in good shape.
AK: I think we're done, David. Thanks very much for talking to us.
DM: Well, thanks all of you. Nice to talk.
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