The moral hazards of non-bank regulation

Following the collapse of Banksia Securities, the idea of regulating non-banks has taken hold. But tougher regulation would weaken both competition and innovation in the sector.

The collapse of Banksia Securities has reignited a debate that dates back to the 1990 collapse of Pyramid Building Society. How should non-bank financial institutions be regulated and to what extent should investors in their securities be protected?

It is a vexatious question that Bill Shorten is now pondering seriously in his role as financial services minister because regulation creates moral hazard and cost. We accept that in relation to the major banks because they are so central to the financial system and ultimately because they are too big to be allowed to fail.

In return banks and authorised deposit-taking institutions generally are intensely regulated and are required to hold minimum levels of capital and liquidity, which impose significant costs.

The four major Australian banks are, as a group, holding more high-quality capital and liquidity than probably any other system in the world other than perhaps Canada’s.

The Australian Prudential Regulation Authority has the domestic banks on track to meet the more stringent, and costly, post-crisis international capital and liquidity regime years ahead of the protracted timetable set by international regulators. APRA has demonstrated that it is a high-quality and pro-active regulator.

That’s not a guarantee against failure but it does provide a measure of insurance and insulation for the taxpayers, who ultimately are the capital and liquidity providers of last resort for a failing major.

There might be arguments about how much capital and liquidity the majors should hold, and whether or not they should pay a premium for that ultimate taxpayer safety net, but fundamentally their regulatory regime is a robust one.

The more difficult question is what to do about non-banks. After Pyramid collapsed there was a vigorous discussion about the appropriate regulatory framework for non-bank institutions, the result of which was the shifting of the regulation of previously state-regulated deposit-taking institutions like building and friendly societies and credit unions to APRA.

That still left, however, a range of non-bank intermediaries, like Banksia, or Storm Financial, or Westpoint, which raised funds from the public to on-lend to property developers. They have been regulated by the Australian Securities and Investments Commission, which is a disclosure-based regulator rather than a prudential regulator like APRA.

The risk of shifting regulation of non-bank finance companies to APRA is that it would extend the net of moral hazard over a larger range of smaller institutions. The issue isn’t just one of APRA’s capacity to regulate a larger range of institutions and the dilution of its current focus on systemically more important organisations but the perception of security it would generate among investors.

The hardline position would be to toughen up the disclosure and liability regimes for ASIC-regulated entities, plaster them with "wealth hazard" warnings and adopt a caveat emptor approach to investor interests.

That does have some appeal. The debenture-issuing entities like Banksia attract funds by offering higher interest rates than banks – there is a risk premium incorporated in the returns they offer investors that ought to signal investors that they are exposing themselves to higher risks than if they put their cash into bank deposits.

The collapse of Banksia therefore could be seen as a useful, albeit painful, lesson for those chasing higher returns from non-bank securities that those returns are only available because they involve the taking of more risk. Bringing APRA next to those entities would muffle that message, provide false comfort and create an additional taxpayer exposure.

It might also, of course, wipe out the non-bank sector. If institutions doing bank-like things – aggregating what are effectively deposits to on-lend – are regulated similarly to ADIs and required to hold minimum levels of capital and liquidity they will face significant additional costs and ultimately a loss of competitiveness relative to ADIs.

The banks wouldn’t be too fussed by that but there could be a loss of competitiveness, innovation and efficiency within the system if entities that pose no systemic risk are regulated as if they did.

This is, of course, part of a broader global debate about how to regulate non-banks or, as the non-bank elements of the global financial system are commonly called, the "shadow banking system".

It would seem obvious that if an organisations looks and acts like a bank – if, as discussed recently (Regulators home in on a growing bank shadow, November 19), its core functions are credit, maturity or liquidity transformation – then it ought to be regulated as a bank, albeit perhaps less intensely.

Certainly any linkages with the core banking system need to be monitored and captured within the banks’ regulatory net.

Alternatively, policymakers and regulators could ensure that non-banks can’t project themselves as something analogous to a bank. They can impose tougher and more investor-useful and more "real time" disclosure requirements and liabilities on the promoters that have real deterrents in them. They can ensure that investors are made more aware of the risks they are exposing themselves in exchange for higher returns.

There is no easy answer to the question of how policymakers should respond to the failings in the regulatory system exposed by the collapses of Westpoint, Storm and Banksia.

In a system which is already highly concentrated and where the taxpayer is already carrying massive latent exposures to failures within the APRA-regulated sector, however, there is a very delicate line to be walked between strengthening investor protection while extending the boundaries of the moral hazard and weakening competition and innovation in the process.

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