|Summary: The Murray Financial Services Inquiry has not made any specific recommendations, but it has identified a range of areas that could be addressed to strengthen the financial system. These include making banks carry even more to protect investors and to overcome the ‘too-big-to-fail’ perception, scrapping SMSF borrowings, and changes to the negative gearing and capital gains tax systems.|
|Key take-out: In what would be a big hit to the investment options for self-managed super funds, the report suggests direct leverage across the superannuation sector be prohibited. This would impact their ability to borrow for investment property and other assets.|
|Key beneficiaries: General investors. Category: Investment Portfolio Construction.|
David Murray’s proposals, if they were to come to pass, would significantly impact the investor environment in Australia. They would dampen or reduce residential property prices, limit the appeal of the big bank stocks, and stop SMSFs using leverage to invest.
While the Murray Financial Services Inquiry’s interim report states that the Australian financial system has performed reasonably well, and it steers clear of issuing explicit recommendations, its ‘observations’ and ‘policy options’ establish potential ways for the system to resist future financial instability.
Suggestions for Australian banks include making them carry extra capital and imposing losses on creditors if they fail. Experts say these measures create uncertainty and could hit bank earnings, which would in turn slow or even stop dividend growth.
Elsewhere, the Murray inquiry says negative gearing and capital gains tax are encouraging a significant source of risk in housing and that leverage by superannuation funds, particularly by SMSFs, may create vulnerabilities in the financial system.
On the flipside, the report also suggests boosting infrastructure investment options and other ways to generate income in the superannuation space, as well as putting the regional banks on more of an even footing with their larger peers – improving their prospects.
The Murray inquiry may have dismissed competition concerns toward Australia’s ‘big four’ banks – against much opposition – but it did waylay the sector in another key area: the perception they are ‘too-big-to-fail’.
This perception leads Australia’s largest banks to not only benefit from a funding advantage because lenders are more willing to lend to them at a reduced rate, but also from increased appetite for their stock, the report finds.
“Investors may believe they will not make a loss, even if the institution fails, so they have less incentive to monitor the institution’s risks and apply market discipline,” the inquiry says.
To combat the ‘too-big-to-fail’ perception, the report proposes a number of solutions. They include higher capital requirements, stronger risk management and stress testing measures, as well as ring-fencing of retail operations and greater resolution powers for regulators.
But the most concerning proposal, according to Macquarie, is the ‘bail in’ requirement where creditors will be responsible for losses if the banks go into liquidation. The investment firm estimates a possible 3-5% hit to earnings because it could have the potential to downgrade the banking sector’s credit ratings, pushing up funding costs.
UBS analysts Jonathan Mott and Adam Lee believe the major banks may be forced to lift their target common equity tier 1 ratios to between 10% and 10.5% by 2017, which translates into an extra $23 billion in core capital required. The analysts say this is the most likely scenario because the report looks at international benchmarks of capital buffers and finds Australia to be at the low end (see graph below).
With the potential for banks having to set aside more capital – creating uncertainty – their management may be unwilling to lift their payout ratios for dividends, capping share price performance.
Indeed, the release of the inquiry report has weighed on bank stocks. When it was released on Tuesday, the ANZ fell 0.9% – the biggest drop on the day among the major banks.
The market’s poor reaction wasn’t only due to the inquiry’s problem with ‘too-big-to-fail’. The report also suggests reducing the mortgage risk-weighted asset gap between the ‘big four’ banks and regional banks to address competition issues.
Currently, the big banks can more highly leverage against mortgages than their smaller peers because they are required to hold less than half the capital as accredited deposit taking institutions under the Australian Prudential Residential Authority (APRA).
In desiring to level the playing field, the report proposes solutions including increasing the majors’ risk weights. Investment firm Credit Suisse says CBA and Westpac would be particularly vulnerable due to the heavy skew of their balance sheets towards Australian mortgages.
Credit Suisse prefers ANZ and NAB because they are more orientated towards business financing. The regional banks, Bank of Queensland and Bendigo and Adelaide Bank, also could be winners as their pathway to achieving advanced accreditation could be accelerated, the bank says.
Australia’s residential property market represents a significant threat to our country’s financial stability and economic growth because of high household indebtedness and the high proportion of mortgages on bank balance sheets, according to the Murray inquiry.
But the report makes it clear that easy access to housing finance, helped by a lower risk weight for banks in mortgages, is by no means solely responsible for the increase in house prices.
“The tax treatment of investor housing, in particular, tends to encourage leveraged and speculative investment in housing,” the report says.
According to RBA statistics, over 90% of the increase in household credit since 1997 has been to borrow for housing, with investors making up a third of the increase in total credit.
The inquiry specifically targets negative gearing and changes to the capital gains tax in 1999 – allowing investors to realise nominal capital gains at half the marginal rate – as drivers of the growth in investor housing credit and the shift towards more leveraged investments over the past 15 years (see graph).
Negative gearing allows investors to reduce their tax liabilities by deducting borrowing costs and other expenses against their total income. This not only makes speculative investment more attractive, but it also creates the incentive to repay mortgages as slowly as possible to maximise tax deductions, the report says.
The Murray inquiry refrained from issuing explicit proposals to policymakers in regards to negative gearing and capital gains tax. It did, however, label it as a distortive influence and suggests the government consider the systematic risk if a sharp fall in house prices were to occur.
“Investors perceive housing investment as less risky than leveraged securities investment; mortgages are less likely to be subject to margin calls, and there is arguably a widespread and falsely held view that housing prices never fall,” the inquiry says.
SMSFs deliver members greater flexibility and control and can be more tax effective than traditional superannuation funds, the Murray inquiry says, but operating costs for many of them can be too high.
The report says that though many SMSFs were set up to reduce fees, evidence of the effectiveness of this strategy is mixed. While the average fee rate for SMSFs is lower than the industry average, those with lower balances are significantly more expensive to run (see graph).
According to 2011-12 ATO data, almost a quarter of SMSFs had balances of $200,000 or less and 50% had balances under $330,000 even after being established for three years.
For the SMSFs with lower balances, the report questions seeks further information on whether it should be concerned about their operating expenses and wonders if there should be ‘limitations’ on the establishment of SMSFs.
The report also suggests direct leverage across the superannuation sector should be prohibited in a prospective basis. This would be yet another blow to banks, cutting off one of their key credit growth opportunities.
“Although direct leverage in superannuation is small, the current ability to borrow directly may, over time, erode this strength and create new risks to the financial system,” the report says.
But the report isn’t completely restrictive in its stance toward superannuation. It proposes the government facilitate liquid, tradable claims on infrastructure projects – creating greater scope for both retail and institutional investors – and it says there needs to be more fixed income products available which are more appropriate on a risk management basis (see Robert Gottliebsen’s How to prepare for 2014-15).