Chapter 15 Financial Regulations and Capital Requirements 15.1 Aims of Financial Industry Regulation 15.2 The Australian Financial Industry 15.3 Financial Modelling 15.4 Capital Requirements 15.5 Credit Ratings Agencies

Aims of Financial Industry Regulation All market participants need to have confidence in the system otherwise they will not use it. A strong regulatory system reassures investors that the market is safe and fair to invest in.

The Current Regulatory Regime The regulatory framework consists of three agencies, each with specific functional responsibilities: The Australian Prudential Regulation Authority (APRA) The Australian Securities and Investments Commission (ASIC) The Reserve Bank of Australia (RBA)

The Australian Prudential Regulation Authority (APRA) APRA is charged with developing prudential policies that balance financial safety and efficiency, competition, contestability and competitive neutrality. Responsible for deposit-taking institutions (banks, building societies and credit unions) as well as friendly societies and insurance companies.

The Australian Securities and Investments Commission (ASIC) ASIC’s aim is to protect markets and consumers from manipulation, deception and unfair practices and to promote confident participation in the financial system by investors and consumers. Administers and enforces a range of legislative provisions. Includes the share market, insurance, superannuation and deposit-taking activities (but not lending).

The Reserve Bank of Australia (RBA) Responsible for monetary policy and overall financial system stability. Deals with threats to financial stability that have the potential to spill over to consumer and investor confidence. The RBA is the ‘lender of last resort’ for emergency liquidity support.

The Bowen Reforms Announced by the Minister for Financial Services, Superannuation and Corporate Law. Designed to address conflicts of interest that can undermine financial advise. Came into effect July 1 2012. Changes include: A ban on commission payments to financial planners. Introduction of a fiduciary duty to act in clients best interests. Clients must be asked to renew fee arrangements annually. A ban on percentage based fees on geared investments.

The Australian Financial Industry The four categories of financial institutions in Australia are: Authorised Deposit Taking Institutions (ADIs). This includes banks, building societies and credit unions. Registered Financial Corporations (RFCs). This includes merchant banks and finance companies. Fund Managers. Insurance companies.

Authorised Deposit-Taking Institutions (ADIs) ADI’s are authorised by APRA and are categorised as follows: Australian owned banks. Branches of foreign banks. Foreign subsidiary banks. Credit Unions. Building Societies.

Banking Activities A bank is an institution which is either licensed under the Banking Act or created under State legislation to conduct banking business. Only those institutions which have met the necessary conditions and have been granted a banking authority may call themselves a bank.

Banking Activities Some common services banks provide: Savings and cheque accounts. Credit cards. Home, personal and business loans. Insurance —home and contents, motor vehicle. Stockbroking. Funds management. Superannuation. Foreign exchange. Financial planning.

Trading Banks/Savings Banks Since 1988 the separation of savings and trading activities has been removed, so that banks may perform both. The banking system in Australia is dominated by the four major banks: Commonwealth Bank of Australia. (CBA) Australia & New Zealand Banking Group. (ANZ) Westpac Banking Corporation. National Australia Bank. (NAB)

Credit Unions Traditionally occupationally or community based intermediaries offering: Consumer finance Housing Loan Small Commercial Loans Investment advice Insurance and travel facilities

Building Societies Prior to deregulation of banks, building societies provided loans to those whom were unable to borrow from banks Since then, many have converted to banks or shrunk substantially.

Friendly Societies Friendly societies are non-profit organisations which pool investors resources to earn returns.

Special Purpose Banks Special Purpose Banks provide finance to specific sectors of the market such as: Commonwealth Development Bank (CBD) Primary Industry Bank ( PIBA) Australian Industry Development Bank (AIDC) Australian Resources Development Corporation (ARDB)

The ‘Big 4’ Commonwealth Bank of Australia National Australia Bank ANZ Westpac 90% of the industry Closely regulated by the APRA and ACCC Have faced reduced competition since the GFC, and have been raising prices. Accused of collusion.

Financial Modelling Financial Modelling is building a mathematical or statistical equation to forecast future performance.

Credit Scorecards Mathematical models used by financial institutions and banks that attempt to predict the probability of a customer defaulting on their loan. Uses regression modelling to estimate this probability by looking at the characteristics of previous home loan defaulters such as age, income, family size etc.

The Basel Accords A set of banking regulations designed to promote stability in world banking sectors and provide a comprehensive set of world banking standards. They are not enforceable, but are a set of recommendations that most developed countries enforce domestically.

Basel I Formulated in 1988, in Basel, Switzerland. Primarily focused on credit risk - the risk associated with a borrower not repaying borrowed funds. Assets of banks were classified into categories according to how much credit risk they carried. The idea was to regulate the amount of credit risk that a bank could take on.

Tier 1 and Tier 2 capital Under the Basel accords capital is split into two types, tier 1 and tier 2. Tier 1 capital is the most reliable form of capital and is comprised of stock and cash holdings. Tier 2 capital is the second most reliable form of capital and is comprised of undisclosed reserves, revaluation reserves, hybrid instruments and subordinated term debt.

Basel II Basel II is a revision and expansion of Basel I that was published in 2004. Expanded the focus to operational risk, market risk and other forms of risk. It contained: more sophisticated minimum capital requirements Enhanced supervision of capital management Materially increased disclosure requirements

Basel II Under Basel II banks must have at least 50% of their total capital in the form of tier 1 capital. APRA enforced Basel II in Australia from the 1st of January 2008 for all Authorised Deposit Taking Institutions (ADI’s).

Capital Adequacy Ratio The ratio of tier 1 and tier 2 capital to risk-weighted assets. Determines the capacity of the bank to meet its time liabilities and deal with credit risk, operational risk and market risk. Under Basel II the capital adequacy ratio (CAR) for a bank must be above 8%. CAR = tier 1 capital + tier 2 capital > 8% Risk-weighted assets

Basel III Basel III is a new update to the Basel accords that is expected to come into use in Australia by 2015. The draft Basel III regulations include: The introduction of a leverage ratio, A framework for counter-cyclical capital buffers, Measures to limit counterparty credit risk, Short and medium-term quantitative liquidity ratios.

Value at Risk (VaR) Measures market risk. Measures the potential loss in value of a risky asset or portfolio over a defined period of time for a given confidence interval. VaR is used to measure potential losses on investment portfolios in the case of adverse market movements.

Credit Rating Agencies A company that assigns credit ratings for issuers of debt securities such as bonds. Makes it easier for investors to get an idea of the credit risk that they are taking on. CRA’s do thorough research of a company’s current financial position and future prospects, from which they assign a rating. The higher the rating the more credit-worthy the company’s debt instruments are. The lower the credit rating the more risky a company’s debt securities are, meaning that investors will demand higher interest rates to invest. This will make debt funding more expensive.

Criticism of Credit Ratings Agencies Underestimated the risk of mortgage backed securities prior to the GFC, which played a large role in the crisis. Sometimes too slow to downgrade poorly performing companies. Downgrading of a company can lead to a vicious cycle where-by debt becomes more and more expensive, which lowers a firms’ profitability, which in turn may lead to further downgrades.