University of Melbourne 1 Funding Australia’s Future: From where do we begin? & Implications for Mutual ADIs Kevin Davis Professor of Finance, University of Melbourne Research Director, Australian Centre for Financial Studies (and Professor, Monash University)

University of Melbourne 2 Background and Objectives Funding Australia’s Future project at ACFS –Identify possible developments in demand for and supply of finance –Implications for financial flows and financial sector structure –Impediments to efficient financing Stage 1: three background papers –Release July 10, Sydney Conference Aug 7 Stage 2: further commissioned studies on specific topics

University of Melbourne 3 Rationale and Issues Financial sector in continual state of evolution –Adjusting to technology, regulation, changing pattern of real sector demand & supply of finance Future development will be influenced by current situation and recent trends What does Australian financial sector look like (vis a vis others) and why? Are recent trends transitory or long-lasting? What are some scenarios? –& policy and strategy issues

University of Melbourne 4 Session Overview 1.Major Post GFC changes 2.Special Characteristics of the Australian Financial Sector 3.Future-gazing 4.Mutual ADI issues

University of Melbourne 5 Post GFC Changes Initial table discussion Identify 4-5 of the major changes in financial trends post the GFC, whether they are likely to be permanent or transitory, and implications These could include aspects of: financial flows / patterns of financing; sectoral (household, corporate, govt, international) balance sheets; financial products; financial sector prices; financial sector structure; etc (We’ll then discuss and compare with my list)

University of Melbourne 6 1. Financial sector growth relative to GDP has ceased Both activity level and asset valuation effects are relevant * Table excludes assets of SMSF Financial Institution Assets / GDP

University of Melbourne 7 1. Financial sector growth relative to GDP has ceased (cont.) Finance & Insurance: contribution to Gross Value Added

University of Melbourne 8 Growth rate Growth rate Size ($ trill) at September 2012 Deposits & Currency14%9%1.81 Bills & CP15%-6%0.44 Bonds issued in Australia13%20%1.15 Bonds issued overseas13%3%0.56 Derivatives21%7%0.40 Loans13%6%2.84 Listed shares & equity20%-6%1.24 Unlisted shares & equity14%-1%1.82 Accounts receivable2%6%0.47 Australian Financial Instruments: September 2012

University of Melbourne 9 2. Growth in Market Turnover (other than debt) declined Despite HFTDespite credit markets being the GFC problem

University of Melbourne Securitisation slowed dramatically (domestic) and ceased (internationally)

University of Melbourne Securitisation slowed dramatically (domestic) and ceased (internationally)

University of Melbourne Funds management industry growth interrupted.

University of Melbourne 13 5 Banks shift towards domestic deposit funding

University of Melbourne 14 With the result that…

University of Melbourne Increasing scale and leverage of household balance sheets has paused scale leverage Debt/ Assets Housing Debt/ Housing Assets Debt/ Income * Total Assets/ Income Financial Assets/ Income Interest Payments/ Income Housing Interest Payments/ Income Jun Jun Jun Jun Jun Jun Jun Jun

University of Melbourne 16 Household financial asset composition changed DepositsSharesSuper/Life Unfunded SuperOther Sep-9029%10%36%13%11% Sep-0019% 44%9% Sep-0715%27%46%6%5% Sep-1222%16%46%11%5%

University of Melbourne Household savings ratio (Nat. Acc. Basis) has increased Definition: includes increased home equity; imputed income and expenditure; super contributions - Long run Implications for bank deposit growth?

University of Melbourne 18 Change in household financial position Source: ABS cat Table 20 Four Quarter Moving Average

University of Melbourne 19 Household Sector: Net transactions: eight quarter moving average

University of Melbourne Long term downward share of NBFI lending to households ended Mid 1980s: Banks 2/3; NBFIs 1/3 2007: Banks 2/3; Securitisers 1/5; NBFIs~ 10% 2012: similar to 2007 Few NBFIs left Share of loans for investment housing increased from 15% in mid 1990s to 30% at GFC and constant since. Share of owner-occupied housing loans relatively stable at around 60%

University of Melbourne Gradual decline in corporate leverage in the decades prior to the GFC ceased Liabilities = Debt + Market Value of Equity

University of Melbourne Increase in net funding of the business sector by households and the ROW relative to financial sector Recent RBA research: large business gross saving by foreign owned miners Retained earnings count as income debits on BOP current a/c Corresponding (offsetting) capital inflow credit Banks have ceased to be main vehicles for funding BOP

University of Melbourne Finance Sector Funding of BOP declined Source: ABS 5302 Table 84

University of Melbourne Corporate accumulation of financial assets slowed markedly after the GFC Corporate sector holdings of financial assets –increased 13.2% p.a. over 2002 – 2007 –increased 3.1% p.a Main changes –share holdings: -5.1 % p.a. v 12.1% p.a (partly valuation effects) –accounts receivable growth slowed from 17.3% to 4.3% p.a.

University of Melbourne Decline in Government Debt/GDP over the prior decade was reversed

University of Melbourne Increased holdings of Federal Govt debt by the ROW. Government Debt: Percentage held by Rest of World Why the lower interest in semis?

University of Melbourne 27 Is the Australian financial system different? Table Discussion In what ways does the Australian financial system differ from those found in other advanced economies? Are there any implications for business opportunities, risks etc for ADIs Differences could relate to types of institutions; financial markets; financial products; demand, supply and allocation of finance; etc

University of Melbourne 28 Current Features of Australian Financing Patterns 1.banks and superannuation funds dominate the financial sector, holding approximately ¾ of financial sector assets. relatively few financial assets held by non-prudentially regulated financial institutions (excluding SMSFs)

University of Melbourne 29 Australia has one of the largest pension fund sectors in the world, both in absolute terms and relative to GDP FUND ASSETS AS A PERCENTAGE OF GDP

University of Melbourne 30 Australia’s Stock Market is large by international standards And 13 th largest in USD terms (CIA Factbook)

University of Melbourne 31 Listed Companies/Population

University of Melbourne 32 Relative to GDP, Australia’s domestic bond market is of comparable size to most other OECD countries But few non-financial corporate issues

University of Melbourne 33 The Australian banking sector is of comparable size to that of other OECD countries bank assets/GDP = in 2010 versus median bank assets/GDP = for the OECD). –(There is significant dispersion in this measure with the USA = 64.6 and the UK = 202.6). Similarly bank deposits/GDP of 98.8 (a lower figure reflecting the role of wholesale and equity funding of assets) is close to the OECD median

University of Melbourne 34 But “Bloody Big Building Societies”

University of Melbourne 35 Household sector a net borrower from banks. Bank deposits $660 bill; loans from banks $1,130 bill. Household equity in super and insurance $1,491 billion shares in financial corporations $151 billion, prepaid insurance premiums $54 billion. Loans from securitisers $310 billion; loans from other depository corporations $100 billion. Net claims on financial corporations overall (incl. super) of around $857 billion. Since 1990s share of financial assets in household total assets has been relatively stable (37 to 42 per cent) –increased value of superannuation assets largely matched by increased valuations of housing.

University of Melbourne 36 Aggregate Household balance sheet not unusual by international standards Sources: OECD Economic Outlook No. 92 (database); RBA Bulletin

University of Melbourne 37 Low Corporate Leverage

University of Melbourne 38 Limited Corporate Use of Debt Capital Markets

University of Melbourne 39 Low Government Debt/GDP

University of Melbourne 40 Finance and Insurance Sectors: Share of Gross Value Added YearGross Value Added Australia % Canada % France % Germany % Italy % UK % USA % Figures – treat with caution, but… Explanations?

University of Melbourne 41 Equity Bias in International Investments Share of FDI in stock of overseas assets has fallen from over 40% at start of 2000’s to around 30% (growth of superfund portfolio investment)

University of Melbourne 42 Significant Financing by Rest of World

University of Melbourne 43 Foreign Direct Investment (Stock)

University of Melbourne 44 Net Stock of FDI Outward FDI relatively low (but lots of portfolio investment)

University of Melbourne 45 Large Overseas exposure to AUD

University of Melbourne 46 Sector Financial Positions: Dec 2012 ($Trillion) Owed byto Assets / liabilities Include equity & debt

University of Melbourne 47 An Overview Financial sector not markedly different to others, but: –Household savings flow into super for ultimate investment –Households major borrowers from banks –Australian companies use less debt –Large ROW financing: was a large role for bank borrowing –Small Aust. corporate and government bond market –Large financial sector by developed world standards

University of Melbourne 48 Thinking about the Future GFC provided transitory shock to financing patterns –But unleashed regulatory reform with major implications for future financing patterns –Took attention away from long term issues Financing patterns haven’t fully adapted to implications of compulsory superannuation –Flows of funds, liquidity creation Tax system features are a major influence –Incentives for household sector risk taking –Patterns of corporate financing Structural changes in financing likely

University of Melbourne 49 Financial System Structure “Lagging” Superannuation has “re-routed” financial flows –Household savings increasingly fund securities investments, not lending and real sector project assessment (or the creation of securities) –Some credit / project risk appraisal by super funds and new security creation - commercial property, infrastructure. Should there be more (super & home mortgages?) What are consequences of increasing ownership of national capital stock by super for: achievable returns, innovation & entrepreneurship, capital stock growth?

University of Melbourne 50 Financial System Structure “Lagging” Long-term household portfolio balance –Short run dynamics complicated: deposits = money Banking sector still focused on “liquidity creation” (eg LT housing loans, ST deposits) –Even though large stock of illiquid savings exists (super) –Basel 3 “penalizing” bank liquidity creation AssetsLiabilities ?Transaction DepositsBorrowings? ↓Savings Deposits ↑Super ?Housing etc

University of Melbourne 51 Resolving Liquidity Preferences Demand for Liquid Assets Demand for Illiquid Assets Supply of Illiquid Assets Supply of Liquid Assets Money market Mutual funds (CMTs) Traditional banking Pension Funds Savers/ Investors Deficit Units Borrowers Secondary (capital) markets

University of Melbourne 52 Financial System Structure “Lagging” Potential Outcomes –Bank funding via superfund investments? Deposit and bond products (including for SMSF) –Bank securitisation of assets, loan sales (eg syndications) But level of credit risk assessment skills outside banks? –Less “commercial” more “investment” banking Corporate bond, equity issuance underwriting Logic of deposit guarantees for universal banks? –Bank structure implications? –Superfund involvement in asset creation Joint ventures with experts in risk assessment In house risk assessment capabilities

University of Melbourne 53 Infrastructure Investment Large stock of long term savings (super) available, but: –“Greenfields” project risk (and tender costs) PPPs not the answer: How best to share risks? –Should government bear demand (but not construction) risk? –“Tranching” claims and risk (securitisation)? –Pooling risk of many projects? –“Brownfields” risk and illiquidity Liquid claims on illiquid assets can be created Investment structures enabling diversification But low expected returns on low risk projects?

University of Melbourne 54 A super tax conundrum Dividend Imputation Tax concessions for super Both –Particularly zero tax rate concessions If all Australian equities are held by zero tax rate investors, corporate tax revenue is effectively zero – a growing Federal Budget problem!

University of Melbourne 55 Corporate Bond Market Development Super growth suggests demand side should be there Basel 3 incentives for debt capital markets v on-balance sheet lending - securitisation, corporate debt finance Government initiatives for easier issuance But –Imputation: no tax bias to debt v equity funding Except for foreign owned companies –Investor ability to assess credit risk –Investor ability to diversify credit risk –Investor “equity bias” – imputation and capital gains tax concession – is it super equity bias excessive? –Bank bond issues are competition But tendency to be “non-vanilla” (to qualify as regulatory capital) –Financial Claims Scheme - risk free alternative

University of Melbourne 56 BOP Funding & Financial Market Development If less bank funding of current account deficit –More portfolio and FDI investment inflow Including govt debt purchases Retained earnings of foreign owned cos. –One of the largest net FDI recipients Is imputation a disincentive to offshore expansion? Unlike domestic firms, foreign owned firms have tax incentives for debt financing –Either in domestic or offshore capital markets

University of Melbourne 57 Some Policy Issues: Financing Inadequacies Popular concerns (but not “evidence based”) –SME and venture capital –Infrastructure –Real estate investment bias –Retirement savings products –Equity bias –Banking competition, profits, systemic risk –Corporate bond market absence –“Too much finance”

University of Melbourne 58 Some Policy Issues: regulation and risk bearing What perimeter for prudential regulation? Currently relative few assets held by non- prudentially regulated financial institutions –Overseas interest in “ring fencing” But: Basel 3 should increase supply of capital market assets; demand from SMSF growth; incentives for advisers, product creators Investor protection increasingly problematic area –direct investments (eg shares, bonds), MIS, financial firm debentures Reliance on Education, Advice, Disclosure has been found wanting

University of Melbourne 59 Issues for Mutual ADIs Competition for household savings –Profitability and internal capital generation Contingent capital / Mutual Equity Interests –Demutualisation incentives Financial Claims Scheme (Deposit Insurance) –Distortions (Cap size), Funding Personal loan markets –Credit reporting, alternative lenders Mortgage markets –Securitisation, new lenders / originators Financial advice, transactions services

University of Melbourne 60 Conclusion Structural changes in financial sector inevitable –Patterns of financial flows have changed –Competitive advantages have changed –Regulation has changed Real sector adjustments also relevant –Industry sector changes – potentially different financing requirements (including SMEs / micro-businesses) –Demography – demand for financial products –Income distribution – implications of open economy and low cost international competition for “low skilled” employees

University of Melbourne 61 Conclusion: Mutual ADI future What competitive advantages for mutual ADIs? Financial sector functions are: overcoming information problems, reducing transactions costs, providing diversification and risk management services, transferring financial resources between individuals (lending / borrowing) and over time (wealth management), enabling payments Technology has radically changed information flows, transactions costs, creation of alternative financial products and markets etc. Maybe few advantages in the technical “production process” of financial services and products But ultimately dealing with individuals and their behavioral biases – does mutuality / customer owned banking provide an advantage and if so, how?