What does Australasia's biggest bank want from a government financial system inquiry?

By Gareth Vaughan

Question: What do you do if you are a major company and your former CEO is chairing a high profile government inquiry into your industry?

Answer: Send in a wish list cunningly disguised as a submission.

To be fair to ASB and insurer Sovereign's parent Commonwealth Bank of Australia, which is a company currently in the scenario outlined above, there is a fair bit more to its 132 page submission to the Australian government's Financial System Inquiry than a wish list.

But if you want an insight into some of the things that keep bank executives awake at night on both sides of the Tasman, you could do worse than peruse CBA's submission.

Before I get into the submission's contents, I can't resist a dig at the inquiry itself.

A five member panel overseeing the inquiry is being chaired by David Murray who was CBA's CEO from 1992 to 2005. The other panel members are Professor of Finance Kevin Davis from the University of Melbourne, ex-AMP CEO Craig Dunn, token woman Carolyn Hewson who is a former Schroders Australia investment banker and company director, and Brian McNamee the former CEO of CSL.

There's not a consumer representative in sight, including on a four member international advisory panel that features another former bank boss in ex-Westpac CEO David Morgan. Given the inquiry is tasked with making recommendations "that foster an efficient, competitive and flexible financial system, consistent with financial stability, prudence, public confidence and capacity to meet the needs of users," I would've thought a consumer representative might be a useful addition to the panel. Because surely what customers want is reasonably important.

My guess is there'll be little in the inquiry's final report, due to be provided to Treasurer Joe Hockey by November, that'll upset the big banks too much.

But I digress.

Protecting banks in the digital economy

We know bank bosses on both sides of the Tasman are keeping a close eye on the likes of PayPal, Google, Apple, Facebook, peer-to-peer payments, Bitcoin and assorted other new-fangled developments casting a shadow over the ancient profession of banking.

Technology enabled low cost, efficient competitors are clearly causing some concern. Section three of CBA's report is entitled Protecting Australians in the digital economy. Parts of it could be renamed Protecting banks in the digital economy.

One of the points CBA makes is that although innovation in the financial system should be encouraged, allowing new players to enter an uneven playing field distorts the market. Here the bank notes technology has enabled non-bank entities to provide bank-like and finance-related applications and services without being subject to the regulation banks are such as Know Your Client,
Anti Money Laundering, Suppression of Terrorism Financing, plus capital and liquidity regulations.

"This may discourage entities which invest in the safeguards mentioned above from making the investments that have to date improved the system for customers while maintaining its stability," CBA says. "Australian customers must be offered the same protection and security by new players that they receive from traditional banks."

Avoiding 'arbitrary handicapping of certain system participants'

CBA rightly acknowledges the internet and smartphones have changed the way people pay for goods and services

"Options for moving outside of regulated payment systems are growing as a result of innovation. Examples include closed loop payment systems, international money transfer services and digital currencies. These pose emerging challenges and risks to the payments system."

"Any new risk and associated cost imposed upon the payments system is borne by its existing users and participants. Regulators must be vigilant in managing the risks introduced to the payments system by new and innovative payment offerings," CBA says.

"The Reserve Bank of Australia’s approach to regulation of the payments system to date has been to regulate payments according to clearing system or institution type. This has been acceptable while electronic payment has been in its infancy. However, as innovative payment options using new technology rapidly emerge and distinctions between card and peer-to-peer payments blur, it is important that the RBA adjusts its approach to payments regulation."

"It is important that similar products are regulated consistently regardless of their technology platform or service provider. To do otherwise would risk stunting certain components of the payments system while advantaging other payments services. It also risks allowing new participants to introduce vulnerabilities to the payments system. Such an arbitrary handicapping of certain system participants will not deliver an efficient payments system shaped by competition and customer preference," CBA says.

Coming soon to NZ, 9% interest for savers via peer-to-peer payments

Interesting to note the mention of peer-to-peer payments here. The Financial Markets Conduct Act, which came into effect in New Zealand on April 1, clears the way for crowd sourcing and peer-to-peer payments. That is, after licences are obtained from the Financial Markets Authority first, with the FMA suggesting around 10 may be doled out to begin with.

One peer-to-peer payments (P2P) firm currently seeking a licence from the FMA is Harmoney. Its website says as iTunes changed how people buy music, and Trade Me changed how we buy used goods, peer-to-peer will revolutionise personal loans, "liberating" personal lending by challenging the banks.

"The four Australian owned banks now dominate NZ personal loans. They have the profits to show for it too. For people borrowing money for things like cars, holidays and home renovations, P2P means lower interest rates without the patronising attitude. For investors with $500+ in savings in the bank, it means interest rates of 9% plus, not 3-4%," Harmoney says.

In terms of Bitcoin, CBA says it doesn't seem to have broad acceptance within the merchant community. And the bank adds the risk of an unregulated new digital currency and companion payments system is that illegal activity may flourish by avoiding the safeguards of the banking system.

'Make cheque users pay'

CBA also has a bit to say on the future of cheques, which it says will become economically unviable at some point in the future. As reported by interest.co.nz last month, cheques are here to stay in New Zealand for years yet. But it's safe to bet New Zealand's major banks are as keen to see the back of them as CBA.

It notes a 2007 RBA study found the per-unit cost of a cheque payment to be A$5.17, which would have risen since then because the volume of cheques is down 54%.

"Much of the cost of a cheque payment is borne by the financial institutions involved in processing the payment. This cost is largely cross subsidised by other banking products, rather than being charged to cheque users," CBA says.

"Commonwealth Bank believes if cheque payers were confronted with a transparent and upfront charge for making a payment, many would re-evaluate their payment choices. Providing merchants with the option to surcharge for acceptance of cheque payments would ensure the customer’s choice of payment instrument considers the relative cost of each instrument, resulting in a more efficient usage of the payments system. This is in keeping with the objectives of the RBA’s card market reforms."

'Inflation adjust long-dated income earnings from fixed income'

CBA's submission also includes a chapter on ensuring sustainable funding for Australian banks. In this it makes the point the Australian tax system has a number of features that encourage investors to invest in equities and property rather than debt. Some things feature here, such as capital gains tax, that have been hotly debated on this side of the Tasman;

• Negative gearing allows investors to borrow to invest and to claim a tax deduction for interest costs. Investors have an incentive to do this via equities and property, which are more likely to be inflation driven and increase in value as opposed to fixed income investments. The dividend or rental income may not cover the borrowing cost but the cost is subsidised by the tax saving and the balance of the borrowing cost is made up over time through capital appreciation (some of this capital appreciation is effectively compensation for inflation).

• Capital gains tax defers the time at which profit on investments, particularly equities and property which again are more likely to be inflation-driven and increase in value, is paid.

• The discount on capital gains on investments held for more than 12 months significantly reduces the tax paid on these profits.

The combination of all three mechanisms of negative gearing, tax deferral and the capital gains tax discount influences investment away from debt.

These features have a significant impact upon investor demand in the domestic debt markets, which then discourages issuers from using the market.

"Commonwealth Bank recommends that measures be implemented to encourage investors to invest in debt. Specifically, Commonwealth Bank believes it is necessary to CPI-adjust long-dated income earnings from fixed income, where debt investment is most disadvantaged from a tax perspective," the bank says.

"In 2010, Australia’s Future Tax System Review recommended introducing a tax discount of 40% for interest income, net residential rental property income, and capital gains, with the specific aim of ensuring a more consistent outcome across these asset classes. Commonwealth Bank suggests that this discount be introduced for long-term fixed income securities. By limiting the measure to long-term instruments, the impact upon the Government revenue would be minimised."

"Such a measure would be attractive to both individuals and superannuation funds. The ability to issue such securities would also facilitate the provision of debt funding for Australian infrastructure projects," adds CBA.

'Lift the limit on covered bonds'

Also on the funding front, CBA raises the issue of covered bonds. They are controversial both because they see a chunk of a bank's assets ring fenced as security for covered bondholders, and because covered bondholders go to the front of the queue - ahead of depositors - for repayment in the event of a bank failure.

CBA says the  limit in Australia, where the value of a bank's assets used to secure covered bonds can't exceed 8%, should be increased. In New Zealand the limit is 10%. CBA doesn't suggest a particular percentage of assets it'd like to see the limit increased to. It does however, provide a list of various countries and their respective limits, which includes several countries in Europe where there's no limit.

The inquiry will recommend policy to the Australian government. Its full terms of reference can be seen here.

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