What could the Government do to fix our Broken Business Banks? And why does it really matter?

Insightful analysis by Alan Kohler in The Australian this weekend on what is holding business back and the negative effects on our economy. Sadly, our politicians seem to be disconnected from the reality of how to manage our economy.

How banks are running the economy

"A small business tax break is worthwhile perhaps, and likewise an RBA rate cut, and in each case it’s really all the government and the central bank can do."

Our view:

The Government could get involved investing modest sums on alternative finance platforms, like the UK Government did 3 years ago with powerful positive effects (and good returns on investment).

That would help overcome people's natural caution and skepticism. People tend to think that banks have some super-natural powers in deciding who is creditworthy. Overseas' experience makes it clear that they are simply expensive, bureaucratic building societies that have lost their way.

My father was a bank manager and retired when the computer took away his discretion. Bank managers in his days had real discretion and could support businesses with their growth plans. We need to re-invent banking by going back to why they came into existence in the first place. It had nothing to do with household mortgages which simply inflated the price of unproductive assets.



Here's a more detailed extract from Alan's article:

APRA, in line with global bank regulators, has also told them to increase their capital ratios, and since the system of risk-weighting means that only a quarter of the value of a real estate mortgage is counted against capital versus 100 per cent of a loan secured only against a business, that means all lending these days is more or less confined to mortgages.

It means the banks are basically not lending to those who don’t own a house or are already fully committed on their mortgages, and those who are building houses for investors.

So they are going elsewhere and paying 10-15 per cent more in interest than the banks would charge, except they’re not.

It means the divide between the haves and have-nots (a house, that is) has never been this great, and it’s also why this week’s rate cut by the Reserve Bank will make no difference and why the government’s efforts in the budget to help small businesses and middle income earners will only scratch the surface.

Banks actually run the economy by both creating money and circulating it, not the RBA or the government, and these days banks are only serving those who have equity in real estate.

According to economist Saul Eslake, home ownership rates among households headed by people aged 25 to 55 have dropped by an average of 9 per cent since 1991.

Most dramatically, the rate of home ownership among 25-34 year olds has fallen from 61 per cent in 1981 to 47 per cent in the latest census.

That is a huge social change: in one generation the number of families starting out and having children who also own their own home has dropped from almost two-thirds to less than half, and in the past 10 years the decline is accelerating.

It means the number of young people able to get a bank loan to start or expand a business, or to get a car loan or personal loan for anything less than 15 per cent interest, has also fallen significantly.

And a lot of that change is caused by the real estate market distortion inherent in negative gearing and the capital gains tax discount, which rewards highly geared property investors at the expense of owner-occupiers, who are in turn paying higher taxes than they otherwise would be in order to fund the subsidy to property investors.

So the combination of high house prices caused, in part, by negative gearing and the capital gains discount, with the transformation of banks into little more than building societies that lend almost exclusively against real estate, is the reason growth is weak.

A small business tax break is worthwhile perhaps, and likewise an RBA rate cut, and in each case it’s really all the government and the central bank can do.

But what’s really crimping entrepreneurship and growth is the post-GFC change to banking.

It means business people looking to expand have to come to Shylocks like your correspondent.

Most don’t bother.

Basel Committee's new approach: banks will turn further away from SME lending

The Basel Committee released its second consultative document on Revisions to the Standardised Approach for credit risk in December (comments due by 11 March 2016).

There has been little or no commentary about its impact on SME lending - we believe that the effects will be far reaching.  

The committee pulled back from the penal ‘negative equity =>150% risk weighting’ approach that was previously proposed. Now they propose a general 85% risk weighting. This compares with a current 60% weighting so is still bad news for SMEs looking to raise finance from banks.

There are statements in the document about having to apply 100% risk weighting if due diligence requires it. The proposed revision to lease accounting (IFRS 16) could be a factor here.

So the future of SME lending remains in a state of flux, with the 'Big 4' IRB version yet to be released. The outcome is likely to have a major impact on SME lending by banks, especially as it affects mid-sized businesses that drive growth and jobs across Australia.

SMEs now only represent 15% of new business lending by banks and outstanding loans have fallen to 30% of all business lending (early ‘90s – 50%).

It is already quite uneconomic for banks to lend to SMEs and becoming more so. We believe that this downward trend is set to continue, as is happening globally.

Sound management of risks related to money laundering and financing of terrorism

Timely updated guidance from the Basel Committee on account opening. Just as important for P2P lenders as banks.

The three lines of defence

19. As a general rule and in the context of AML/CFT, the business units (eg front office, customer facing activity) are the first line of defence in charge of identifying, assessing and controlling the risks of their business. They should know and carry out the policies and procedures and be allotted sufficient resources to do this effectively.

The second line of defence includes the chief officer in charge of AML/CFT, the compliance function but also human resources or technology.

The third line of defence is ensured by the internal audit function.

20. As part of the first line of defence, policies and procedures should be clearly specified in writing, and communicated to all personnel. They should contain a clear description for employees of their obligations and instructions as well as guidance on how to keep the activity of the bank in compliance with regulations. There should be internal procedures for detecting and reporting suspicious transactions.

21. A bank should have adequate policies and processes for screening prospective and existing staff to ensure high ethical and professional standards. All banks should implement ongoing employee training programmes so that bank staff are adequately trained to implement the bank’s AML/CFT policies and procedures. The timing and content of training for various sectors of staff will need to be adapted by the bank according to their needs and the bank’s risk profile. Training needs will vary depending on staff functions and job responsibilities and length of service with the bank. Training course organisation and materials should be tailored to an employee’s specific responsibility or function to ensure that the employee has sufficient knowledge and information to effectively implement the bank’s AML/CFT policies
and procedures. New employees should be required to attend training as soon as possible after being hired, for the same reasons. Refresher training should be provided to ensure that staff are reminded of their obligations and their knowledge and expertise are kept up to date. The scope and frequency of such training should be tailored to the risk factors to which employees are exposed due to their responsibilities and the level and nature of risk present in the bank.

22. As part of the second line of defence, the chief officer in charge of AML/CFT should have the responsibility for ongoing monitoring of the fulfilment of all AML/CFT duties by the bank. This implies sample testing of compliance and review of exception reports to alert senior management or the board of directors if it is believed management is failing to address AML/CFT procedures in a responsible manner. The chief AML/CFT officer should be the contact point regarding all AML/CFT issues for internal and external authorities, including supervisory authorities or financial intelligence units (FIUs).

23. The business interests of a bank should in no way be opposed to the effective discharge of the above-mentioned responsibilities of the chief AML/CFT officer. Regardless of the bank’s size or its management structure, potential conflicts of interest should be avoided. Therefore, to enable unbiased judgments and facilitate impartial advice to management, the chief AML/CFT officer should, for example, not have business line responsibilities and should not be entrusted with responsibilities in the context of data protection or the function of internal audit. Where any conflicts between business lines and the responsibilities of the chief AML/CFT officer arise, procedures should be in place to ensure AML/CFT
concerns are objectively considered at the highest level.

24. The chief AML/CFT officer may also perform the function of the chief risk officer or the chief compliance officer or equivalent. He/she should have a direct reporting line to senior management or the board. In case of a separation of duties the relationship between the aforementioned chief officers and their respective roles must be clearly defined and understood.

25. The chief AML/CFT officer should also have the responsibility for reporting suspicious
transactions. The chief AML/CFT officer should be provided with sufficient resources to execute all responsibilities effectively and play a central and proactive role in the bank’s AML/CFT regime. In order to do so, he/she must be fully conversant with the bank’s AML/CFT regime, its statutory and regulatory requirements and the ML/FT risks arising from the business.

26. Internal audit, the third line of defence, plays an important role in independently evaluating
the risk management and controls, and discharges its responsibility to the audit committee of the board of directors or a similar oversight body through periodic evaluations of the effectiveness of compliance with AML/CFT policies and procedures. A bank should establish policies for conducting audits of (i) the adequacy of the bank’s AML/CFT policies and procedures in addressing identified risks, (ii) the effectiveness of bank staff in implementing the bank’s policies and procedures; (iii) the effectiveness of compliance oversight and quality control including parameters of criteria for automatic alerts; and (iv) the effectiveness of the bank’s training of relevant personnel. Senior management should ensure that audit functions are allocated staff that are knowledgeable and have the appropriate expertise to conduct such
audits. Management should also ensure that the audit scope and methodology are appropriate for the bank’s risk profile and that the frequency of such audits is also based on risk. Periodically, internal auditors should conduct AML/CFT audits on a bank-wide basis. In addition, internal auditors should be proactive in following up their findings and recommendations.18 As a general rule, the processes used in auditing should be consistent with internal audit’s broader audit mandate, subject to any prescribed auditing
requirements applicable to AML/CFT measures.

27. In many countries, external auditors also have an important role to play in evaluating banks’ internal controls and procedures in the course of their financial audits, and in confirming that they are compliant with AML/CFT regulations and supervisory practice. In cases where a bank uses external auditors to evaluate the effectiveness of AML/CFT policies and procedures, it should ensure that the scope of the audit is adequate to address the bank’s risks and that the auditors assigned to the engagement have the requisite expertise and experience. A bank should also ensure that it exercises appropriate oversight of
such engagements.

Why SME lending doesn't make sense for our banks, according to the RBA

It's time that our banks started to be upfront about lending to small businesses. It doesn't make any sense for them and they only do it to access cheap deposits.

The Reserve Bank of Australia issued an interesting report in October 2015, the main focus being on leveling the playing field in residential mortgages between the Big 5 banks and the smaller ones.

However, it also succinctly highlighted why SME lending is so unattractive for our banks. They need 4 times more of their own capital to lend to a small business than the amount required to advance a residential mortgage loan. Add in the costs of dealing with the complexity of business lending and it is clear why it is such an unattractive business for them.

And with the looming regulatory capital changes ahead, SME lending is going to become a lot less attractive: up to 10 times less in fact.

Thankfully, the Alternative Finance market is now developing but, if not actively supported by our policy-makers,  it will take too much time to plug the gap that really needs filling now, not in 5 years time.

Let's hope Canberra is on to this.