FoFA Fearmongering A Blow To Deregulation

Never has so little been met with so much panic.

Alan Kohler has described the Abbott Government’s amendments to Labor’s Future of Financial Advice (known as FoFA) reforms as unseemly, suspicious and like blessing union corruption. Bernard Keane believes the Government’s plans are “a big blow to consumers’ rights”. Ian Verrender, at The Drum, says the changes will be “enormous”.

The Abbott Government intends to cut regulation across the board. But the hysteria about these FoFA amendments demonstrates how hard it is to get even minor deregulation done.

The original FoFA reforms were in response to a corporate collapse: that of Storm Financial and Opes Prime in October 2008, at the beginning of the Global Financial Crisis.

In 2010 the Labor government introduced a huge package of new regulations, new powers for regulators, and new obligations on firms that offer financial advice.

For our purposes, the key ones were a ban on financial advisors earning commissions from recommending investment products, and another one that required financial advisors to act in the “best interest” of their clients. The bulk of FoFA came into effect in 2012.

Now in 2014 it’s being amended.

That’s amended, not repealed. A casual reading of the press would suggest that Arthur Sinodinos, the Assistant Treasurer, plans to rip away every vestige of FoFA.

Instead, the Government intends to distinguish the regulation of personal financial advice – that given by an advisor who works closely with you, understands your specific goals and needs – from the regulation of “general” advice – that given over a bank counter, over the phone, or through promotions, investor newsletters, or advertisements.

For personal advice, everything important in Labor’s FoFA remains. Commission-driven advice is still banned. Advisors still have to act in their clients’ best interests.

The first controversial change is that the best interest rule is being modified to remove an ambiguous and all-encompassing “catch-all” provision.

There are nearly a dozen criteria that are used to determine if an advisor is acting in the best interest of their client. Things like: does the client understand the product? Is the advisor qualified to give the advice? These remain.

The catch-all provision (Section 961B(2(G)) of the Corporations Act if you’re playing along) is basically a “anything we haven’t thought of” step. It’s absurdly broad.

How – without scrutinising everything about a client’s life and finances, scrutiny which would cost thousands of dollars – could you be sure you knew absolutely everything a court might decide constituted the client’s best interests?

Would you want to give financial advice under that sort of legal uncertainty?

Simply put, FoFA’s best interest, know-your-client rule is massively, dangerously overwritten. The Government wants to slightly relax it. Not remove it.

The second change concerns general advice. This covers things like bank tellers making recommendations about travel insurance. Here, commissions, now banned, are to be made lawful once more. Sounds terrible? Hardly.

Commissions are a completely legitimate form of employee remuneration. FoFA describes commissions as “conflicted remuneration”. This is nonsense. A commission, in practice, is not so different from a sales target, or (for higher paid professions) a key performance indicator, or (for higher paid again) an annual bonus. It’s just a different way to slice the salary pie.

If you go into a bank and ask for recommendations about financial products, you ought to expect that they will try to sell you one of their products. Just like if you ask a Telstra store employee what mobile phone plan they recommend they’re probably going to recommend a Telstra plan. Regardless of whether they’re being paid a commission.

Banning commissions in these circumstances achieves no policy goal. Remember, all advisors, including general advisors, are still required to work in their clients’ best interests. Removing the ban on commissions just cleans up a little regulatory ludicrousness.

Perhaps you disagree with the Coalition’s FoFA changes.

But it is true that Labor’s original FoFA remains – in letter and spirit. It is not being gutted. The Coalition’s changes are not radical. They do not deserve the extreme hyperbole they have received.

More fundamentally, it is not the Government’s responsibility to restore the reputation of an industry.

Voluntary industry charters or private ratings agencies are common solutions to the reputation problem. Personal financial advisors had been reducing their reliance on commissions in the years before the FoFA reforms.

Regulation suppresses innovation, raises consumer prices, ties the sector down in compliance costs, and opens up opportunities for rent-seeking.

Indeed, rent-seeking is the real story of the FoFA reforms.

The battle here is between the super funds and the banks. Australia’s superannuation system has created a titanic financial industry based entirely on the compulsory acquisition of a portion of our salary. Super funds – particularly the union-managed industry super funds – lobbied hard for a crackdown on avenues of financial advice outside the superannuation system. With FoFA they got it.

Industry Super Australia is now predicting these minor FoFA adjustments will bring a wave of financial collapses. Sure they will. Storm Financial did not collapse because bank tellers were selling travel insurance on commission.

Where commentators fall on these changes is usually determined by their pre-existing attitudes towards the super funds and the banks.

Most of the debate has been a loose proxy for bigger questions about Australia’s financial system.

But minor tinkering of FoFA isn’t much to hang these questions on.

The backlash against the Government’s plans demonstrates just how hard deregulation really is – held back by a mire of special interests and an unfortunate natural human tendency for doomsaying and fearmongering.

Accountability Goes Missing In Iraq Bank Note Scandal

In February 1998, John Howard’s cabinet agreed to support American military action against Saddam Hussein. But three months later, in May, officials from Reserve Bank were secretly offering the Iraqi tyrant our unique plastic bank note technology.

This stupefying discovery was contained in the most recent Fairfax and Four Corners investigation, which aired last Monday night. Yes, the Reserve Bank scandal is worse if you put it in context.

Allegations that Reserve Bank subsidiaries used bribery to secure banknote contracts in foreign countries have been around for years. But bribery is one thing. This is something else. One arm of the Australian government – the central bank, no less – was trying to cut deals with a dictatorship that the rest of the Australian government was preparing to go to war with.

(At least the body at the centre of the last Iraq scandal, the Australian Wheat Board, was a private company. It did not travel on official passports. It did not represent the Australian government.)

Even more amazing – it was the Reserve Bank’s responsibility to enforce financial sanctions against Iraq.

The Reserve Bank’s actions in Iraq reveal a massive, endemic governance problem that goes beyond this scandal to the structure of the Australian regulatory state.

After the 1991 Gulf War and subsequent United Nations embargo, Iraq could no longer import its bank notes from printers in Britain and Russia. So the Central Bank of Iraq cobbled together its own printing equipment to do the job. The notes they produced were nicknamed “Saddam” bills – plastered with the tyrant’s face, they were easily counterfeited, badly devalued, and so poorly made that the ink ran.

In the late 1990s, the Iraqi central bank started looking around for a supplier to replace its shabby currency outright. Saddam Hussein was shown polymer notes. He loved them. So representatives of the Reserve Bank’s printing division popped over to Baghdad to spruik our merchandise.

Its trip had to be secret because, while they were there, 190 Australian troops were on the other side of the Kuwait border waiting for orders to attack.

The United States eventually passed the Iraq Liberation Act, and Bill Clinton ordered a bombing campaign in December that year.

The Reserve Bank is not just one of the most important government agencies. It is also the premier independent agency. It has been deliberately separated from the traditional Westminster lines of ministerial control. It does not take directions from elected representatives.

This governance structure is supposed to eliminate political interference in Reserve Bank decisions. But it also reduces accountability.

The two Reserve Bank subsidiaries involved in the scandal are even further removed from parliamentary oversight. Securency, which makes the high-quality plastic film, was a private firm founded in 1996 and 50 per cent owned by the Reserve Bank. (In damage control, the bank bailed out of Securency earlier this year.)

Note Printing Australia takes Securency’s film and produces banknotes and passports. It was originally a division of the Reserve Bank itself but was corporatised – that is, spun off and converted into a commercial corporation, seeking a market rate of return, but still wholly owned by the central bank.

And when did this corporatisation happen? July 1998. That is, while the division secretly had outstanding business with the Ba’athist government of Iraq.

The scandal occurred at the very moment when all the responsible institutions were being granted further independence; that is, being reformed to be less directly accountable to our elected representatives.

The Reserve Bank itself had just passed a major milestone. In 1996, Peter Costello released a statement on the conduct of monetary policy which formally confirmed the central bank’s independence from government. This was a big deal. It had been less than a decade since Paul Keating had bragged he had the Reserve Bank “in my pocket”.

While most commentators have focused on the monetary implications of this institutional change, the Iraq scandal shows that the central bank believed it could act independently of Australia’s foreign policy as well.

For the last few decades it has been fashionable to praise “independence” as a desirable attribute for regulators, bureaucracies and central banks.

The appeal is obvious. Politicians are venal creatures. The further we keep them away from government the better. The result of bureaucratic independence is – at its best – a technocratic rejection of politics.

But at its worst, independence fosters unaccountable bureaucratic fiefdoms pursuing their own agendas, backed x`by the full force of government but unconstrained by democratic norms like ministerial responsibility and public accountability.

In other words, exactly what we can see in the Reserve Bank scandal.

In its memo reporting back from the May 1998 Iraq trip, the Reserve Bank officials acknowledged that no banknotes could be delivered to Iraq until the United Nations embargo was lifted. But “nothing was stopping us to sign a contract and have products (banknotes, machines, etc) manufactured”.

You can imagine them patting themselves on the back for such clever, disingenuous reasoning. The Department of Foreign Affairs and Trade was not as impressed.

So why are we only hearing about all this now?

The investigations so far have made much of the failure of the Australian Securities and Investment Commission to chase down the bribery allegations. Once again, context makes it worse.

ASIC is one of the big three mega-regulators, along with the ACCC and APRA. All are blessed with formal independence from government. And all were being reformed in the early Howard years.

ASIC only gained its current form in (you guessed it) 1998, when it was given a new suite of powers and responsibilities. It has since gained a reputation for being capricious and draconian. In its actions against AWB, the judge accused it of bringing justice into disrepute.

Yet it has let this scandal slide. But don’t worry. According to ASIC, “the public can be completely and utterly confident in ASIC’s actions.”

We’re supposed to take it on faith that one independent government agency has fully investigated possible wrongdoing by another independent government agency.

There is nothing in the Reserve Bank scandal that should make us comfortable with how Australian democracy functions.

Losing Interest In Our Rate Obsession

As the 20th century opened there were 18 central banks around the world. One hundred years later there were 173.

But none of them have as tight a grip on the political culture as Australia’s Reserve Bank.

No other country grants so much mystical significance to their central bank’s interest rate decisions. We are obsessed.

Last Tuesday the bank lowered the cash rate to 3 per cent, releasing another torrent of claims and counterclaims. Wayne Swan declared it was testimony to his great management of the economy. Joe Hockey said the rates had been dropped to “emergency levels”. Retail banks were threatened. Peter Costello’s name was invoked.

Politicians have deified the Reserve Bank. It’s unusual for a politician to publicly second guess the board’s encyclicals. Happily, commentators do not share their faith. So last week, as always, columns were written and talking heads talked. Is the bank’s board being bold, prudent, reckless, negligent? Take your pick.

We’re so used to these theatrics that we don’t realise how unusually Australian it all is.

But compare how foreign politicians and parties view their interest rate movements.

For the British Conservative Party, low interest rates are merely a feature of a healthy economy – and not a particularly central one. Here’s a Google search of the Conservative Party website. The most concrete claim they make is that their hard-won fiscal credibility keeps interest rates low.

The Australian Liberal Party’s website shows a completely different picture. Here, low interest rates are themselves the goal. Interest rates will be lower under the Coalition. They’re higher under Labor. Gillard finally admits she has forced up interest rates. And on and on and on.

We can play the same game with the labour parties, although to be fair the difference is not as stark. Here’s the ALP, and here are their British cousins.

And the Americans? Well, in the 32,000 word, 55 page Republican Party platform (PDF), interest rates are mentioned … once. Even though it’s pretty plausible that extremely low Federal Reserve rates were a major cause of the financial crisis.

So yes, Australians are a bit different. Interest rates are the bread and butter of the political contest – as Australian as asylum seekers. The federal Liberal campaign in 2004 was almost entirely structured around interest rates.

In April this year Bill Shorten even suggested that knowledge of Reserve Bank meetings was central to political leadership in this country. Yes, we smugly all laughed as Shorten tried to correct Tony Abbott’s factual error with his own factual error (the bank meets the firstTuesday of every month, not the second). But more important was why Shorten thought Abbott’s mistake was a big deal: “when you want to be the alternative Prime Minister of Australia, interest rates is just such an important issue”.

And all this rhetoric for something governments have almost no control over.

The Reserve Bank is independent; it makes its decisions in private, pretending to know nothing of the busy political world outside its boardroom. When parties take credit for rate cuts or damn their opponents for rate rises, they are simply bluffing. They have no direct control over the rates. They have little indirect either. Of all the sources of inflation in a modern, open, liberal economy, national governments can only really influence one or two.

In other words, our politicians are playing a game with pieces they don’t control, but it’s worse than that. If rates go up, mortgage holders will hate it. If they go down, then the economy may be going down as well, but the Mum and Dad homeowner will be delighted. Throw into this mix the typical contrarian lines: the economy is “over-heating”; what about retirees? Nobody can win this game, but everybody is desperate to play.

A more interesting issue has arisen in recent years: we’re learning that even the Reserve Bank has only so much power over economy-wide interest rates.

Australia grew accustomed to the big four banks dancing to the tune of the Reserve Bank’s decisions. During the Howard years rate cuts were dutifully passed on to consumers. But history may record that as an anomaly – a short decade where retail banks and the central bank were aligned.

We tend to imagine anything that lasts a few years is natural and permanent. But Australia’s banking sector is still evolving since the financial liberalisation of the 1980s. So too is the Reserve Bank itself; it only achieved full independence in 1996.

When the Global Financial Crisis came, the close relationship between banks and the central bank broke. Few regretted this breakup more than the Labor Government. Now we have the embarrassing spectacle of a Government trying to bully mortgage rates down, and an Opposition pretending they possess a magic hammer that would set the banking system straight again.

Nothing frustrates politicians like powerlessness. For much of the 20th century, governments were able to control prices across the economy. They had many levers to do so – tariffs and taxes and quotas and so forth – and the public expected governments to pull those levers.

But the 20th century was a long time ago. The Reserve Bank cash rate is one of the few centrally planned prices left, and even then it set by a body independent of the government of the day.
When the Reserve Bank cut rates last week, Wayne Swan proclaimed this was the early Christmas present Australia’s hard-working families deserved.

But if rate cuts are gifts, does that mean rate rises are punishments? Of course not. Sometimes prices go up and sometimes prices go down. Our political culture needs to stop being so futilely obsessed with the Reserve Bank.

The World Will Be No Safer Under Basel III

The Basel Committee on Banking Supervision is about to introduce its Basel III accords, global regulatory standards which govern how much capital banks are required to hold.

But it’s not typically a great idea to introduce huge regulatory increases when the world is on the brink of economic collapse.

And the Institute of International Finance (IIF) suggests Basel III implementation could slice 3.2 per cent of GDP in Europe, North America, Japan and the United Kingdom in the next five years alone, and leave the global economy with 7.5 million fewer jobs.

Sure, the IIF represents more than 400 banks, so they would say that. Governments admit it will slow the economy, but by much less. (They would say that too.)

Basel III was developed in haste after the financial crisis. Like its predecessor, Basel II, its purpose is to ensure banks have an adequate buffer of capital if there is a bank run.

Regulators say capital requirements are necessary because governments insure bank deposits. The idea of deposit insurance is to guarantee depositors won’t lose their money if the bank goes under. But the insurance also means banks and their customers don’t wear the cost of wild speculation and risky banking practices. So regulators believe banks need to be compelled to be prudent.

In other words, a new regulation introduced to patch up the unintended consequences of older regulations.

The existence of Basel II in the lead-up to the financial crisis has always been a gaping hole in the theory that we should blame a lack of regulation.

But it’s worse. The Basel II Accords – designed to keep the banks secure, designed to protect the depositors against excessive risk-taking, designed by some of the world’s most intelligent people – were the primary cause of the crisis in the first place.

That is the conclusion of Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation by the political scientist Jeffrey Friedman and the economist Wladimir Kraus. The book was released in October.

Friedman and Kraus’s argument complicates both left and right crisis narratives. The causes of the housing bubble are well known: policies to boost home ownership, low interest rates, and Freddie Mac and Fannie Mae’s 71 per cent stake of the non-traditional mortgage market.

But explaining the housing bubble is just the half of it. You have to explain how that bubble turned into a banking crisis.

Basel II actively encouraged banks to hoard mortgages. Its capital buffer rules weighted mortgages far higher than business or consumer loans. When the bubble burst, the banks were holding a disproportionate number of dodgy mortgages because they’d been urged to do so.

This is not a completely new story. Friedman and Kraus give it empirical support. They show that American bankers weren’t actually that reckless. They favoured what they imagined to be safer, more expensive assets over cheaper, riskier ones. And the banks were nowhere near as leveraged as they had a legal right to be under Basel II.

Furthermore, it wasn’t “irrationality” that caused the crisis. That widespread theory assumes bankers and regulators had enough information to know what they were doing was bad, but they all went crazy and did it regardless. The irrationality thesis has no explanatory power.

It was just that everybody – regulators, bankers, politicians, investors – thought highly-rated mortgages were a lot safer than they were.

So how did the banking crisis become an economic crisis? Basel II, after all, was supposed to halt a contagion at Wall Street’s edge.

Friedman and Kraus argue that Basel rules are inherently contradictory. The capital buffers which Basel requires aren’t buffers at all. The idea behind capital buffers is, again, that if there is a run on a bank, the bank will be able to dip into reserves to survive. But if it uses those reserves, even in a crisis, it will suddenly be under Basel’s required capital threshold, and will be legally penalised.

As one economist pointed out, there has been little “consideration of the paradox that the buffer function of regulatory capital is limited because this capital is needed to satisfy the regulator”. When the banks hit Basel’s capital minimums in the last months of 2008, credit froze, and the “real” economy started to hurt.

So it is sickly perverse that Basel III’s main purpose is to raise capital minimums even higher. And analysts from the Cato Institute have argued that it “retains many of the weaknesses of its predecessors” – particularly “a highly gameable weighting system” that led to the hoarding of mortgages in the first place.

Basel III shows that governments are trying to fix the finance sector’s problem before they’ve figured out what the problem actually is. The first and most important question has to be why the crisis occurred. Answering that takes reflection.

But legislators work faster than academic economists. Already by 2009 politicians were running down new regulatory paths. In February that year Kevin Rudd had concluded that Basel II was “inadequate” and that it needed a successor. This is meaningless. All regulations were inadequate at stopping the crisis.

Anybody who says they’ve got a handle on the causes of a crisis that big and that complicated in its immediate aftermath is wrong. And they’re being deceitful if they say they know how to fix it.

The United States Congress passed the Dodd-Frank financial reform act six months before its own Financial Crisis Inquiry Commission released its report into the causes of the crisis.

Such is the false confidence of regulators and politicians.

Basel III standards are about to be disseminated around the world. There is no reason to believe that the economic system will be any safer or more stable. And it could be a lot poorer.