They said it would never happen again. The collapse in 2005 of property financing firm Westpoint was branded a “national shame” and sparked a royal commission that was meant to overhaul the local regulatory framework and prevent a repeat.
But it has happened again.
The collapse of Banksia Financial Group in late 2012, which left $650 million of funds in jeopardy, is irrefutable proof that money lost by investors in Westpoint was largely in vain. More important, it is a timely reminder that individual investors cannot lean on the regulator to protect them.
The starkest lesson from the collapse of Banksia – and sadly the failures that preceded it – is the vast gulf between heavily regulated banks and unlisted, unrated institutions that essentially engage in bank-like activities.
Not even close
Banksia’s business model was not dissimilar to that of a bank. It borrowed money from the public by issuing debentures and then lent the funds to the public by financing residential and commercial mortgages. But despite its business and unlike its name, it was not even close to being a bank.
Banks, or regulated authorised deposit-taking institutions (ADIs), are carefully monitored by the Australian Prudential Regulation Authority (APRA), which is tasked with enforcing the Banking Act and protecting depositor funds.
It does this by enforcing capital requirements (the amount of equity a lending institution must hold to protect against bad loans) and overseeing the policies, procedures and the quality of loans. ADIs have the additional benefit of the federal government guarantee on deposits in APRA-regulated banks. The government is in effect making a statement that it trusts APRA to regulate the banks properly to the extent that they will pay out funds lost to depositors.
APRA oversight reduces a number of risks for investors but there are two factors particularly relevant to Banksia.
The first is that banks must hold a minimum level of equity capital to protect against bad loans. This means that if a borrower defaults on a loan, the owner of the bank, which is the shareholder, loses money. The more capital the institution holds, the more can be lost before depositors are affected. Most banks must hold $10 of capital for every $100 of loans written.
Banksia had less than $3.60 for every $100 of loans. So when a review of the loan book revealed more losses, it didn’t take much for debenture investors to have their funds threatened.
After the Westpoint failure, the Australian Securities and Investments Commission (ASIC) did not overhaul the legislation governing debentures issued by unlisted non-ADI lenders but implemented an “if not, why not” regime. This involved setting eight benchmarks, including minimum capital ratios, loan-to-value ratios on specific loans and disclosures about funding and loan profiles.
But missing the benchmarks doesn’t prevent institutions from raising the funds. It only means they have to disclose this to investors in the prospectus.
This puts the onus on the individual investor to identify the risks of the non-regulated institution that has issued the debenture.
The mere fact the institution has been approved to raise funds is not an endorsement that it is safe.
There is a strong case to be made for regulation to be changed so that benchmarks are enforced and companies that don’t comply are shut out of the funding markets.
ASIC has announced it will set up a taskforce to look into the debenture market, where 18 issuers are still raising money in this format. Of these, 12 miss ASIC’s benchmarks.
In the interim, investors and their advisers will be well served to ensure they conduct thorough research before committing a cent to non-APRA regulated lenders.
By the same token, investors should not put absolute faith in the prudential regulator to protect them. Sometimes APRA, at least in a theoretical sense, doesn’t mind if you invest in risky securities.
Bank tier I hybrid securities are an example of this.
These securities constitute the equity capital of a bank and form part of the $10 required to protect depositors against losses for every $100 of loans written. APRA’s remit is to protect depositors, so it requires that hybrids are structured in such a way that if a bank runs into trouble, investors will take the hit ahead of depositors.
After the global financial crisis, regulators deemed that bank hybrids were not sufficiently equity-like and did not adequately protect depositors. As a result, APRA, in applying global rules, has made the banks tweak hybrids so they are more able to absorb losses. This includes automatic conversion to equity under certain circumstances.
Are hybrids OK?
On the other hand, ASIC, as the consumer watchdog, has a remit to ensure that the investor in the hybrid is fully aware of the risks being taken in providing this form of capital to the bank. It has warned investors that hybrids should not be confused with debt.
This does not mean bank-issued hybrids are a poor investment. A decision to invest in bank hybrids should be based on a number of factors. These include whether the investor favours growth over income, as well as the outlook for share returns and dividends.
A key decision is whether the investor feels the return of the security is sufficient to compensate for the risk of being placed lower in the capital structure and of forgoing the deposit guarantee that comes with a term deposit.