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Melbourne APEC Finance Quarterly Issue 7, December 2009
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Welcome to the newsletter of the Melbourne APEC Finance Centre. In our 7th edition we look at important, contemporary issues impacting the global economy and provide an insight to a review recently undertaken comparing the effectiveness of pension schemes in 11 countries. Specifically, University of Southern California's Professor J. Kimball Dietrich examines the challenges the US Federal Reserve faces in relation to unwinding their massive liquidity injections; Ernst & Young’s Tim Coyne comments on how Asia countries should approach their Basel II priorities, Melbourne Centre for Financial Studies Director, Deborah Ralston overviews the recently released Mercer Pension Index, and Australian APEC Study Centre Director Ken Waller provides a summary on the recent 2009 APEC Lecture with guest speaker David Murray AO. Wishing you a very happy holiday season! ISSUES FACING THE U.S. FEDERAL RESERVE AS LIQUIDITY PROVIDER DURING THE GLOBAL FINANCIAL CRISISJ. Kimball Dietrich, is Associate Professor Finance and Business; Marshall School of Business, University of Southern California
U.S. Monetary Policy Reaction to the Financial Crisis in 2008 and 2009 Starting in mid-2008, the central bank of the United States, the Federal Reserve System (FRS), injected an unprecedented amount of liquidity into the U.S. financial system. The FRS consists of 12 semi-independent banks and the Board of Governors in Washington, D.C., coordinated through a central policy-making committee, the Federal Open-Market Committee (FMOC). The Federal Reserve’s policies, as is the case for all central-banks, are implemented through changes in its aggregate balance sheet, the sum of all 12 regional Federal Reserve banks’ balance sheets. By purchasing or borrowing assets from the private sector, the liability side of the balance sheet for the FRS increases the monetary base, or the sum of currency and bank reserves. The chart below demonstrates the enormous impact of a sequence of actions taken by the FRS to increase the monetary base in the period until October 2009. The monumental increase in the monetary base was accomplished through a sequence of actions expanding the historical role of the FRS beyond interactions with commercial banks to a broader class of financial and nonfinancial institutions. These actions are discussed in the following section.
Source: Federal Reserve Bank of St. Louis, Monetary Trends, November 2009 Changes in Investments and Loans Until the summer of 2008, the FRS restricted its purchases of assets to those issued or guaranteed by the U.S. Treasury and loans to commercial banks collateralized mainly by those same assets. While procedures changed for collateralized loans to banks and advances to foreign central banks, the traditional channels of FRS credit were used until the end of 2007. The initial innovations were to extend lending to commercial banks to longer terms and by auctions rather than traditional “discount window” lending and were augmented by promises of dollar loans to international central banks facing increased demand for dollars. These expansions of FRS purchases and credits in non-U.S. Treasury markets are of unprecedented size, more than doubling its balance sheet and representing an enormous intervention by the FRS in non-traditional central-bank transactions in many different credit and financial markets. These interventions were justified as necessary to restore financial markets severely disturbed in the crisis worsened by the failures of Bear Stearns, Lehman Brothers, and problems at AIG and the money market funds beyond those being experienced by commercial and investment banks. These actions are credited by some for avoiding a calamitous collapse in the global financial system. We do not question that theory here but focus on the problem posed by this expansion of the FRS balance sheet into new investments and advances of credit. The expansion of FRS liquidity programs are shown in the following table published by the Federal Reserve Bank of New York, where the credit-market intervention tools used by the FRS until 2007 are represented by the first two columns of the table.
Impact on Financial Markets By the middle of 2009, most of the short-term credits to non-banks were winding down as short-term money market conditions returned to conditions more normal in terms of credit-risk spreads and in some cases more normal levels of activity. As these advances have declined, the FRS has moved to stimulate the asset-backed securities markets considered important to restoring consumer and other credit flows to pre-crisis levels. The following figure captures the changing composition of the FRS $1 trillion plus injection over the course of the last two years. Initially, the FRS reduced holdings of U.S. Treasury securities and made loans to the facilities intended to improve money-market conditions. Starting in late 2008 to the present, the FRS has not only supported the long-term securities markets by restoring its holdings of U.S. Treasury securities, it has supported a large increase in consumer finance by acquiring housing agency debt and mortgage-backed securities. It officially announced on November 4, 2009, its intention to increase these latter two holdings to $1.25 trillion by spring 2010.
The most obvious consequence of these FRS credit activities is to have pumped up the level of bank reserves to unprecedented levels. The following chart shows holdings of commercial bank reserves at the FRS divided into two parts: required reserves stemming from banks’ transaction deposit accounts (a relatively small amount) and a massive amount of excess reserves, summing to around $1 trillion. These excess reserves are a potential source of bank lending, deposit creation, and hence money supply expansion and inflation and thus a threat to money market stability. Although the FRS pays interest on these excess reserves a little below the interbank rate, any increase in demand at higher rates acceptable to banks in terms of risk could result in an explosion of private bank credit in financial markets unless these excess reserves are neutralized.
The Current FRS Policy Challenge The major question facing the FRS is how to reverse the huge (over $1 trillion) injection of liquidity to avoid inflation and consequent adjustments in interest and exchange rates. The FRS is obviously aware of the challenge it faces. Many FRS officials, including Ben Bernanke, the Chairman of the Federal Reserve Board of Governors, and the president of the Federal Reserve Bank of New York, William Dudley, have addressed the issue of offsetting the threat of these excess reserves in speeches. Research departments of FRS have studied the effect of these excess reserve and ways to drain bank reserves from the system without disrupting markets. Two ways of neutralizing these holdings of excess reserves have been put forward most often. The FRS now has the authority to raise the interest-rate paid on excess reserves so that banks may be willing to hold them even if other investment opportunities begin to look attractive. That is, banks may be induced to sit on excess reserves. The second means, that has been tried on an experimental basis, employing temporary sales of FRS assets (like mortgage-backed securities) along with agreements to repurchase them, so-called reverse repos. These temporary sales drain reserves out the system with a commitment to return them when the reverse repos mature. Two concerns, however, trouble money-market observers. First, it is always hard to get money back after you have given it away. Banks might require impossibly high interest on reserves to sit on them. Second, and more importantly, most of the mortgage-backed securities and agency debt issues that are available and have been proposed for reverse repurchase agreements are backed by recently made government guaranteed mortgage loans or other credits. Some market observers believe that the credit quality of these loans, many refinanced mortgages coming out of the subprime collapse, will not perform well and have pointed to increasing delinquency and defaults of these mortgages. The ability to sell loans of decreasing credit quality could impair the FRS’s attempt to withdraw reserves. In summary, the FRS will need to exhibit extreme discipline going forward In any case, all of these reserves have the possibility of becoming the focus of political pressure on the FRS. Reviving the housing market and solving the lack of credit for small businesses are hot political issues that could lead to attempts to interfere with the FRS attempt to take the $1 trillion back from the money market. The FRS will have to exhibit extreme discipline in the months ahead if it is to run reserves in excess of $1 trillion or more without seriously disrupting markets. THE ASIAN BASEL II AGENDA – CONSIDERATIONS FROM THE GLOBAL FINANCIAL CRISISTim Coyne is Partner, Financial Services, Ernst & Young.
The Global Financial Crisis has challenged risk precepts in many Asian countries In the recent 12 months, the emerging issues of the global financial crisis have challenged the disciplines and developments of risk and capital management over the last few years. In the period prior, many countries and banks had progressed and indeed adopted the Basel II Accord requirements through their national regulatory systems. However, notwithstanding improvements in measuring, calibrating and monitoring risk, something was missed. A range of reviews2 across the globe has focussed on the adequacy of the approaches undertaken and what lessons can be learnt to ensure that economies and countries are better prepared and able to withstand a fundamental meltdown of confidence in markets. Global policy makers have framed specific objectives to be co-ordinated via the FSB As a result of the crisis, the G20 Leaders have given high priority to international cooperation with respect to reshaping global financial regulation and charging the Financial Stability Board (FSB) with the coordination of national policy makers and international standard setting bodies including, the International Accounting Standards Board (IASB), International Organization of Securities Commissions (IOSCO) and the Basel Committee, in the framing of this new regulatory paradigm. Specific objectives of the G20 summits in London and Pittsburgh were:
The BASEL Committee is also taking steps The Basel Committee is taking steps to revise and strengthen the Basel II framework in a number of key areas: (a) Higher capital for complex and illiquid assets and off-balance sheet exposures via:
There has not yet been an indication by the US Agencies or the FSA regarding the implementation of these changes. The Basel Committee timetable for implementation is December 31, 2010 for the Pillar 1 and Pillar 3 changes, and immediately for Pillar 2. (b) The Basel Committee has also committed to issuing proposals before the end of this year which will:
While the Committee has indicated that calibration of these new proposed requirements will be completed by late 2010, it has stressed that implementation standards will be developed to ensure a phase-in of these new measures that does not impede the recovery of impacted firms. Asian governments and regulators Given the experience of the US, UK, Europe and Australia during the crisis, there are a number of fundamental issues that arose which could render the effectiveness and implementation plans of the more advanced Basel II requirements throughout Asia less reliable. This may require Asian regulators and governments to carefully consider:
When critically assessed it would seem appropriate for Asian regulators to determine the cost and benefits in their moves to adopt Basel II in its more advanced form given the developments that the GFC has required. So in conclusion - where to start? 10 Global priority initiatives: Given the above considerations, there are many priorities for Asian regulators to consider as part of how they will require banks to respond to the Basel changes. The top 10 priorities we anticipate for banks are noted below:
These priority areas are not dependent on Basel or other regulators but will be reflected in one form or another in refreshed regulation and /or regulatory expectations globally. 2FSA: A regulatory response to the global banking crisis: Turner Review March 2009, A review of corporate governance in uk banks and other financial industry entities, July 2009: Walker Review MELBOURNE MERCER GLOBAL PENSION INDEX Deborah Ralston is Director of the Melbourne Centre for Financial Studies and Professor of Finance at Monash University.
Superannuation is firmly in the public eye in Australia. It is a long time since the superannuation system has attracted so much public attention in Australia. Over recent months, the combination of the impact of the Global Financial Crisis on superannuation savings, the Henry1 and Cooper reviews and the decision in the last federal budget to raise the threshold for the age pension have galvanised the public’s interest in our retirement and superannuation systems. So how are we doing? The answer has to be mixed. There are aspects that are good, if not great, others which are average and some aspects which could be described as plain ugly. The Melbourne Mercer Global Pension Index provides an International Comparison Some of the good aspects of our retirement system are highlighted in a recent report, the Melbourne Mercer Global Pension Index, published by the Melbourne Centre for Financial Studies in conjunction with Mercer. The Index provides an international comparison of the adequacy of benefits, sustainability and integrity of retirement systems in 11 countries around the globe: Australia, Canada, Chile, China, Germany, Japan, the Netherlands, Singapore, Sweden, the United Kingdom and the United States. The adequacy of benefits – or how much income is available to a retiree – was given the highest rating in the index. The Netherlands (80.5) and Canada (76.2) scored highest in this index due to the level of the minimum public pension and a relatively high net replacement rate of income for median income earners. Australia was in fourth position in the adequacy sub-index with a score of 68.1. Japan had the lowest score at 39.2. In the sustainability sub-index, participation in private pension plans and the level of pension assets (expressed as a % of GDP) were the two major factors. Sweden (75.2) and Australia (71.0) rated the highest on this sub-index. The integrity sub-index was based on an assessment of four key areas – prudential regulation, governance, risk protection and communication of private pension provisions. The highest rating countries for the integrity sub-index were the Netherlands (88.2), Australia (87.8) and the UK (86.3). What this study highlights is that no system is perfect and no country achieves the highest classification. The following table shows the overall index value for each country, together with the index value for each of the three sub-indices: adequacy, sustainability and integrity. Each index value represents a score between 0 and 100.
The report ranks the Australian retirement system second only to the Netherlands. A major strength of the Australian system is its coverage of almost 90% of the workforce. This contrasts with less than 60% in countries such as the UK and USA and around 20% in China. Another key strength is the depth of the accumulated savings pool. Mandatory contributions have swelled the funds management industry in Australia to almost $1.2 trillion, the 4th largest pool of managed funds in the world and the largest in Asia. And finally, also worthy of note is the integrity of the private pension system, that is, its regulation and governance. An aspect of the Australian retirement system where there is clearly room for improvement is the relatively poor adequacy of benefits paid to retirees. In terms of adequacy we rank fourth behind the Netherlands, Canada and Sweden. The study suggests that the current debate on increasing the 9% superannuation contribution has merit. Also needing attention is the heavy emphasis on a lump sum payout on retirement. The increased longevity of the population requires additional products which can ensure a continuous income stream in post retirement years. Costs and efficiency are negatives in Australia Despite the strengths of the system, costs and efficiency represent a big negative for the superannuation industry in Australia. There is little point in raising the contribution level unless superannuation funds operate efficiently and generate an appropriate return on the funds invested. Investment and Financial Services Association (IFSA’s) 2009 report on International superannuation and pension fund fees, conducted by Deloittes, examines superannuation and pension funds in six countries: Australia, Denmark, Japan, the Netherlands, the UK and the USA. As this study shows, while the very largest Australian industry and corporate superannuation funds are competitive with their international peers, on average Australian super funds are considerably less efficient. Economies of scale are critical to reduce the costs of superannuation funds. Australia currently has 381 superannuation funds with assets over $50m, 200 funds with assets in excess of $200m and an average fund size of $2.38bn. The Deloitte’s study shows that the expense rates of Australian industry funds decline from 2.02% for funds under $50m to 1% for funds over $5bn. In terms of international standards, though, $5bn is still small scale. Only funds which reach a sufficient operating size to develop their own in-house investment management can significantly reduce costs. While scale is critical, costs are also higher in Australia for other reasons. Administrative costs tend to be higher due to a lack of automation and duplicate accounts, problems that have largely been eliminated in more efficient systems. Investment costs are also higher due to a higher proportion of defined contribution funds in Australia, higher asset allocation to growth assets and a greater reliance on active management approaches. Regulation may be required if market forces don’t address competition; superannuation efficiency. International comparisons suggest that the industry also suffers from a lack of competition. Choice of Fund policy which was introduced to drive fees down by encouraging greater competition and efficiency in the industry has largely failed. Only a small proportion of members have elected to choose a fund with a superior investment option, with most remaining in the same fund and in a default option. Consequently, the need to reduce costs and encourage greater efficiency through rationalisation of the superannuation industry is imperative. Regulation may need to intervene in a case where market forces are not achieving an efficient outcome. It is safe to say that with the release of the final report and recommendations from the Cooper Review into Australia’s Superannuation System on 30 June 2010, we will see the way forward to a much more efficient and cost effective industry. Overall though, the Australian retirement system stands up quite well Nevertheless, despite its deficiencies and the need for on-going policy review, the Australian retirement system stands up well on an international basis and provides something of a role model for those countries seeking to develop a retirement system. A healthy and robust retirement system rests on an efficient superannuation system. Getting it wrong will impact not on the quality of life for those who retire but on generations to come who struggle to support the costs of an ageing population. 1Henry and Cooper reviews are concerned with Australia’s future Tax System and Superannuation system respectively. CHALLENGES FOR APEC IN THE POST GLOBAL FINANCIAL CRISIS ERA Ken Waller is the Director of the Australian APEC Study Centre at RMIT.
David Murray OA, Chairman of the Future Fund, addressed these challenges in the 2009 APEC Study Centre Lecture series in Melbourne on 1st December. This note records some of the key points of the lecture.
He noted that the Asian region is weathering the global financial crisis, and this based on a number of factors, including improving current account positions over the last decade, greater exchange rate flexibility, some improvements in major global imbalances and the fact that financial systems in the Asian region are generally more robust that they were a decade ago. APEC had contributed to the strengthening of regional financial systems through a range of capacity building initiatives, including those developed by the Australian APEC Study Centre, to support institutional reforms and to deepen markets. He commended APEC for the success that had been achieved in promoting the conditions for growth, stability and economic integration in the region. Successive Australian governments had provided bipartisan leadership in promoting APEC as the region’s major economic forum. While pursuit of the open trade and investment goals APEC had set for itself were not easily attainable, he commended APEC’s influence in helping contain any immediate break-out in protectionism in the global financial crisis. Economies realized the dangers of retaliatory action at this time. Notwithstanding the relative strength of the Asian region, including the continuing strong growth of China and India, shocks will continue to occur. The region is susceptible to energy price volatility, disruptions to food supplies and to pandemics. The interdependency between Asia and the US and Europe means that the region will continue to be subject to future global shocks. Achieving a stable US dollar/yuan relationship remains as a major challenge. Mr. Murray noted that changes now under consideration in the G20 and the Financial Stability Board are highly relevant to global financial stability and therefore to APEC and to the region. He observed that reconciling the different positions within APEC members on some of the issues at the centre of the global financial crisis would be challenging. Underlying causes of the global financial crisis were excessive leveraging, poor regulation and supervision. Key proposals now before the international community included measures to enhance the capital base of banks and other major financial institutions and constraints on leveraging, improving disclosure and the role of credit rating agencies and constraints on the level and structure of compensation for executives of institutions whose activities could materially impact on systemic risk.
As regards disclosure and the role of credit rating agencies, Mr. Murray noted that reliable credit ratings are fundamental to a sound financial system yet there had been a serious break down in the credit rating function. He also noted that prior to the crisis, major banks had observed the requirements of the Sarbanes Oxley act, had conformed with regulatory capital and supervisory requirements and yet a number of major institutions had failed – in a period notable for regulatory over-kill. He believed that the reason why some had failed and others had survived could be found in the business models employed and in institutional culture. Some models were based on growth at any cost and compensation based on growth related bonuses. The banks that survived had maintained a scientific approach to risk management, pricing risk and the allocation of capital on prudent basis and within solid governance arrangements led by experienced and well motivated boards. He questioned the value of a prescriptive approach to remuneration for bank executives, noting that ultimately, the alignment of a sound business model and culture were at the heart of a successful corporation. There were challenges ahead in aligning monetary policy and inflation objectives. Asset prices needed to be taken into account in policy measures to stabilize prices.
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Drawing on his experience as chairman of the APEC Business Council’s Advisory Board (ABAC) Finance Working Group during the Asian financial crisis, he noted the shock to Asian businesses over the severity and the speed of contagion of that crisis. At that time, ABAC advised APEC Leaders and Finance Ministers of the need to improve macro-economic policy frameworks, to improve risk management in banking systems, to price and allocate risk to reflect the cost of capital and that risk allocation should be supported by effective governance arrangements. He observed that similar advice was now being provided to governments by the G20, the IMF and the Finance Stability Board.
Mr. Murray noted that banks would be required to increase capital to cover existing debts and to cover risk through the economic cycle. Additional capital would be needed as banks brought previously off-balance sheet activities onto the balance sheet. These measures would impact on banks’ competitive advantages and in particular those with cross-border operations. He observed that there could well be resistance to the implementation of new capital standards. A question to consider is whether the call for increased capital buffers and other measures being proposed for Europe and the US are relevant to Asian economies. 
Improved productivity in the US and Europe is important in redressing global imbalances. For this to occur, investment is needed, including foreign direct investment in key ageing industry sectors in those economies. However, political barriers impeded the flow of new capital, particularly from foreign sources. With strong growth in the Asian region and the region’s rising share of global gdp, there are now great opportunities for the region to attract capital. Asian capital markets need to be deepened and reforms to legal systems would be necessary in some economies to facilitate capital flows. Mr. Murray noted that APEC is very well placed to respond to these challenges and to promote structural and institutional reforms to realize the great opportunities ahead. Australia is very well placed in the region with a sound and proven regulatory system and with efficient financial markets and deep expertise.