Before a bank will lend to a personal borrower, a full credit check is done against records with the reporting agencies. If you miss a credit payment on a credit card, mortgage or utility, a black mark lurks in your records for the lender to assess. So why isn’t there a similar arrangement for personal depositors when lending money to financial intermediaries?
Institutions have ready access to intimate financial details on borrowers, but when the roles are reversed there is nothing similar. Available information is often received too late, usually coming after a failure. In the interim, the investor is subjected to the usual advertising, orchestrated by the institution in self-interest.
In establishing and maintaining an orderly market, the current credit reporting on retail borrowers serves a useful role, by allowing lenders to rate borrowers according to their history. Without it, good borrowers will subsidise the bad, with lenders increasing the risk premium or even declining requests outright.
From March 2014, the system has been further refined. Now positive information, such as timely servicing of credit obligations, will also be reported, providing a more complete picture of borrowers (see creditsmart.org.au). Good quality borrowers should be able to negotiate better credit terms as a result.
Financial institutions are borrowers too
This is fair enough, but just as retail borrowers access credit from lenders, the lending industry itself accesses credit from ordinary savers through deposits, debentures, and bonds, as well as more complex intermediation such as insurance premiums for risk transfer. While we see borrowers as diverse individuals, it is easy to forget that lenders represent individuals too in the ultimate analysis: shareholders, investors, financiers and counter-parties and employees.
Financial intermediation - the process of converting retail savings into retail borrowings - serves a critical need to oil the wheels of commerce. Most regimes have put in place controls such as capital, governance, risk management, disclosure, external audit and prudential oversight to facilitate order, consumer protection and market confidence.
However, just as some retail borrowers default in their obligations for a range of reasons – from temporary financial difficulty, borrowing beyond prudent capacity, lack of testing for interest increases, even deliberate unwillingness to meet obligations - so do financial intermediaries.
‘Pretend’ capital that fails to absorb losses as it should, poor governance beset with unacceptable conflicts of interest and duty, skewed risk management that ignores the business downside, non-existent or obfuscating disclosure, failed audit processes and ineffective oversight have all contributed to the many reported failures. Storm, Westpoint, Australian Capital Reserve etc. are poignant reminders. Reported failures must remind us that problems develop over time, and at any time there are a range of circumstances which may inexorably lead to failure. Things do not happen overnight.
As all human activity involves humans, regardless of legal fictions such as partnerships, joint ventures and corporations, the unavoidable impact of human foibles lurks: negligence, placing self-interest ahead of fiduciary duty, a false confidence of being able to get away with default, fraudulent intent, and plain greed. Operational risk and environmental changes complete the cocktail.
Reported failures and near failures tell the same story: poor asset liability management where liabilities are assumed to be rolled over indefinitely, exorbitant asset valuations, inability to withstand market volatility, including extreme events. Piling rules onto existing abused rules might whet regulatory appetites, leading to false complacency.
Where are the signals of impending trouble?
To restore balance, intermediaries who access public savings for lending should be subject to the same discipline as personal borrowers. Savers should be able to know, on demand, their credit history: complaints, delays in payments, disputes and their outcomes, so that they may proceed on objective data, rather than rumour or blind faith as at present.
This suggestion may be opposed because premature information may spread panic, destroy confidence, cause a run and precipitate a crisis. Difficult circumstances may then become real disasters. Confidence and market stability will suffer. This exposes the uninformed customer to significant risks.
Another likely objection is the business confidentiality of the intermediary. The objection can be countered using the very rationale now relied upon by privacy use to facilitate credit reporting (see www.oaic.gov.au): in balancing social objectives versus individual privacy, some loss of privacy must be countenanced. Likewise, in protecting investors, some dilution of business confidentiality is appropriate. Let us treat the lending goose on a par with the retail gander.
The current prohibition against directors trading whilst insolvent has not helped victims of collapsed institutions in sufficient time, going by the empirical evidence. Post mortem reports cannot reduce the grief.
At what point in the various reported failures should the clueless investor have had some signals of impending trouble? More importantly, at what time should we reasonably warn consumers not to risk their money in a business that is spiralling towards extinction? With memories of the GFC fading, it is easy to forget the lessons of finance and real estate investors and off-the-plan buyers getting burnt.
It's not beyond the skill of experts
This can and should be overcome by designing objective parameters, similar to a traffic warning system, of green (solvent, normal); amber (some difficulties, being worked through); red (invest at your peril). Greater granularity could be achieved through additional layers of colours that signal, for example, qualified audits, regulatory intervention, external shocks etc.
Traditionally, rating agencies provided an assessment of various products issued by intermediaries, but even this has declined for retail products as agencies now need a license. In practice, this was always inconsistent in the retail market, unlike the wholesale market where it is standard practice. Many issuers of retail products are not rated at all, including some of the notable failures in Australia where advisers were encouraged by excessive commissions. Where they are rated, the ratings have not always reflected the underlying credit worthiness of the issuers, especially keeping pace with changing issuer fortunes. Negligence, incompetence and outright complicity have all been noted. The Parliamentary Inquiry into the Trio Super Fraud illustrates the weaknesses well.
It is clear that the current reporting system is skewed towards lenders and against investors. This is symptomatic of our enforcement culture in finance. Too often, we see intermediaries being prioritised over consumers, such as when fictional legal constructs are placed ahead of ‘flesh and blood’ humans.
The first step is to recognise the glaring anomaly, and debate how it might be addressed. Our financial engineers, who have devised derivatives upon fuzzy derivatives, must surely be equal to the challenge.
It should not be beyond the wit of man to devise a rating method. An impartial agency that will mandate data and make them available publicly would have social benefits more than the effort. David Murray’s Inquiry would do well to explore this.
Ramani Venkatramani is an actuary and Principal of Ramani Consulting Pty Ltd. Between 1996 and 2011, he was a senior executive at ISC /APRA, supervising pension funds.