Regulation Looms

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By Greg Peel

Ever since the first cave dwellers started lending each other spears and flint stones, some power-that-be has attempted to regulate the market. Regulation always comes as a response to some disaster or other, and is always way, way behind the curve. Often regulation is applied in a hysterical knee-jerk response and can be more destructive than protective. In other instances regulations are rightly applied to protect the innocent.

The last big bit of legislation to hit the Australian financial industry was broker disclosure laws – the ones that ensure you now receive a 200 page report every morning from your broker of which 190 pages are a legal waiver. These “Chinese Wall” amendments ensured clients could not be ripped off by stockbrokers touting a deal for the simple reason their own firm was underwriting it. They also meant brokers and advisors must reveal whether they indeed own shares in a company they are recommending. They came about in concert with US changes, and despite the extraordinary amount of paper work involved are valuable in protecting innocent parties.

While these laws plug a hole, often regulation is put in place after some new financial product has imploded and there is much wailing and gnashing of teeth. While everyone is making money and happy, regulators couldn’t give a hoot. But as soon as the general public is hurt, the witch hunt begins. Pre-emptive regulation is considered to be against free-market principles, so new products are rarely scrutinised until great wealth has been lost. It doesn’t matter that those new products were often created with the specific intention of exploiting loopholes.

As soon as free-market principles result in innocents getting hurt, the regulators start playing the blame game and with the government on their back, start to look important by enacting all sorts of after-the-fact laws. It matters little that a quick look into something like – I don’t know, subprime mortgages? – might have resulted in earlier regulation, but then that might have interrupted lunch.

The problem with financial innovation is that by its nature new products will operate beyond existing regulation, and as soon as one door is closed innovators will set to work on opening another. To switch metaphors, regulators will stick their finger in one hole in the dike only to see another leak sprout beside it. Regulators cannot be clairvoyant, but they could try opening their eyes every now and again.

At least Australia’s new government has an excuse – it’s a new government. This morning treasurer Wayne Swan and corporate law minister Nick Sherry announced a “green paper” on new financial services industry regulation. Ostensibly a green paper is a draft which is open to scrutiny and invites industry representatives to contribute to its final form. The intention of this particular paper is for relevant existing state laws to be scrapped and a new national system established to regulate such services as mortgage broking, margin lending, non-bank lending, trustee funds, debentures, property “spruiking” and a whole range of credit card issues.

It’s pretty hard to argue that this is not a sensible move, as long as the government asks for and receives advice from the right people. One only need look at the Opes Prime situation to decide that laws on margin lending, for example, are long overdue. The fact that margin lending has been around for decades, however, speaks little for previous governments of any stripe, or for existing regulatory bodies. The credit crisis has shown ASIC up as being about as effectual as the UN (ie, not) and the ongoing role of the ASX ((ASX)) as both a regulator and corporate entity as bordering on criminal.

If you want to change anything, the first should be to remove the ASX’s powers to self-regulate in the very market from which it profits.

But there has not yet been more than cage-rattling on that front to date. Along with the government’s financial services green paper however, came yesterday’s indication by the treasurer that Australia’s “four pillars” banking policy will continue to be upheld.

This policy simply prevents any of the Commonwealth Bank ((CBA)), National Bank ((NAB)), Westpac ((WBC)) or ANZ ((ANZ)) from inter-merging. It was a policy first put in place in the 80s when Keating deregulated the banking industry, and its original intention was to protect The Bush. It now seems to have evolved into a wider policy of maintaining competition in the banking industry lest Australians be screwed.

Testament to the policy is the fact Australians pay such extremely low bank fees. Almost miniscule. That’s why you often hear praise for Aussie banks at barbeques and pubs.

The four pillars policy is not just an anachronism and an abject failure, it is quite simply hypocritical. Where’s the Four Supermarkets policy? Where’s the Four International Airlines policy?

As long as regulators keep a watchful eye – and yes, that’s a stretch – Australian banks could quite happily inter-merge without any elevation of risk to the consumer. Take CBA for example. It spent years alienating its customer base by closing branches and reducing personal interface wherever possible. Customers responded by leaving in droves. It has since spent years trying to go back the other way in order to try and win customers back.

Then look at Australia’s regional banks. Why do they exist? Because Australians had already made up their own minds that four big banks are just one big cartel anyway. If four big banks became three or two, you can bet your bottom dollar other financial institutions would spring up to service those disgruntled by a lack of competition. At least that’s something the government allows.

It has been argued the four pillars policy has protected Australia from massive subprime losses. That’s rubbish – no one stopped any bank from issuing mortgages of a subprime nature.

Anyway, it looks like we’re stuck with it. The big banks are annoyed because as a quartet they are each too small to have sufficient critical mass to be competitive on a global scale. Together that could be different. But one could argue that together they could have been Citigroup, and sitting on a 60% reduction in share price right now. We will never know.

It was noticeable that Wayne Swan did not mention St George ((SGB)) yesterday, nor mention anything about “five pillars”. UBS suggests we can probably take it as read that the government will not be opposing the Westpac-St George merger, as long as the ACCC doesn’t.

UBS also suggest the ratification of four pillars instantly makes regional and smaller banks more valuable, as the big four can only look downwards for acquisitive growth in Australia, not sideways. It will be interesting to see what transpires when the first Chinese bank sticks its hand up to take over CBA. Without market cap size the Australian banks would have to rely on government intervention to prevent such a move.

But on to the US. Apart from disasters in financial markets this past year the other issue has been rising food and energy costs. The Americans have decided food and fuel prices are high because of greedy speculation by the few and something should be done about it. The fact that the US is the most obese nation on earth, and consumes more petrol per capita than any other nation by a wide margin, has nothing to do with it.

Regulation in the most speculative markets of all – futures markets – is conducted in part by the Commodities and Futures Trading Commission. It is no secret that the CFTC is currently sniffing around and looking at ways to curb rampant speculation in futures markets, in order to bring down food and fuel prices for average Americans. And the CFTC has recently appointed a new commissioner – a highly ranked official in the National Farmers Union. You can imagine just what farmers think of speculation in futures markets.

As analyst Dennis Gartman yesterday suggested, “Our guess is that Mr Chilton will look and look and look until he finds the smoking gun he wants to find, and when it is found it will be confiscated…to much fanfare!”

What this means is stand for some potentially significant changes to US futures trading regulations which will be intended to curb speculation and thus reduce prices. And be warned – if the CFTC goes overboard the effect could be some very meaningful falls in commodity prices in a very big hurry. As to what the CFTC plans to do about Chinese demand for food and oil has not been revealed.

The upcoming presidential election has also provided some interesting policy offerings, such as the latest one from the Democrats. They want to impose a 25% windfall profit tax on oil companies if oil companies do not plough sufficient money into researching and developing alternative energy sources. That’s right – the oil companies are to be fined for selling too much oil to Americans. Here’s an idea, how about GET A SMALLER CAR.

The other mob are no better, with McCain suggesting an excise holiday. That’ll help. (Sound familiar too).

The bottom line of all of this is that once the regulators start moving in, markets can become very anxious and volatile, rightly or wrongly. Be warned.

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