Industry concerned by new margin lending legislation

New legislation has prompted concern about the future of margin lending among industry commentators. Yet with confidence that the rebounding share market will stimulate further growth in the sector, Benjamin Levy asks whether the lessons of the GFC have actually been learned.

The future of margin lending is uncertain. Wholesale regulatory changes were made after the collapse of Storm Financial and the destructive margin calls during the global financial crisis (GFC).

The financial services industry is divided about what effect the legislation will have on the sector. Some members of the industry believe regulation has not gone far enough, while others are struggling to determine what the practical outcomes may be in terms of disclosure and financial advice.

But the industry is confident that the rebounding share market will drive growth in the sector despite the new laws.

However, this raises alarm among legislators that the lessons of the GFC have not been learned.

Protecting investors

Since the collapse of Storm and its use of what was deemed to be aggressive margin lending, a swathe of legislation has emerged — ostensibly designed to protect investors from the misuse of margin loans and surprise margin calls.

The former minister for financial services, superannuation and corporate law Nick Sherry brought the new regime into effect.

Margin lenders are required to hold a licence from the Australian Securities and Investments Commission (ASIC) to give advice, and they must ensure their representatives are appropriately trained.

Commissions paid to advisers from margin loans must be listed in a Product Disclosure Statement, while margin loans must be included as a financial product under Chapter 7 of the Corporations Act.

Importantly, the responsibility for margin calls defaults to the margin lender — unless there are specific arrangements for the financial planner to do so.

A key piece of the reforms to the margin lending sector is the placement of responsibility for the margin call firmly in the hands of the major lenders.

This is designed to protect investors from another Storm scenario, in which clients’ margin lending portfolios were sold down with minimal or no notification from either the lender or the dealer group itself.

However, some members in the industry have questioned whether these new laws are needed to change margin lending practices by lenders and advisers.

Eric Blewitt, general manager of Bendigo subsidiary Leveraged Equities, believes the legislation will have no major impact on the lenders in the sector because the government has brought into law practices that were already in operation by the major lenders.

“Many of the key lenders, [namely] all the major banks, are APRA regulated, so many of the things that we are required to do are things that we have already been doing,” Blewitt says.

Blewitt points out that Leveraged Equities was already taking on responsibility for contacting its clients when they were getting close to their minimum share margins — and, subsequently, a margin call — before Storm’s collapse pushed the government to intervene in the sector.

“It’s not as though people are suddenly going to say that [they’re] not able to conduct [their] business,” he says.

Adrian Hanley, head of National Australia Bank (NAB) margin lending, voices similar thoughts when asked about the effect of the legislation on his bank’s business.

“It probably isn’t going to have a great deal of an effect on us, simply because with margin calls — as part of what we saw with the global financial crisis — we introduced, a number of months ago, an automatic email and SMS service for clients when they go into their [share portfolio] buffer, as well as notification of the actual margin call,” he says.

Dealer groups, too, are confident that new regulation will not have a major impact on their margin lending practices.

“We feel quite good about our ability to meet the requirements, there’s no issues there,” says Rick Di Cristoforo, managing director of Matrix Planning Solutions.

Di Cristoforo refers to new laws requiring dealer groups and lenders to assess the true loan-to value-ratio of the client as an example.

Under the laws, advisers are only able to recommend a margin loan if they are ‘reasonably sure’ the client could afford the loan without suffering substantial hardship, with former financial services minister Sherry declaring that the government will not tolerate consumers being misled into “grossly inappropriate” margin loans that will cost families everything they own.

Di Cristoforo says Matrix’s Prospera software already allows the company to track the ongoing cash flow of its clients. Matrix will continue to use Prospera to look at clients’ overall cash flow and debt positions before Matrix recommends a margin loan, he adds.

“For our purposes, this absolutely helps us with that [regulation],” he says.

Bernie Ripoll, chair of the Parliamentary Joint Committee (PJC) inquiry into financial services and products, makes it clear in the inquiry’s final report that while the PJC accepts there have been instances of inappropriate advice, the actions of Storm did not necessarily reflect those of the general industry.

The industry’s confidence in its ability to fulfil the new regulation seems to vindicate Ripoll’s belief.

“For the major lenders to say ‘they were doing that anyway’ is all the better, because there’s no change — it’s something they’re doing anyway,” Ripoll says.

“I know that’s one of the points we made out of the [PJC], that many people’s recommendations that we put forward will be no change to them, because they’re already operating at that standard,” he says.

Further regulation and the right direction?

But despite the confidence of the large players in the industry in their ability to keep to the measures, Ripoll maintains that the regulation was a necessary step.

“There are lots of circumstances in which there were just poor margin lending practices, where the rules of engagement weren’t clear, where the responsible lending principles that might apply in other areas didn’t apply in margin lending,” he says.

“It was enough so that regulation changing is needed and is being implemented.”

While there were good practices, there was breakdown in other areas — and if you looked at a range of lenders, some were doing better than others, he says.

However, members of the industry question whether the legislation is the right move.

Peter Worcester, a consultant to the financial services industry, agreed that the legislation will not stop the misuse of margin loans.

“I remember my quote to the PJC public hearings in Melbourne where I said ‘gentlemen, these products are dangerous’ — and I still think they are dangerous to the unsophisticated investor,” he says.

Referring to part of the legislation that forced dealer groups to apply for a variation to their AFSLs if they intended to provide advice on margin loans, Worcester says that did not mean that investors should be allowed to use them.

Retail investors cannot use margin loans to make extra returns from their share portfolios, Worcester says.

“We have proven that the average person can’t make money out of margin lending unless he or she can time the market, because the banks charge about five per cent on top of the cost of bank bills to provide you with a margin loan.

"You would expect to get that back from shares plus dividends over time, so unless you can pick when you go into the market, you aren’t going to make any money,” he says.

Margin loans should be banned for retail investors, he adds.

Although Di Cristoforo thought the legislation was a step in the right direction, he questions what the end result of the new requirements will be and whether they will have unintended consequences.

He also questions whether the practical outcomes of the margin lending requirements will end up doing exactly what was intended — that is, keeping retail investors out of unintended risk.

He also says another outcome may end up being more paperwork for planners and lenders.

“Is the practical outcome going to end up being more paperwork though, or more inconvenience to the client, in order to get the job done for them to meet the goals? That’s something we need to watch out for,” Di Cristoforo says.

The increased disclosure requirements for planners and lenders might simply slow people’s ability to meet their goals through using the margin loan, he says.

“In terms of the additional disclosure, where a margin lender needs to look at the advice documents and the underlying position of the client base from an asset and income perspective, you need to balance that requirement up with the fact that if you make too many hoops for people to jump through they won’t engage,” he says.

The major concern is that the processes of implementing a margin loan that will emerge from the legislation will push investors away, Di Cristoforo says.

“How does an adviser efficiently collect the information, prior to implementation? Those clients are going to be asking ‘Why are you asking me for this? Why are you passing this on?’

"This is the issue, that we are required to do a whole bunch of things in our industry that don’t make apparent sense to mums and dads,” he says.

“That doesn’t mean that they are wrong, it just doesn’t mean that they’re not explained or understood,” he says.

The proposed margin lending regime had already come under criticism in 2009 from commentators in the industry who felt that the legislation was being rushed through.

Writing in Money Management in September last year, David MacLeod, a former partner at McMahon Clarke Legal, criticised the way in which the proposed legislation was being pushed through parliament only seven weeks after the draft legislation was released for public comment.

“Once you allocate time to receive and then review submissions, consider the issues and then rewrite sections of the draft legislation and prepare the bill for Parliament, there isn’t a lot of time left for genuine consultation,” he wrote. “This smacks of process being sold short.”

MacLeod wrote that the proposed changes were telling investors they may not be sophisticated enough to use complex products like margin loans, when the real challenge for regulators was to introduce a regime where it could monitor licensees to ensure the products that were recommended were appropriate to their circumstances.

“This is not the first time regulatory and legislative changes have savagely impacted financial services providers,” he wrote.

However, Ripoll says the point of the legislation is for ASIC to have regulatory oversight of the sector — something it has previously lacked.

Ripoll also emphasises that the legislation is an ongoing process that will be taken into account with other inquiries.

“My report is done, and out of [its recommendations] is a path, a way forward for reform, for the financial services sector and I’m awaiting what Jeremy Cooper does with his report,” he says.

Responding to regulation and its effect on the use of margin loans

Although it is early days, it appears that the new regulation has had little or no effect on the size of the industry or its processes.

“There is a fair amount of change from the current situation, but it’s not of the magnitude that I would expect to cause any major significant impact other than making the new requirements operational,” Blewitt says.

“I would not expect to see a fall-away of any of the key players in terms of providers of margin loans,” he adds.

Blewitt says he will be surprised if advisers decide not to advise on margin lending because of the regulation, and suggests that an adviser might be failing their fiduciary requirements if they cannot give advice on the product.

“It could be seen as an opportunity to not advise on margin lending, but it would be an interesting decision, because concurrently, there is a suggested and recommended requirement for advisers to have a fiduciary requirement to act in their clients’ best interests.

"If you aren’t able to provide advice or understand the impact of any particular product, how are you fulfilling your fiduciary requirement?” Blewitt asks.

Hanley says that the impact the legislation will have on the major lenders depends on their ability to absorb the legislation, and that depends on the existing infrastructure in the company.

“Some people will have to build the infrastructure to absorb the legislation, other people will simply be able to tap into existing infrastructure that’s available,” he says.

NAB already has a significant amount of infrastructure for credit and other products, so they didn’t anticipate the same amount of work that other institutions have to go through, he says.

However, Hanley admits that some of the smaller players in the market may decide to opt out of the sector, rather than putting in the funds and effort necessary to create an infrastructure capable of dealing with the legislation, Hanley says.

“It all comes at a cost, so people have to do a cost-benefit analysis to assess whether it’s actually worthwhile,” Hanley says.

However, all the major lenders interviewed for this article believe that improving market conditions will offset any impact of the financial crisis and incoming legislation.

“We’d anticipate that market activity will probably drive demand for margin lending to a greater extent than I suppose the incoming legislation will reduce it,” Hanley says.

Robert Thomas, AXA technical and research general manager, says while they will be amending their AFSL licence to continue to advise on margin loans, they did not expect much change in their business.

Thomas says that while the fallout of the financial crisis will “dampen” investor enthusiasm for margin lending, the improving market conditions will drive the use of margin loans and the growth in gearing. This activity, while lower than during “boom times”, will be higher than during the financial crisis, Thomas adds.

“As performance comes back and consumer confidence comes back (something that is definitely growing in Australia), there is growth in investments and gearing is just a form of investing.”

Blewitt says Leveraged Equities has seen growth in margin lending, which is broadly correlated to underlying equity markets, at a little over 5 per cent over the last two quarters.

Existing borrowers who remained in the market during the financial crisis — and had taken the opportunity to gear into rising markets and take advantage of recent capital raisings — have driven this growth, he says.

A Reserve Bank of Australia bulletin on margin lending trends has backed up their opinions, with the number of clients in a margin loan now higher than before the start of the financial crisis, at just below 200,000 investors.

However, the growth in margin lending has left regulators worried that the lessons of the financial crisis have not been learnt.

Ripoll, in an article in Money Management in February this year, wrote that regulators should be concerned about the growth in margin lending since September 2009.

“The promised high returns of leveraging into risky products is tempting and back in vogue since markets have bounced back spectacularly from the lows of the GFC, the most vulnerable are always the first targeted,” he wrote.

“The startling evidence that the total number of clients in a margin loan is now higher than before the GFC should be of concern to banks and regulators,” he wrote.

While the government and the PJC have recommended a number of reforms to margin lending, the best consumer protection will always come from good advice, well-informed decisions, and realistic, affordable investments, Ripoll wrote.

However, the RBA bulletin showed that although the number of clients in margin loans have risen, the size of the margin loan has dropped dramatically, with the average loan size in September 2009 approximately $85,000 — compared to $190,000 in December 2007.

Blewitt says that the vast majority of margin loan holders hold conservatively geared diversified portfolios, and may not have even experienced a margin call.

“The general perception that everyone has had an underlying margin call or that everyone has had to have a fire-sale of underlying assets is probably a misconception, and the stuff that tends to get reported is the extremes,” he says.

The right margin lending

Despite regulatory concerns that margin loans may again be misused, there is broad consensus about the right client profile and market conditions needed to recommend a margin loan.

Di Cristoforo, Blewitt, Hanley and Thomas all agree that a steady cash flow and the ability of the investor to repay debt is a key concern in recommending a margin loan.

According to Di Cristoforo, the key characteristics for a margin loan holder is someone who is “asset poor, and very income-rich: a person who’s got significant surplus cash flow and may not have an asset base to be able to borrow against in other ways.”

“I underline the fact that they need to have significant free cash flow, because you don’t ever want to be put in a position where you’re forced to sell,” he adds.

Thomas says investors with a margin loan need to remember that borrowing to invest is a long-term investment, and they need to have the proper understanding of market risk.

They need the cash flow to be able to fund interest rate rises for at least a five-year period, he says.

AXA always investigates whether the client will be able to pay off the margin loan with an interest rate rise of 2 per cent, Thomas says.

“Last year when interest rates were so low, you could borrow at much lower rates than today, so we increased that sensitivity to 4 per cent — which is how much we thought interest rates would rise, which they have done,” Thomas adds.

In the current situation of rising interest rates, investors can also consider borrowing against their home loans (which carries a lower interest rate) and invest into a safe stock, he says.

“With a 4 per cent dividend you would just about break even straight away,” Thomas says.

However, Hanley says that rising interest rates will not put a halt on people’s investments.

Rising interest rates is a sign of an economy that people perceive as performing reasonably well, and that perception of good performance flows through to the share market as well, he says.

However, Hanley says the experience of the previous 12 months has still left clients cautious. The average borrowing level of the margin lending industry had dropped, leaving clients with extra capacity to manage any volatility if it starts to creep back into the market, he says.