Regulation and the department of Mickey Mouse

Today I got a message from the Victorian Government. I had to get a new drivers licence but . . . the good news was that as part of their arrive alive! strategy I was getting back one third of the cost of the licence for not having had any demerit points for the last three years. That comes to $10.75 or (the letter enthused) $32.25 over ten years. Pretty good huh?

This is on top of the Bracks Government following the Howard Government’s lead and sending us a cheque of $150 for having a kid at school aged between something and something.

Meanwhile red tape continues apace. I would have really appreciated it if the government had told me that I’d been such a good boy that I could just send them an updated photo and some cash and they’d send me the licence. But no such luck. I have to take the form to a ‘Photo Point’ and have my photo taken.

Meanwhile the excellent finance newsletter ‘The Sheet‘ has a story on the regulatory hoops that Rismark had to jump through to get their innovative new financial product ‘Equity Finance Mortgages‘ approved. With their permission the article – by John Kavanagh is over the fold.

Regulation stifles industry innovation

By John Kavanah

The Australian government must appoint an over-arching body to guide innovators through the regulatory maze or risk missing out on genuine product development in financial services, one of the entrepreneurs behind the shared equity market contends.

The managing director of Rismark International, Christopher Joye, said Rismark spent more than two years negotiating with the Australian Securities and Investments Commission, Australian Taxation Office, the Treasury, various state Fair Trading Offices and the Australian Competition and Consumer Commission in the lead-up to the launch of the companys new shared equity mortgage.

We spent $4 million on legal fees alone and there were times we thought we were dead in the water Joye said.

The regulatory system is designed to minimise risks. It pours too much sand into the wheels of innovation. In the long run, this stifling of productivity and growth will undermine Australias ability to compete with more efficient countries.

Rismark last week launched a product called the Equity Finance Mortgage in a partnership with Adelaide Bank, the first shared equity mortgage to be offered by an Australian lender.

Joye said Rismark started working on the product in 2003, after the Federal Government convened a taskforce on home ownership. Joye was the architect of the report of the taskforce.

Over two years ago Rismark started communicating with regulators over a number of matters that would have to be resolved before the product could come to market.

The first issue was whether the shared equity mortgage would be treated as a consumer credit contract and be regulated under the Uniform Consumer Credit Code, or as a financial product regulated by ASIC and needing a full prospectus and distribution only through licensed financial planners.

Joyes legal advisers view from the outset was that Rismark was creating a consumer credit product but there was a remote possibility that ASIC would see it as a derivative instrument. Rismark made its submission to ASIC 18 months ago

Eventually ASIC gave Rismark relief from coverage under certain parts of the Corporations Act but made it a condition of relief that the company issue a detailed disclosure document with the loan.

Joyes next priority was to clarify the tax treatment of the loans once they were securitised and in the hands of investors. Rismarks EFM has no interest rate and no payments required until the end of the term.

The Income Tax Assessment Act allows for the taxation of securities with deferred or discounted interest on an accruals basis. If Rismarks loan securities were going to be taxed in this way investors would be asked to pay tax on any change in the estimated value of the properties in the portfolio. Tax on unrealised gains would have made the securities very unattractive, Joye said.

The ATO has given Rismark a product ruling saying that the securities will be taxed on realisation and not on an accruals basis, thereby aligning the investors tax liabilities with the timing of EFM cash flows.

Treasury is working on changes to the tax system under a program called Taxation of Financial Arrangements that could have had an effect on Rismarks loan securities. The company has made a submission to Treasury aimed at making sure the securities are taxed on a realisation basis under new arrangements, consistent with the ATOs ruling for the EFM.

Rismarks discussions with the ACCC were about the potential problem of third-line forcing, a practice where a provider of a service makes it compulsory to take a related service as a condition of receiving the service sought. In financial services, a common example used to be finance companies making personal loans available only as long as the borrower took out insurance with a related underwriter.

Joye said: Since Rismarks EFMs are being targeted at first home buyers and upgraders, they need to be used in conjunction with a standard home loan. To bring the product to market, Rismark needed to partner with a traditional lender – in this case Adelaide Bank.

Rismark could never have distributed the EFM. As the first to market, Adelaide Bank will make EFMs available to borrowers who are also taking out a standard Adelaide Bank home loan.

While there was a possibility that the question of third-line forcing would arise, the borrower can get rid of the Adelaide Bank loan at any time and replace it with another lenders product. They can also discharge the EFM at any time without any penalty. And over time Rismark expects its home loan partners, Wizard and ING Direct, to offer borrowers EFMs.

Joye said the ACCC reviewed a submission from Rismark and gave it a no action order.

An issue arose with the state bodies that regulate consumer finance because, under the terms of the UCCC, lenders must disclose the interest rate being charged in a credit contract. Rismarks problem was that the EFM did not have an interest rate.

We were advised by the states Fair Trading departments to clearly disclose the method used to calculate the cost of the product. We have worked hard to ensure that the documentation spells out how the EFM cost is calculated and we provide case studies.

As well as making submissions to regulators, Rismark conducted an extensive round of consultations with consumer groups, research companies and other industry bodies. We wanted to get feedback on the approach we were taking to disclosure. We got feedback that we had produced very good documentation and in one case were told it was too much. But we wanted to remain faithful to the terms of the ASIC relief.

We wanted the industry to recognise that there was rigour in what we were doing and I think we achieved that.

Joye said that despite the time and expense involved in getting the Equity Finance Mortgage to market, it was worthwhile. You often hear the comment that you cant gain advantage in financial services by innovating because competitors can copy your product so quickly.

A lot of product developments do not involve genuine innovation and can be mimicked quickly. Another lender wanting to get a shared equity loan into the market will face similar challenges. The product rulings, relief and general guidance we have got from the regulators apply, in almost all cases, only to our product.

A rival would have to go through the same process and then start raising the risk capital to underwrite the loans. We are comfortable with our first mover advantage and believe we will earn some reputational capital that will enhance Rismarks name for bringing innovative financial offerings to market and get people bringing opportunities to us.

But having been through the experience once, Joye would like it to work a bit more smoothly next time. I think there is a role for a high level coordinating body within government to get innovation going. Too many people in regulatory bodies are there to manage the downside.
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