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ASX announcement - Impact of Finance Sector Reform

20 April 1999

Address by Richard Humphry, Managing Director, Australian Stock Exchange to Association of Superannuation Funds of Australia Canberra, 20 April 1999

"Reform" seems to have become one of those Humpty Dumpty words that means whatever you choose it to mean. Change is called "reform" whether the result is a step forwards or a step backwards. I want to discuss finance sector reform today in the positive sense of the word, and I want to consider particularly the reforms that have started to equip Australia to prosper in the coming era when we are living with the full effects of globalisation and the communications revolution.

In doing that, I am conscious that reform, if you regard it as making something better or removing impediments, can sometimes be in the eye of the beholder. There may even be some here today who would believe that was the case with our recent reform of the All Ordinaries Index. That is a subject I will come back to, because I am sure it is of more than passing interest.

But first let’s consider how far we have come in financial reform in Australia, and what its impact has been.

One of the most telling graphs in the report of the Wallis Committee showed how net private sector wealth had increased in Australia over the past 40 years. In that time it has almost quadrupled – and that is in real terms. By far the steepest growth, however, was in the past 15 years: the years when deregulatory reform stemming from the Campbell Committee and the Martin Committee took effect.

This is not surprising, if you accept the fact that a free and efficient financial sector lifts economic growth, whereas repression of the financial sector depresses it. That proposition used to be disputed by quite a number of economists, but as evidence has accumulated in its favour I think a substantial majority now accept it.

The financial sector in Australia certainly used to be repressed. It was only 14 years ago that we allowed foreign bank subsidiaries to operate here, with a couple of token exceptions, and now we have 14. It is only seven years since foreign banks were allowed to open branches here, and now we have 23, despite continuing problems with our OBU tax regime. There has been an equally strong foreign influx into some non-bank businesses, not least the stockbroking industry.

That one aspect of financial deregulation, the welcoming of foreign investment, has seen some $280 billion of overseas funds injected into the Australian financial sector, but that still represents only a quarter of the sector’s assets.

There is no doubt that the accompanying influx of new ideas has been one of the drivers of innovation in the financial sector, which is one aspect of reform. The level of innovation has been impressive, as the following table concentrating on the banking industry indicates:

Source: Adam Boynton (Treasury) / Financial System Inquiry

There has also been a wealth of innovation in our own area, the stock and derivatives markets. It’s only a dozen years since all our business was done on six trading floors around the country, with no fixed settlement period. Now trading and settlement are both screen-based, with huge efficiency gains, settlement is T+3, and stockbrokers are beginning to offer their clients virtually direct electronic access to the stock market.

One broking firm recently provided retail investors with access to the U.S. stock market as well, with trading available through the night. That is probably only the beginning of easy private-investor access to international markets. More intrepid investors, of course, can simply use the Internet to reach brokers attached to a variety of markets around the world.

All these developments, which I am sure we would regard as positive, are aspects of globalisation and its effects. But there is still a significant number of people in Australia who regard globalisation as a bad thing. They want us to return to the old days of protectionism, and what I saw described the other day as the victim mentality in Australia.

Happily, there is little chance of such a retrograde step, because of the changes in Australian society that financial-sector reform has brought about.

Back in what the economic nationalists seem to regard as the good old days, we were not only an insular society but a highly regulated one. There was limited innovation, not just in the finance sector but in consumer behaviour. If people had savings, they tended to put them in the bank, even when the real interest rate was negative. As recently as ten years ago, only one brave person in ten invested in the stock market.

The change in that situation is one of the most dramatic examples of how Australia has changed as a society. The 40 per cent of Australians who invest in the stock market today aren’t going to revert to putting their money under the mattress or into a savings account. Nor are they likely to believe that governments are responsible for wealth creation.

There has been a rapid and fundamental change in Australians’ attitude to investment. Traditionally, we regarded banks and real estate as the only places to invest our savings. Until the start of this decade, the number of Australians who thought the stock market was the wisest place to invest averaged less than 4 per cent. At the end of last year it was more than 28 per cent, which was the highest of any investment category.

The globalisation of markets can’t be reversed, because it would require uninventing the Internet and undoing the whole computer and communications revolution that has made globalisation possible. Nor can Australia go back to the 1970s, because it is a radically different economy today.

Nowhere is this better illustrated than in the composition of the equities market. Over the last 20 years, it has changed from a predominance of resources and manufacturing companies, with the finance and services sector smallest, to a market in which finance and services account for more than 60 per cent of capitalisation.

The growing importance of the finance sector in the economy, and the growing international competition both on and off the Internet, make it urgent that the deregulatory reforms that brought about its growth are now matched by tax reforms that make Australia internationally competitive in financial markets.

Some of the proposals in the government’s tax-reform package would contribute greatly to that objective: the abolition of financial institutions duty, bank account debits tax and stamp duty on marketable securities, for example, and a more competitive regime for non-resident investors. But there are still problems with taxation of offshore banking units, as I mentioned earlier, which might be exacerbated by some of the proposed reforms. There are also major issues with the suggested capital gains tax changes, where some beneficial reforms are offset by moves against averaging and indexation.

Tax is not the only area where reform is afoot. In a period of such rapid growth and change, we can’t avoid a re-examination of even the icons of the finance sector. One of those icons is the All Ordinaries Index, which has been measuring the stock market in one form or another for 125 years. Its most recent incarnation dates from 1980, when rules for exclusion and inclusion were developed that depended on the market capitalisation and liquidity of a company’s shares.

At that time the overall liquidity of the market was 12 per cent – just over a tenth of its capitalisation turned over in a year. The necessary liquidity for inclusion in the Index was set at half that level – 6 per cent. Last year the overall market liquidity reached 55 per cent, nearly seven times higher than in 1980, but in those 19 years the liquidity requirement for inclusion in the All Ordinaries hadn’t changed. Instead of needing half of the market’s liquidity to be in the index, you could now be in with one-ninth.

So when some fund managers pointed out to us that it had become very difficult for them to replicate the All Ordinaries, because it was hard to accumulate stocks that had such low liquidity, it wasn’t difficult for us to see their point of view. The obvious answer, we thought, was to restore the liquidity requirement to its original condition of half the market liquidity.

That decision was accepted calmly enough when we announced it, but it wasn’t greeted with universal enthusiasm when it came into effect and a number of companies were dropped from the index for low liquidity. Another group of fund managers started to campaign, not just for a return to the status quo, but for a greatly expanded index.

index couldn’t meet all the market’s requirements, even though it had been accepted as the benchmark for so long. To discover what was really wanted, we did two things. We issued a consultation paper suggesting how a new All Ordinaries might be constructed, and we appointed an advisory panel drawn from the various interested groups, including ASFA.

The responses to the technical paper made the division of opinion about the index even clearer. One group of fund managers wanted a narrow index that they could replicate easily; another group, equally large by weight of capital, wanted a broader index from which they would pick stocks to invest in; and companies on the margin of inclusion or exclusion naturally wanted an even broader index that would assure their membership.

This posed a difficult problem for the advisory panel, and for ASX, because none of the proposals put forward in response to the consultation paper would satisfy everyone. The solution that was developed was an index that arose out of further consultations and a suggestion from a member of the advisory panel, which the panel agreed was equitable to everyone.

It is an index of 500 stocks – twice the present size – within which there would be an ASX100 as now, an ASX200 that would meet the needs of the index replicators, an ASX300 that would meet the needs of the stock selectors, and an equivalent of the current Small Ordinaries that excludes the top 100 stocks in the 500. We are going to have further consultations about this proposal, but we hope to be able to implement it in the second half of the year.

The All Ordinaries will in effect become an umbrella index, with market capitalisation as the only criterion for entry. The series of sub-indices will be the principal benchmarks used for investment mandates, and will have various market capitalisation and liquidity criteria for inclusion as the industry users of those sub-indices require. That means that trustees are going to have to consider which of the sub-indices they want to link their investment mandates to, and instruct their fund managers accordingly. I don’t imagine a 500-stock All Ordinaries will be a common choice.

An important attribute of this new model is that it will enable further development as industry needs change without disturbing the All Ordinaries itself. It is also important that the model doesn’t fundamentally change the All Ordinaries in its role as the market benchmark on the nightly TV news. Its 250 stocks already represent 92 per cent of market capitalisation, after downweightings. Because of the market’s rather top-heavy structure, inclusion of another 250 smaller companies actually adds less that 2 per cent to that.

I might add that we have learned a lesson from the index experience, which is part of our transition from a mutual organisation of stockbrokers to a commercial enterprise. A large part of that transition has been accomplished very successfully, but some cultural changes are slower to bring about. We understand intellectually that we now have a very broad constituency to consider, rather than principally a single group who were also our owners, and I am sure you will find that our behaviour catches up very quickly with that understanding. We will be consulting widely on all significant changes.

ASX’s demutualisation and self-listing has itself been a significant part of the reform process in the financial sector, and it is a model that is being studied by a number of major stock exchanges around the world. It has freed us to do a number of things that would have been much more difficult as a mutual – or indeed without the wider reforms that have taken place in the finance sector – including broadening access to the equities market, discussing a merger with the Sydney Futures Exchange and exploring the possibility of alliances with exchanges in other parts of the world. We need to be constantly on the front foot like this, because we are a small player in the world context – about 1.3 per cent of the total capitalisation of developed markets.

Australia as a whole is also a minnow in the world financial pond, and it has to be both internationally competitive and internationally integrated if it wants to maintain any significant position at all. We also have to be nimble, and prepared to adapt our ways of doing business both rapidly and radically.

I began by mentioning a striking graph in the Wallis Report, and I want to end by quoting from its summary of possible futures. Referring to the belief that a radical transformation is under way in the financial system, the Report had this to say:

Those holding this view expect that financial processes and structures will be transformed by the rapid emergence of much lower-cost information technology and its equally rapid dissemination into homes and workplaces. This shift would not only dramatically alter service delivery channels but could also redefine the characters and boundaries of markets.

If that view is correct – and I believe it is – then, to use the vernacular, we ain’t seen nothin’ yet in financial sector reform. We must all hope that both the government and we ourselves are up the task.

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