Chapter 3

Chapter 3 Non-bank Financial Institutions (NBFIs) Website: www.apra.gov.au www.efic.gov.au

Learning objectives • Understand the different types of NBFIs and their roles in the financial system • Investment and merchant banks, managed funds, cash management and public trusts, superannuation funds, life and general insurance offices, hedge funds, finance companies and general financiers, building societies and credit unions, and export finance corporations • Outline the financial products and services provided by NBFIs • Describe NBFIs’ principal sources and uses of funds

Chapter organisation 3.1 Investment and merchant banks 3.2 Managed funds 3.3 Cash management trusts 3.4 Public unit trusts 3.5 Superannuation funds 3.6 Life insurance offices 3.7 General insurance offices 3.8 Hedge funds 3.9 Finance companies and general financiers 3.10 Building societies 3.11 Credit unions 3.12 Export finance corporations 3.13 Summary

3.1 Investment and merchant banks • Evolved under regulation • Are not authorised banks and are officially classified as ‘money market corporations’ in Australia • Share of total financial institution assets declined from 7.2% in 1990 to 1.4% in 2010 • Today, there is very little difference between a ‘merchant’ bank and an ‘investment’ bank (cont.)

3.1 Investment and merchant banks (cont.) • Sources of funds • Mainly securities issued into international money markets and capital markets • Uses of funds • Limited lending to clients, usually on short-term basis • These loans tend to be sold into the secondary market • Primarily focused on off-balance-sheet advisory services (cont.)

3.1 Investment and merchant banks (cont.) • Off-balance-sheet business • Innovative products and services in provision of advice, management and funding services, generating their main income from fees, e.g.: • FOREX dealers, advice on raising funds, underwriting equity/debt issues, shares placements, balance-sheet restructuring, venture capital • mergers and acquisitions—takeover company seeks to gain control over a target company • horizontal, vertical, conglomerate and hostile takeovers • synergies, economic/legal/accounting/tax considerations • analysis, valuation, negotiation, due diligence

Chapter organisation 3.1 Investment and merchant banks 3.2 Managed Funds 3.3 Cash management trusts 3.4 Public unit trusts 3.5 Superannuation funds 3.6 Life insurance offices 3.7 General insurance offices 3.8 Hedge funds 3.9 Finance companies and general financiers 3.10 Building societies 3.11 Credit unions 3.12 Export finance corporations 3.13 Summary

3.2 Managed funds • There has been tremendous growth in the amount of funds under management • Despite the financial crisis, funds continue to flow into Australia’s superannuation funds, which are by far the largest component of the managed funds sector • Indeed, between 2008 and 2010, funds under management in superannuation funds increased by more than $100 billion • This increase more than offset the falls (of about $10 billion) experienced in other parts of the sector, particularly cash management trusts and unit trusts (cont.)

3.2 Managed funds (cont.) • Investment vehicle for investing the pooled savings of individuals in various asset classes in domestic and international money and capital markets by fund managers • Mutual fund (USA) • Managed funds established under a corporate structure; investors purchase shares in the fund • Trust fund (Australia and UK) • Managed funds established under a trust deed, managed by a trustee or responsible entity • Investors in the fund obtain a right to the assets of the fund and a share of the income and capital gains (losses) derived (cont.)

3.2 Managed funds (cont.) • Main categories of managed funds • Cash management trusts (section 3.3) • Public unit trusts (section 3.4) • Superannuation funds (section 3.5) • Statutory funds of life offices (section 3.6) • Hedge funds(section 3.8) • Common funds • Operated by trustee companies, they pool funds of beneficiaries and invest in specified asset classes • Differ from unit trusts in that units are not issued • E.g. solicitors offering mortgage trusts (cont.)

3.2 Managed funds (cont.) • Main categories of managed funds (cont.) • Friendly societies • Mutual organisations that provide members with investment and other services (insurance, sickness, unemployment benefits) • Investment products include the issue of bonds that invest in asset classes like cash, fixed-interest, equities and property (cont.)

3.2 Managed funds (cont.) • Growth in sector driven by deregulation, affluent and ageing population, and more educated investors • Sources of funds • Funding derived from specific contractual commitments of investors • Periodic payments to the fund, e.g. superannuation • Single payment or premium, e.g. insurance policy • Total assets $1,600 billion as at December 2010 • More than $1,000 billion managed by superannuation funds • Funds under management about 35% of all financial institution assets (cont.)

3.2 Managed funds (cont.) • Uses of funds • Large funds typically allocate a portion of the total asset portfolio to several professional fund managers for risk- and performance-management purposes • Professional managers invest in asset types authorised under the trust deed of a particular fund (cont.)

3.2 Managed funds (cont.) • Categorisation of managed funds by investment risk profile • Capital guaranteed funds • Value of contributions guaranteed, but not future earnings • Investments are low risk, low return, e.g. government and semi-government securities, bank bills, debentures and cash deposits • Capital stable funds • Contributions are mostly protected by investments in low risk securities • Investments as per capital-guaranteed fund plus property (cont.)

3.2 Managed funds (cont.) • Categorisation of managed funds by investment risk profile (cont.) • Balanced growth funds • Investments in longer term income streams supported by limited capital growth • Investments include domestic and foreign equities • Managed growth (or capital growth) funds • Invest for greater return through capital growth and less through income streams • Investments include a greater proportion of domestic and foreign equities

3.3 Cash management trusts • A mutual investment fund, often managed by a financial intermediary, established under a trust deed, specifying the trust’s investments • Generally invest in short-term money-market instruments • Provide high liquidity for the investor • Share of total financial institutions assets grew from 0.6% in 1990 to 1.1% in 2008. This declined to 0.8% following the GFC • Provide retail investors with access to the wholesale market • Cash and deposits 70%, bills of exchange 7%, other assets 23%

3.4 Public unit trusts • Investment fund established under trust deed • Investors purchase a share in the trust called a ‘unit’ • The trustee invests the pooled funds received from investors • Unit holders receive a return in the form of income and/ or capital gain • Types of unit trusts and share of public unit trusts assets: • Property trusts (44%) • Equity trusts (47%) • Mortgage trusts (2%) • Other (including fixed-interest trusts) (5%) (cont.)

3.4 Public unit trusts (cont.) • Share of total financial institutions assets grown from 3.7% in 1990 to 5.6% in 2010 • Listed trusts • Units quoted and sold on the ASX (more liquid)—mainly property trusts • Unlisted trusts • Units sold back to trustee after giving the required notice (less liquid)—mainly equity trusts

3.5 Superannuation funds • The largest part of the managed funds industry is the superannuation sector • Indeed, superannuation funds account for almost one-fifth of the assets held by financial institutions in Australia • Most surprisingly, self managed superannuation funds hold the largest amount of assets within the superannuation sector • There are more than 400,000 SMSFs holding a total of more than $400 billion in assets. This exceeds the asset holdings of retail funds by almost $60 billion (cont.)

3.5 Superannuation funds (cont.) • Savings accumulated to fund an individual’s retirement • Superannuation assets exceeded $1,300 billion as at December 2010. More than $400 billion of this is held in SMSFs. • APRA classifies superannuation funds as: • corporate funds • industry funds • public sector funds • retail funds • small APRA funds • self-managed funds (cont.)

3.5 Superannuation funds (cont.) • Sources of funds • Corporate, industry and public-sector superannuation funds • Corporate funds provide benefits to employees of a specific company • Industry funds provide benefits to employees working within a particular industry • Public sector funds provide benefits to government employees and can be underfunded • Can be contributory (employer and employee contribute) or non-contributory (only employer contributes) • About 40% of total superannuation assets (cont.)

3.5 Superannuation funds (cont.) • Sources of funds (cont.) • Compulsory superannuation funds • Legislation requiring employers to contribute a defined amount to employees’ superannuation accounts • Australian employers not paying the mandatory 9% into employees’ superannuation funds must pay the superannuation guarantee fund (SGC) • Rollover superannuation funds • Hold eligible termination payments (ETP) within the regulated superannuation environment • ETPs are superannuation funds due on termination of employment plus related redundancy payments (cont.)

3.5 Superannuation funds (cont.) • Sources of funds (cont.) • Private (or personal) superannuation funds • Retail funds—offer superannuation products to the public on a commercial basis; have more than four members • Small APRA funds—have fewer than five members and are regulated by APRA • Self-managed funds—regulated by the ATO and have fewer than five members, all of whom are trustees • Retail, small APRA and self-managed superannuation funds represent 57% of total superannuation assets • Savings plan—regular contributions by an individual • Single-premium scheme—single up-front contribution (cont.)

3.5 Superannuation funds (cont.) • Defined benefit funds and accumulation funds • Defined benefit funds • Amount paid to employee on retirement is based on a defined formula • Risk lies with employer, who must make good any shortfall • Accumulation funds • Amount of funds available at retirement consists of contributions plus earnings less taxes and expenses (cont.)

3.5 Superannuation funds (cont.) • Regulation • Legislation directly impacting on the operation of superannuation funds is: • Superannuation Industry (Supervision) Act 1993 (Cwlth) (SIS) • Income tax Assessment Act 1936 • Concessional 15% tax treatment of fund contributions and earnings • Limitations on maximum annual contributions • Members can withdraw funds as pension or in lump sum tax free at age 60

3.6 Life insurance offices • Sell life insurance and superannuation policies • Sources of funds • Premiums paid and policy holders or beneficiaries receive payment upon death/disablement or at a nominated maturity date, subject to policy terms • Superannuation/Retirement contributions • Inflow of funds is regular, predictable and long term • Life insurance office policies • Whole-of-life, term-life, total and permanent disablement, trauma, income protection, business overheads (cont.)

3.6 Life insurance offices (cont.) • Uses of funds • Outflow of funds quite predictable and stable and therefore invest mainly in long-term securities • Statutory funds invested in: • equities and unit trusts • long-term securities • cash and short-term securities • overseas • Regulation • Supervised by APRA, which applies the same capital and liquidity management requirements as for banks • Life Insurance Act 1995 (Cwlth)—licensing and control

3.7 General insurance offices • Insurer pays the insured a predetermined amount if some prespecified event occurs • Sources of funds • Contractual premiums paid in advance for: • house and contents • co-insurance, public liability insurance • motor vehicle insurance • comprehensive; third party, fire and theft; third party; compulsory third party • other risk insurance policies to individuals in retail market and businesses in the commercial market • Inflow of funds not as stable as life offices (cont.)

3.7 General insurance offices (cont.) • Uses of funds • Generally shorter term, highly marketable securities, owing to the less predictable nature of the risks underwritten • Examples • Money market securities, such as bills of exchange, commercial paper and certificates of deposit • Share of total assets declined from 4.4% in 1990 to 3% in 2010

3.8 Hedge funds • Hedge funds operate in a relatively unregulated environment • Often, hedge funds are open to ‘high net worth’ individuals who will be required to invest a relatively large sum • Because the strategies and operations of hedge funds are neither transparent nor straightforward, hedge funds are often the target of criticism when markets experience significant levels of volatility • This was certainly the case during the GFC where the short selling activities of the hedge funds attracted much scrutiny (cont.)

3.8 Hedge funds (cont.) • Use sophisticated investment strategies and products mainly for high-net-worth individuals and institutions to achieve higher returns • Tend to specialise in different financial instruments such as equity, FOREX, bonds, commodities and derivatives • Hedge fund sector generally divided into single-manager hedge funds and fund of funds • Sources of funds mainly from superannuation and life offices, and high-net-worth individuals • May leverage investments through debt financing and/or use of derivative products

3.9 Finance companies and general financiers • Borrow in domestic and international financial markets and make loans to small business and individuals • Emerged largely owing to previously highly regulated banking sector to circumvent restrictions on interest rates and lending • Sector can be classified into: • diversified finance companies • manufacturer-affiliated companies, e.g. Ford Credit • niche specialists, e.g. motor vehicle and lease financing • Sector share of total assets has declined from 7.5% in 1990 to less than 3% in 2010 as commercial banks are more competitive in deregulated environment (cont.)

3.9 Finance companies and general financiers (cont.) • Sources of funds • Issue of debentures and unsecured notes • Borrowings from related corporations and banks • Borrowing direct from domestic and international money and capital markets • Uses of funds • Loans to individuals, possibly higher risk • Lease financing • Loans to small- and medium-sized businesses (e.g. bills finance, term loans, floor plan financing, factoring and accounts receivable financing)

3.10 Building societies • Authorised deposit-taking institutions mainly lending for residential property • During period of regulation building societies gained market share at the expense of savings banks • Since deregulation the sector share of total assets declined from 3.1% in 1990 to 0.5% in 2010. In response some building societies have: • merged to rationalise costs • become banks, e.g. Challenge Bank, Advance Bank and Heritage Bank • improved technology for service and cost reasons • diversified activities and products offered to savers and borrowers (cont.)

3.10 Building societies (cont.) • Sources of funds • Mainly deposits from customers • Uses of funds • Personal finance to individual borrowers • Mainly housing finance • Term loans and credit card finance • Regulation • As they are ADIs (i.e. authorised by APRA to accept retail deposits), regulation is by APRA with the same prudential and reporting standards as banks

3.11 Credit unions • Common bond of association often exists between members owing to employment, industry or community (e.g. Shell Employees’ Credit Union) • Share of total financial institutions assets remained relatively stable, only declining from 1.2% in 1990 to 1.1% in 2010 • Sources of funds • Mainly deposits from members (payroll deductions) • Other credit unions and the issue of promissory notes and other securities (cont.)

3.11 Credit unions (cont.) • Uses of funds • Primarily personal finance to members • Residential housing loans • Personal loans and credit card facilities • Limited commercial lending • Regulation • As ADIs, they are regulated by APRA, which applies the same prudential and reporting standards as for banks and PBSs

3.12 Export finance corporations • Export finance companies support the export activities of domestic firms • In Australia, the official export credit agency is the government authority: Export Finance and Insurance Corporation • The purpose of the EFIC is to: • “Overcome financial barriers for exporters by providing financial solutions, risk management options and professional advice, when the private market lacks capacity or willingness, we create opportunities for Australian exporters and offshore investors to grow their international business.” (EFIC.gov.au) (cont.)

3.12 Export finance corporations (cont.) • Government authorities that provide financial support and services to exporting corporations • Official Australian export credit agency is Export Finance and Insurance Corporation (EFIC) (cont.)

3.12 Export finance corporations (cont.) • EFIC facilitates export trade by providing trade insurance and financial services and products, which may not be available from other financial institutions • Insures Australian exporters against non-payment • Guarantees trade finance for the purchase of Australian goods and services • Insures Australian firms against political risk of overseas investments • Indemnifies financial transactions of insurers that provide bonds/guarantees to overseas buyers and provide performance bonds in support of Australian export contracts

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