A lot of people in Victoria and southern New South Wales have lost a lot of money with collapse of Kyabram based Banksia Securities Limited (Banksia).  While it appears customers might yet have a reasonable chance of recovering of some of their money[1], the collapse has no doubt caused sleepless nights for many.

Banksia type collapses are nothing new in Australia – it’s happened before. Westpoint springs to mind so too does Estate Mortgage in 1990 and some readers might recall the collapse of Cambridge Credit in the mid-1970s which took more than 20 years to see some money returned to depositors.

You can be sure that unless we see sensible regulation of the non-bank deposit sector, this type of collapse will happen again.

Your task is to avoid these high-risk investments for the rest of your days!

Banksia was not a bank!

Let’s be very clear here – Banksia was not a bank yet, according to some reports, many customers assumed that they had ‘bank’ like security of their deposits.  Similar to a bank, the money deposited by Banksia customers was largely then on-lent to borrowers – home buyers, farmers, businesses and property developers – at a higher interest rate than what the Bankisa depositors were being paid. Banksia’s profit was essentially the difference (the margin) between the interest charged to borrowers and the interest paid to debenture holders (depositors).  While this is not unlike a bank’s primary role, the bottom line is that Banksia was not a bank.

In order for a bank to be licensed by the Reserve Bank of Australia, and thereby have access to a ‘lender of last resort’[2] facility, an Australian bank must meet legislative requirements that are administered by the Australian Prudential Regulation Authority (APRA).

In short, the banking regulations administered by APRA dictate that banks must maintain certain levels of capital in particular assets to protect against ‘bad loans’ – these are the so called ‘Capital Adequacy Requirements’ (CAR).  In return for meeting the CAR requirements, since the onset of the Global Financial Crisis, banks now also receive a government guarantee of the deposits they hold.

While non-bank deposit takers like Banksia also have capital requirements administered by APRA, if they don’t comply the legislation merely requires them to disclose their capital position to investors in prospectuses – it does not preclude them from taking deposits.  In more than 20 years of professional practice, I’m yet to meet an investor who would be able to see the risk that’s embedded in a prospectus which discloses a non-bank depositor taker’s (eg Banksia) compliance failures.

In broad terms, a bank must hold $10 of capital for every $100 of loans it writes.  In Banksia’s case, there was less than $3.60 capital for every $100 of loans.  Leading up to its demise, the number of Banksia loans in default rose quite dramatically. In part, this was a reflection of downturns in the regional economies where Banksia was based however it also reflected the higher risk nature of the parties that borrowed from it.

And ‘debenture’ means?

From an investor’s perspective, a debenture is a document which simply acknowledges that money has been lent to another party at an agreed rate of interest for an agreed term.  In the case of Banksia debentures, depositors lent money to (invested with) Banksia and it then lent that money on to borrowers.

The crucial point here is that there is very little – if anything – securing the debenture.  In general terms the only security which might underpin debentures is a so-called ‘fixed and floating charge’ over the borrower’s (eg Banksia’s) assets however there is no guarantee – no lender of last resort facility for the finance company (Banksia) to rely on in the event of needing to pay back debenture holders.

Debenture investors almost always have absolutely no protection!

If the interest rate is higher than bank interest rates…

Here’s the bottom line on debenture risk! If you see any interest bearing investment offering you interest rates that are higher than stock-standard bank deposit rates you can be sure there is much higher risk.

Why so? Well think about what’s going on here.  An investor lends money onto a finance company (eg Banksia) which then lends that money on to a borrower.  How good (bad?) a risk is the borrower?

Here’s the question you need to ask: Why doesn’t the party borrowing the (your) money from the finance company borrow it from a bank? 

And this is THE point!  The answer is that the borrower is too high of a risk for a bank to lend to so they need to borrow from a lending source that is prepared to accept the higher risk.  However, the lender (eg Banksia) knows the borrower is high risk so they charge a higher loan interest rate than what a bank would charge.  The higher loan rate results in a higher interest paid to the debenture (lender) holder and therein lays the risk for the investor.

Buyer (investor) beware!

On a final note, I should point out that it is possible for investors to earn very competitive interest rates with strong capital stability that are not high-risk debentures.  It’s a matter of knowing where risk exists and understanding how to reduce it, before investing.

[1] The receivers recently indicated they hope to make a payment of 15 cents in the dollar to account holders before Christmas 2012.

[2] A lender of last resort facility is provided to allow licensed banks to borrow from the RBA in the event that they should experience a ‘run’ on depositors’ funds. In such an event the RBA would provide (lend) funds to the bank to cope with the withdrawal requests from depositors.

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