Australia likes to boast about its well regulated financial and banking system, but out there in the shadows of the industry some strange things have happened.

Firstly, the spotlight was on the so called “shadow brokers” – around 650 of them who trade the ASX and Chi-X markets through intermediaries and thereby avoid regulation from ASIC.

A roll call of some of their names (not all of course) charts a trail of failure and, sadly, lost savings and investments for mum-and-dad investors.

Does anyone remember Opes Prime, Lift Capital, Chartwell or Sonray? They accounted for well over $1 billion in lost investments, and – in two cases – jail time for several founders.

Shadow banking

Now, the regulatory spotlight is on the “shadow banking” industry, the core business of which is offering debentures to retail investors at attractive interest rates.

It is estimated that just under $5 billion in funds resides in these organisations, whose existence is now a key focus after the $660-million collapse of Banksia Securities and the sudden sale of non-bank lender Southern Finance to Bendigo and Adelaide Bank, a sale that pre-empted an old-fashioned bank run.

For many people, the shadow bank issue is one of financial literacy. Many retail investors would not understand the difference between Approved Deposit Institutions (ADIs), regulated by the Australian Prudential Regulation Authority, and the debenture-issuing finance companies, which in many cases “borrow” BSB numbers from their banking providers.

ANZ Bank, for example, has lent out more than 70 BSBs to its clients to manage their receivables, a practice chief executive Mike Smith said last week is “like a cash-management tool”.

Asked if this was misrepresentation, Smith says its up to the regulators to decide, saying it was a similar situation to speeding in a motor vehicle, where the onus is on the police to act.

Bracing for a regulatory tsunami

Look beyond the strength of the big four banks and the $1.3 trillion in superannuation funds, and there are some major weaknesses in our financial system. In the lower echelons, the last few years have seen a plethora of failures of shadow brokerages, shadow banks, and managed-investment schemes.

Names such as Storm Financial and Westpoint highlight the fact that out there in the shadows, naïve and financially illiterate investors have lost significant amounts of money to organisations that existed outside of the tight embrace of our key regulators.

Critics of Australian regulation say the industry is bracing for a regulatory “tsunami”, with the FoFA reforms and a new suite of standards from APRA. The danger now is that our energetic approach to bank regulation could force some operators, who find compliance too onerous, outside of the system into a “shadow world” of lower supervision.

If that happens, much of the good work our regulators have done will be at risk, because it simply won’t be able to be enforced on a whole segment of the financial industry.

Financial industry players should not have the ability to opt out of vigorous regulation. Only a small percentage of them may have failed, but one financial collapse of this type is one too many.

You don’t have to be a devotee of Big Regulation to be in favour of increased supervision for those in the shadows. APRA, ASIC and the government need to shine the regulatory light deep into the shadows and ensure that there is nowhere for anyone to hide.

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