Australia's Financial System Inquiry

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The final report of Australia’s Financial System Inquiry (Inquiry) was released on 7 December 2014 (Final Report). According to the Treasurer, The Hon Joe Hockey MP, it lays out a blueprint for Australia’s financial system over the next decade.

Background and current status

Before the 2013 federal election, the current Government pledged to commission an extensive review of Australia’s financial system. The last inquiry of a similar nature was undertaken 17 years ago and resulted in major reforms to Australia’s financial landscape, including streamlined financial services regulation, the creation of the Australian Prudential Regulation Authority (APRA) and the current form of the Australian Securities and Investments Commission (ASIC).

The present inquiry, chaired by Mr David Murray (the inaugural Chairman of the Australian Government Future Fund Board of Guardians and the former Chief Executive Officer of the Commonwealth Bank of Australia), was tasked with examining how the financial system could be positioned to best meet Australia’s evolving needs and support Australia’s economic growth.

An International Advisory Panel was also appointed by the Treasurer. The panel’s role was to provide the Inquiry with an expert perspective on various aspects, including technological change, Australia’s global competitiveness and offshore regulatory frameworks.

The Inquiry released an interim report on Tuesday, 15 July 2014. This report made observations about the financial system and raised a range of policy options for stakeholder feedback. The release of the interim report was followed by a period of consultation. The Final Report was released this week (7 December 2014).

The Final Report

The Final Report made 44 recommendations that are intended to promote the efficiency, resilience and fairness of the financial system to facilitate the system’s role in supporting a vibrant, growing economy that improves the standard of living of all Australians.

The report focussed on the following seven themes:

Main Themes Descriptions
General Themes  
Funding the Australian economy Removing distortions to efficiency
Competition Allowing competition and market forces to drive efficiency
Specific themes  
Resilience Strengthen the economy by making the financial system more resilient
Superannuation and retirement incomes Lift the value of the superannuation system and retirement incomes
Innovation Drive economic growth and productivity through settings that promote innovation
Consumer outcomes Enhance confidence and trust by creating an environment in which financial firms treat customers fairly
Regulatory system Enhance regulator independence and accountability, and minimise the need for future regulation

An overview of the main themes identified in the Final Report

GENERAL THEMES

The Inquiry identified two areas where there is scope to improve the functioning of the Australian financial system:

1. Funding the Australian Economy

Key point: Removing distortions to efficiency

In the view of the Inquiry, the framework for the issuance and trading of debt and equity in Australia is operating reasonably well. However, the Inquiry observed that some funding markets, including the corporate bond and venture capital markets, appear underdeveloped compared with those of international peers. To address this, the Inquiry recommended that obstacles to the growth of the corporate bond market should be addressed, including regulatory barriers and tax distortions, particularly the non-neutral treatment of savings vehicles. It was also recommended that the disclosure requirements for large listed corporates issuing ‘simple’ bonds be reduced and industry encouraged to develop standard terms for such products.

In addition, the Inquiry identified a number of distortions that impede the efficient market allocation of financial resources, including taxation, information imbalances and unnecessary regulation. In this regard, the Inquiry recommended that the Government’s White Paper on the Reform of Australia’s Tax System should consider the reform of tax settings that distort the flow of funds.

The Inquiry also recommended the removal of obstacles for small to medium size enterprise (SME) financing, including facilitating crowd funding for both debt and equity, and over time, other forms of financing; and reducing information imbalances by supporting industry efforts to expand credit data sharing under the new voluntary comprehensive credit reporting regime.

Further, the Inquiry emphasised the importance of strengthening Australia’s ability to continue to access funding, both domestically and from offshore sources and building a more efficient superannuation system.

2. Competition

Key point: Allowing competition and market forces to drive efficiency

The Inquiry noted that whilst competition is generally adequate, the high concentration and increasing vertical integration in some parts of the Australian financial system has the potential to limit the benefits of competition in the future and should be proactively monitored over time.

In respect of the banking sector, the Inquiry recommended narrowing the differences in risk weights for the purpose of calculating capital ratios between authorised deposit-taking institutions (ADIs) using internal ratings-based models and those using standardised models, to improve the competitive neutrality of capital regulation.

In respect of the superannuation sector, the Inquiry also proposed introducing a competitive mechanism to allocate members to more efficient superannuation funds, unless the recently introduced Stronger Super reforms prove effective.

The Inquiry also made a number of further recommendations targeted at improving competition including reviewing the costs and benefits of increasing access to and improving the use of data, taking into account community concerns about appropriate privacy protection; refining the payments regulation framework; supporting innovation and new entrants; ensuring regulators are more sensitive to the effects of their decisions on competition, international competitiveness and the free flow of capital; and reviewing the state of competition in the financial system every three years.

SPECIFIC THEME

1. Resilience

Key point: Strengthen the economy by making the financial system more resilient

The Inquiry made several recommendations to improve the resilience of Australia’s financial system, particularly in the longer term and in times of financial stress. Significantly, the Inquiry recommended setting capital standards such that Australian authorised deposit-taking institutions capital ratios are seen to be unquestionably strong. In particular, a baseline target in the top quartile of internationally active banks was recommended.

As noted in 1(b) above, the Inquiry also recommended narrowing differences in risk weights for the purpose of calculating capital ratios between authorised deposit-taking institutions (ADIs) using internal ratings-based models and those using standardised models, to improve the competitive neutrality of capital regulation.

In order to reduce the costs of failure the Inquiry recommended ensuring authorised deposit-taking institutions maintain sufficient loss absorbing and recapitalisation capacity to allow effective resolution with limited risk to taxpayer funds — in accordance with international practice.

Further recommendations to improve resilience included recommendations that APRA develop a loss absorbing and recapitalisation framework in line with emerging international practice, sufficient to facilitate the orderly resolution of Australian ADIs and minimise taxpayer support; developing a reporting template for Australian ADI’s capital ratios that is transparent against the minimum Basel capital framework; and removing the exception to the general prohibition on direct borrowing for limited recourse borrowing arrangements by superannuation funds.

2. Superannuation & Retirement Incomes

Key point: Lift the value of the superannuation system and retirement incomes

The Inquiry made several recommendations aimed at making the superannuation system more efficient. In particular, the Inquiry recommended strengthening the superannuation system by setting a clear objective for the superannuation system to provide income in retirement.

Further, the Inquiry noted that long-term net returns for members could be improved by introducing a formal competitive process to allocate new workforce entrants to high-performing superannuation funds, unless the recently introduced Stronger Super reforms prove effective.

Finally, the Inquiry identified that the needs of retirees could be better met by requiring superannuation trustees to pre-select a comprehensive income product for members’ retirement, unless members choose to take their benefits in another way.

3. Innovation

Key point: Drive economic growth and productivity through settings that promote innovation

The Inquiry recommended several means of promoting innovation in Australia’s financial system in order to increase competitive tension, deliver greater efficiency and enhance user outcomes.

The Inquiry recommended implementing a national digital identity strategy that would involve the Government setting up a framework under which private and public sector identity providers would compete to supply trusted digital identities to consumers and businesses.

In addition, the Inquiry recommended the removal of regulatory impediments to innovation, particularly in the payments system and in fundraising for small businesses. In respect of payment systems, the Inquiry recommended improving interchange fee regulation by clarifying thresholds for when they apply, broadening the range of fees and payments they apply to, and lowering interchange fees. Surcharging regulation could also be improved by expanding its application and ensuring customers using lower-cost payment methods cannot be over-surcharged by allowing more prescriptive limits on surcharging.

Further, the Inquiry recommended that the Productivity Commission hold an inquiry into the costs and benefits of increasing access to and improving the use of private and public sector data, while taking into account community concerns about appropriate privacy protections.

4. Consumer Outcomes

Key point: Enhance confidence and trust by creating an environment in which financial firms treat customers fairly

The Inquiry identified a range of measures that seek to strengthen the current framework and promote fair treatment of consumers and trust in the system.

In relation to product design and distribution, the Inquiry noted that the existing framework relies heavily on disclosure, financial advice and financial literacy, which it found may be ineffective in some instances. As an alternative, the Inquiry advocated the introduction of a targeted and principles-based product design and distribution obligation requiring product issuers and distributors to consider a range of factors when designing products and distribution strategies. In addition, the Inquiry recommended strengthening product issuer and distributor accountability, and implementing a new proactive product intervention power for ASIC where there is a risk of significant consumer detriment.

In addition, the Inquiry recommended removing regulatory impediments to innovative product disclosure and communication with consumers; improving the way risks and fees are communicated; and better aligning the interests of financial firms with those of consumers by raising industry standards, enhancing the power to ban individuals from management and ensuring remuneration structures in life insurance and stockbroking do not affect the quality of financial advice.

In respect of financial advice, the Inquiry made several recommendations including seeking to raise the competency of financial advice providers generally; improving guidance and disclosure for general insurance products; renaming "general advice"; and requiring advisers to disclose ownership structures.

5. Regulatory System

Key point: Enhance regulator independence and accountability, and minimise the need for future regulation

The Inquiry proposed changes to the regulatory system to improve regulator independence and accountability, and minimise the need for future regulation.

In relation to accountability, the Inquiry recommended creating a new Financial Regulator Assessment Board to allow the Government to better monitor and assess the performance of financial regulators. The Inquiry also recommended providing clearer guidance to regulators in Statements of Expectation and increasing the use of performance indicators for regulator performance.

In relation to independency, the Inquiry encouraged the adoption of a three-year funding model to provide regulators with more stable funding, and increase their capacity to pay competitive remuneration. In addition, the Inquiry recommended that regulators undertake periodic capability reviews to ensure they are adequately resourced to deliver effectively on their mandates.

The Inquiry also recommended strengthening ASIC’s funding and powers. The proposed mechanism to achieve this is through industry funding, increased fees and levies for ASIC’s regulatory activities.

Finally, as highlighted in 1(b) above, the Inquiry recommended strengthening competition in the financial system by improving reporting of how regulators balance competition against their core objectives, identifying barriers to the cross-border provision of financial services and including consideration of competition in ASIC’s mandate.

NEXT STEPS

The Treasurer has indicated that the Government intends to consult with industry and consumers before making any decisions on the recommendations. This consultation will occur up until 31 March 2015, with the Government releasing a formal response in mid-2015. In addition, several of the Inquiry’s recommendations, including those on bank capital and the payment system, will need to be considered by APRA and the Reserve Bank of Australia, as independent regulators.

Allen & Overy will be preparing a number of articles looking at discrete aspects of the proposed reforms. These will be circulated as they become available.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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