Executive summary

Objectives and principles

This Inquiry’s objective is to assess, and make recommendations on, how the financial system can most effectively help the Australian economy be productive, grow and meet the financial needs of Australians.

To meet this objective, the Inquiry considers that the financial system must satisfy three principles: efficiently allocate resources and risks, be stable and reliable, and be fair and accessible. These three principles underpin the following analysis.

The Inquiry’s initial assessment

Based on the input of submissions, regulators and international perspectives, the Inquiry’s initial assessment is that, to date, the Australian financial system has performed reasonably well in meeting the financial needs of Australians and facilitating productivity and economic growth.

Indeed, many areas of the financial system are operating effectively and do not require substantial change. Those areas are not the focus of this Interim report.

However, there is no room for complacency. The Australian economy will face a number of opportunities and challenges in the coming decades. Each of these has implications for the financial system:

• Future financial crises: History has demonstrated that financial crises can and will occur at significant cost to the economy. Although we cannot predict their cause or timing, our financial system framework should reduce the likelihood and impact of such events.
• Fiscal pressures: The Commonwealth’s fiscal position will continue to come under long-term pressure, particularly from the effect of an ageing population.
• Productivity growth: On its current trajectory, productivity growth will not be able to sustain the same rate of income growth experienced over the past decade. The financial system has an important role to play in facilitating higher productivity growth through funding the economy more efficiently, including funding new businesses and using new technology.
• Technology change: The rapid pace of technology change has already had a significant impact on both consumers’ interaction with the financial system and how the system functions. Although difficult to predict, future changes will present both opportunities and risks for the financial system and are expected to continue to have a significant impact.
• International integration: Although Australia’s key financial relationships remain with Europe and the United States, the weight of global economic activity is shifting towards Asia. This trend presents opportunities and risks for Australia.

In analysing how well the Australian financial system is prepared to meet these challenges, the Inquiry has identified nine priority issues facing the system, as outlined in the diagram below.

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The Inquiry makes a number of observations related to each issue. These observations are based on the evidence presented to the Inquiry through the consultation and submission process as well as the Inquiry’s judgement. In most cases, these observations reflect areas where submissions suggest the performance of the system may be improved in some way.

Based on these observations, the Inquiry puts forward a range of possible policy options for consultation. These policy options should not be considered as draft recommendations. The Inquiry has sought to consult on a broad range of policy options to ensure informed practical policy recommendations in the Final Report.

The remainder of the executive summary outlines the Inquiry’s observations and possible policy options for stakeholder feedback.

Growth and consolidation

Since the Wallis Inquiry, the financial system as a whole has grown significantly, especially the superannuation sector. The system has also seen considerable consolidation and integration, particularly in banking.

Against this backdrop of growth and consolidation, and noting the consequences of the global financial crisis (GFC), the Inquiry observes several issues, including opportunities for improvement in competition and contestability, distortions in funding flows, and issues with the efficiency and policy settings of the superannuation system.

Competition and contestability

Competition is the cornerstone of a well-functioning financial system, driving efficient outcomes for price, quality and innovation.

Most sectors of the Australian financial system are concentrated, with that concentration generally increasing since the Wallis Inquiry. Banking, payments, financial market infrastructure (FMI) and personal general insurance have a relatively high degree of market concentration. However, competition can be strong between players in a concentrated market. Indeed, market concentration can be a by-product of competition, if more efficient firms grow at the expense of their less efficient competitors.

On balance, the Inquiry considers that the banking sector is competitive. The net interest margins of the major banks are around historic lows, and their average return on equity is comparable to those achieved by other large Australian companies. However, although the banking sector as whole appears competitive, the level of competition may vary across individual banking markets.

Risk weights affect the extent to which a bank must fund its assets using regulatory capital rather than potentially cheaper deposits and wholesale debt. The IRB banks have lower risk weights for mortgage lending than standardised ADIs, although the advantage is less clear in relation to other asset classes. This provides the IRB banks with a cost advantage for mortgage lending. However, the extent of the disadvantage would vary between ADIs, depending on the riskiness of their assets, as well as over time.

Large banks derive funding advantages from their size and sophisticated risk management systems. However, some submissions argue that large banks also benefit from a funding advantage because they are perceived as being too-big-to-fail. The Inquiry considers the best way to deal with any potential competitive advantage arising from these perceptions is to directly address the systemic risks posed by large banks.

During the GFC, the residential mortgage-backed securities (RMBS) market became dislocated and the cost of RMBS funding increased. Since then, the market has started to recover, although not back to pre-GFC levels. There is little evidence that the current state of the RMBS market and the associated deterioration in the competitive position of smaller ADIs and non-bank lenders relate to an ongoing market failure.

The Inquiry considers that interchange fee caps have improved the functioning of four-party payment schemes. They have reduced merchant service fees. Although difficult to measure, the caps have also most likely reduced cross-subsidisation from customers who use low-cost payment mechanisms, such as cash, to those who use high-cost payment schemes.

However, payment systems of similar economic substance should be regulated consistently. Arguably four-party interchange fees, companion card service fees and incentive payments under all schemes are equivalent in economic substance.

The Competition chapter also seeks information on the following topics:

• Competition in small- and medium-sized enterprise (SME) and personal lending
• Vertical integration in the banking sector

Funding Australia’s economic activity

The efficiency with which Australia’s financial system allocates funding and risk in the economy affects Australia’s economic growth and long-term living standards. Although it is difficult to assess allocative efficiency, it is likely that distortions are hampering the operation of price mechanisms that would otherwise promote an efficient allocation of funding and risk. The Inquiry has identified three main sources of distortions: taxation, regulation and market imperfections.

Australia has been a net importer of foreign funds for much of its history and has therefore recorded persistent current account deficits. Used productively, additional investment increases the economy’s growth potential.

Financing constraints can limit a firm’s development and ability to transform ideas into technical advances. This can affect broader job creation, productivity and economic growth.

Information asymmetries are the most significant structural factor contributing to the higher cost and lower availability of credit for SMEs. Lenders typically will have limited knowledge about a new borrower’s financial position, the financial performance of the business and the financial behaviour of the business owner.

Traditionally, private non-financial corporations have made relatively little use of the domestic bond market. A more developed and accessible corporate bond market would provide corporates with more funding options and allow investors to better diversify their portfolios.

Corporate issuers face impediments in making public offers of listed corporate bonds, particularly to retail investors. Reducing such impediments would likely increase investor demand for domestic corporate bonds.

The Inquiry has identified a number of tax issues that affect the allocation of funding and risk in the economy.

Certain tax and regulatory settings distort households’ saving decisions towards housing, for both owner-occupiers and investors. Tax incentives also encourage investors to use more leverage than otherwise might be the case.

Since the Wallis Inquiry, the increase in housing debt and banks’ more concentrated exposure to mortgages mean that housing has become a significant source of systemic risk.

A number of other taxes may materially affect the demand for, and supply of, funding for particular sectors and the broader allocation of funding and risk. Details of tax issues raised in the report are in Appendix 2 (Tax Summary).

The Funding chapter also seeks information on the following topics:

• Australia’s insolvency regime
• Infrastructure financing
• Impact investment and social impact bonds
• The banking system
• Superannuation
• Equity financing

Superannuation efficiency and policy settings

Principally as a result of Government policy, the superannuation system is large and growing rapidly. It is an important source of funding for long-term capital formation, which is important for national productivity growth.

Notwithstanding the difficulties in comparing fees and costs across funds, Australia’s superannuation sector has some of the highest operating costs among Organisation for Economic Co-operation and Development countries. The decline in fees over the past decade is modest, given the economies of scale that the sector has achieved. That said, high allocations to growth and alternative assets contribute to these costs, but they can also deliver higher after-fee returns to members.

In general, competition has led to feature-rich, but more costly, superannuation products, in part reflecting that many consumers are not fee sensitive. It is too early to assess the effect of recent reforms to default arrangements (MySuper) on fees. There is an opportunity for fees to fall significantly over time, with further expected increases in scale and increased competition for MySuper products.

High demand for liquidity from superannuation funds may be reducing after-fee returns to members. The mandatory inter-fund portability timeframe of three days is contributing to higher allocations to liquid assets than the system requires.

It remains unclear whether funds are chasing short-term returns and, if so, whether this is contributing to lower after-fee returns, as well as to what extent more individual tailoring of asset allocations would produce net benefits to members.

The general lack of leverage in the superannuation system is a major strength of the financial system. Although direct leverage in superannuation is small, the current ability to borrow directly may, over time, erode this strength and create new risks to the financial system.

Constant change in superannuation and retirement income policy settings imposes costs on superannuation funds, which are ultimately paid by members. As superannuation is a long-term savings vehicle, change can also undermine confidence and trust in the system.

To ensure policy stability, the system needs to achieve, and be seen to achieve, its objectives efficiently and equitably, and the fiscal cost needs to be sustainable. Some evidence casts doubt over whether current policy settings will stand the test of time.

The Superannuation chapter also seeks information on the following topics:

• Mechanisms to drive down fees
• Vertical integration
• Tailoring asset allocation and the focus on short-term returns
• Active asset management
• Pricing of member investment switching
• Liquidity management
• Trust structure
• Self-managed superannuation fund operating costs and establishment

Post-GFC regulatory response

The GFC tested both the resilience of the Australian financial system generally and the performance of its regulators. We can learn many lessons from the GFC. This has been reflected in the substantial volume of regulatory change over recent years in Australia and internationally.

The Inquiry considers this an opportune time to revisit Australia’s approach to stability and the prudential framework, consumer and conduct regulation, and our regulatory architecture. In light of the GFC experience, the Inquiry will consider the need for any change.

Stability and the prudential framework

Australia’s approach to financial stability proved resilient during the GFC. No prudentially regulated institution experienced a disorderly failure, and there was only a minor interruption to economic growth.¹ However, there are many lessons on which to reflect.

Financial institutions that were of such size, market importance or interconnectedness that their failure would cause significant financial or economy disruption were at the heart of the GFC. Unprecedented government support was extended to these institutions globally, which — although necessary to avoid worsening the crisis — perversely entrenched views that such institutions are too-big-to-fail and therefore receive an implicit government guarantee. Reversing these perceptions and their associated moral hazard has been a focus of the international regulatory agenda.

The Australian Government can adopt a number of measures to reduce these perceptions. It can take steps to make it more likely or more credible to achieve orderly failure without Government support and to lower the probability of failure in the first place. Some of these steps would be relatively low-cost and straight forward to implement, while others would involve substantial changes to the Australian financial system. Many of these measures could also have an effect on competition.

Systemic risks have the potential to cause financial system–wide disruption and inflict severe damage on the economy, as demonstrated by the GFC. The ability to identify and manage systemic risks is critical to long-term financial stability and economic growth. In general, Australia has a robust framework for monitoring and responding to systemic risks, although risks arising outside the prudential perimeter may be more difficult to manage.

A number of international jurisdictions have introduced quantitative ‘macroprudential’ tools for managing systemic risk. Empirical evidence and academic research is still limited on the effectiveness of these tools. Nevertheless, the Inquiry sees merit in investigating whether some additional tools for addressing systemic risk would be helpful, but it is cautious about Australia adopting tools that are yet to be proven.

Australia adheres to a number of international prudential frameworks, in particular the Basel framework for the banking industry. Among other benefits, this strengthens Australia’s international reputation and facilitates the integration of Australia’s financial system with the rest of the world. Australia is an active member of many international standard-setting bodies and has had considerable success in ensuring that such standards are fit for Australia.

As an importer of capital, it is critical that Australia continues to adopt appropriate international standards. This will require Australia’s active participation in the international bodies that set these standards to ensure they suit our national circumstances.

Submissions highlight some areas where Australia has used national discretion to diverge from baseline international standards. In some instances, this divergence has obscured international comparisons of prudential ratios, potentially creating real costs for industry. However, Basel Committee on Banking Supervision data shows that Australian banks do not have excessively high capital ratios relative to their peers.

The GFC revealed the failure of both the boards and senior management of some international financial institutions to understand fully the risks their institutions were undertaking, as well as a culture of focusing on short-term gains. Recognition of the role boards and senior management play in fostering corporate culture and determining the risk appetite and behaviour of financial institutions is critical.

However, stakeholders are concerned that, in Australia, regulatory burdens unduly require boards to play a quasi-management role, taking time away from other appropriate governance activities and strategic oversight. Part of this may stem from a lack of clarity around regulators’ expectations of boards, which should be addressed.

In addition, the primary duty of governing bodies differs across different types of financial institutions. For example, the relevant legislation requires that insurer directors and superannuation fund trustees place the interests of policy holders and members ahead of those of shareholders, yet there is no equivalent for ADIs. It is not clear if this diversity is appropriate.

The Stability chapter also seeks information on the following topics:

• Financial Claims Scheme
• The appropriate primary duties of financial institution governing bodies

Consumer outcomes and conduct regulation

The financial system should meet the financial needs of Australians. Retail consumers are an important end-user of the financial system. Trust in the financial system is an important prerequisite for consumers to participate confidently and actively in the financial system. Since the Wallis Inquiry, consumers have been increasingly required to participate in the financial system through compulsory superannuation. Fundamental to the effective operation of the financial system is the appropriate allocation of risk between participants. Consumers, like other participants, must take responsibility for both the risk and reward of financial decisions. However, adverse consumer outcomes in the financial system may result from a variety of factors, including fraud, mis-selling, product unsuitability, lack of information and lack of financial literacy.

Consumer outcomes can be enhanced by a variety of methods, including competition, innovation by industry and effective regulatory regimes (including self-regulation). Regulation seeks to create confidence and trust in the financial system, inform consumers and assist them to manage their risk. Active surveillance and enforcement are an important part of enhancing confidence and trust in the financial system and encouraging consumer participation. Although Australia’s financial system performed reasonably well during the GFC, consumers still suffered substantial loss in some areas. In addition, a series of domestic failures in the last decade have demonstrated limitations in a number of vital elements of the consumer protection framework introduced following the Wallis Inquiry.

Although disclosure is an important part of the regulatory regime for providing financial products and services, it alone has not been sufficient to enable consumers to make informed decisions and purchase products and services that meet their needs. Over the past decade, industry and Government have made efforts to improve the quality of disclosure documents. However, a culture of legal compliance, rather than a focus on how best to inform consumers, continues to influence the design of disclosure documents. This has resulted in lengthy and complex documents, rather than short, targeted documents that highlight product features, risks and rewards. Submissions also argue that disclosure compliance has been costly for industry.

For consumers to engage effectively with the financial system and meet their financial needs, they need access to advice that helps them make informed financial decisions. Many consumers consider that their advice needs are currently unmet.

Studies suggest there are significant issues with the quality of financial advice, due in part to varying standards of adviser competence and the impact of conflicted remuneration structures. Some submissions suggest aligned or vertically integrated structures may also reduce the quality of advice consumers receive.

At times, consumers also lack access to affordable advice. In addition, some submissions question whether general advice is properly labelled and whether consumers understand its nature, given general advice often includes sales and advertising information.

Insurance can mitigate risks of significant loss for consumers. The decision to insure against certain risks is a personal one, which means there will always be a level of non-insurance and underinsurance in the system. However, other factors may also drive levels of underinsurance. The increasing trend towards risk-based pricing may make insurance more affordable for some consumers. However, it will also disadvantage others through increasing costs, potentially to the point of unaffordability, or may mean that some people are simply not offered insurance. That said, risk-based pricing provides important price signals to consumers, which may encourage risk minimisation in some cases.

The Consumer outcomes chapter also seeks information on the following topics:

• Financial literacy
• Financial advice
• Disclosure for prospectuses
• Levels of underinsurance
• Industry self-regulation
• Microfinance facilitating access to credit
• Small business lending
• Regulation of managed investment schemes
• Consumer loss as a result of misconduct
• Product rationalisation of legacy products

Regulatory architecture

Australia’s regulatory structure has served us well, and the perimeters defined by the Wallis Inquiry remain broadly valid. However, market developments, technological advancements and stakeholder feedback suggest there is value in re-examining certain aspects.

The Inquiry has also commissioned work on the costs and benefits of the extent of regulation in the financial system, and seeks further evidence in this regard. In parallel, the Government is running a deregulation process that includes improving policy development processes and assessing existing regulation.

The Inquiry also notes that concurrent with the preparation of this report, the Senate has been examining the performance of the Australian Securities and Investments Commission. The Senate Committee’s Report contained a large number of recommendations that are relevant to the work of this Inquiry. The Senate Report was issued at the time the Interim Report was being finalised for printing. The findings of the Senate Report will be carefully examined by this Inquiry in the lead-up to its Final Report.

The Inquiry’s intention is to assess the current regulatory perimeters and align regulation for like risks. A number of areas have been examined, building on the Wallis Inquiry’s intensity of promise.

Strong, independent financial regulators are crucial to the efficient, stable, fair and accessible operation of the financial system. However, regulators also require robust accountability mechanisms that provide appropriate checks and balances.

Submissions identify areas of improvement in relation to operational and budgetary independence. Current funding models for the Australian Prudential Regulation Authority (APRA) and ASIC diverge from best-case funding models for financial regulators. In particular, the current funding models potentially could be improved through increasing the certainty of year-to-year funding.

Although Australian financial regulators are subject to a range of existing accountability mechanisms, the Inquiry recognises there is room to strengthen accountability mechanisms, particularly in light of proposals to increase independence.

The Council of Financial Regulators (CFR) is a well-functioning mechanism, playing an important role in coordinating financial regulation and stability issues.

The CFR’s objective is to contribute to the efficiency and effectiveness of financial regulation by providing a high-level forum for cooperation and collaboration among its members. The capacity of the CFR to perform this function was tested during the GFC, to the satisfaction of both domestic stakeholders and the International Monetary Fund.

Regulators also participate in a number of councils, committees and working groups with each other, through which regulatory interventions and supervision activities are coordinated.

Underlying these coordination mechanisms is a strong culture of cooperation and collegiality among the financial sector regulators and the Treasury.

An effective regulatory model requires Government to specify regulators’ mandates and objectives with clarity and transparency. Although the individual parts of Australia’s regulatory mandates are clear, they are not entirely unambiguous: they require judgement in balancing sometimes competing objectives. Submissions typically raise this issue in the context of competition.

Stakeholders also question the breadth of ASIC’s mandate, which has grown over time.

Regulators face strong competition for top talent, given the size and high remuneration levels of the Australian financial sector. Another hurdle is the perception that APRA and ASIC’s operational independence and effectiveness are unduly hampered by public sector operating constraints.

The Regulatory architecture chapter also seeks information on the following topics:

• Costs and benefits of regulation
• Regulator mandates, including the role and remit of ASIC

Emerging trends

Over the coming decades, Australia will confront a number of continuing trends as well as new drivers of change for the financial system, creating both opportunities and risks. These changes include our ageing population, technological change and Australia’s international integration. To varying degrees, these trends are already manifesting themselves.

Retirement incomes and ageing

The superannuation drawdown phase of Australia’s retirement income system provides limited choice for managing risk in retirement. It also gives little guidance to retirees in navigating complex and important financial decisions. Retirees do not efficiently convert superannuation benefits into income streams in retirement.

During the accumulation phase, employers make Superannuation Guarantee contributions automatically on behalf of employees, with defaults applying to those who are less engaged with the system. This framework to guide individuals ceases at retirement. Retirees make critical, once-in-a-lifetime decisions regarding when and how to draw down their savings over the remainder of their lives, and how to manage the investment, inflation and longevity risks involved. Many retirees are unprepared for these decisions.

Risk management is a major weakness of the drawdown phase. Although individuals are concerned about outliving their savings, few retirees use income stream products with longevity risk protection, and there a limited choice of these products. Australia is unusual in not encouraging its citizens to use income streams with longevity protection in retirement. Also, the Government bears significant longevity risk by providing the Age Pension.

Around half of superannuation benefits in retirement are currently paid as lump sums, while the other half are paid as income streams. Australians who wish to convert their superannuation assets into a retirement income stream can essentially choose from two types of products: account-based pensions and annuities. The overwhelming majority of retirees who take income streams choose an account-based pension.

There are products that could help retirees achieve their desired levels of income and help them manage their risks better. These do not exist in Australia due to market impediments.

The Retirement income chapter also seeks information on the following topics:

• Potential increased government provision of longevity insurance
• Reverse mortgages

Technology opportunities and risks

Technology is a powerful force for change in the financial system, potentially improving efficiency and competition, and benefiting consumers. Consumers have better access to information and products to meet their needs. Firms can better customise products and enhance internal processes. Competition is emerging from technology-enabled alternative business models, new entrants and new services.

Financial services boundaries are shifting as firms from inside and outside the sector harness the power of data to create and capture value in new ways. In particular, many are seeking to influence a greater share of consumers’ spending. Increasingly, technology firms and retail groups are also becoming part of financial service delivery. These trends and benefits bring new or intensified risks.

Government and regulators face ongoing challenges from the need to apply existing regulatory frameworks to new participants and products. In a rapidly changing environment, a technology neutral approach facilitates regulatory flexibility. As firms outside the regulated financial sector increasingly perform financial-type functions, challenges are raised for the regulatory perimeter. Although innovation may bring risks, it is important for Government to enable technology’s benefits to flow through the financial system, while also maintaining stability.

Firms are collecting, storing and using growing volumes and types of customer data. Information analytics has the potential to provide consumers with better products and improved access. It may also present opportunities to empower consumers through access to better information for decision making. Firms may be able to improve internal processes, such as those for risk assessment and pricing, and create more efficient marketing and better cross-sell opportunities. Although there are many potential benefits from the growth and use of data, concerns are increasingly raised about the way in which personal information is used and handled.

The rise of e-commerce and widespread internet connectivity expose financial institutions to increasingly more cyber crime. Cyber attacks are growing in sophistication and frequency. Cyber security is one of the Government’s top national security priorities and the financial system is considered part of Australia’s critical infrastructure.

Consumers’ growing preferences for online and digital delivery of financial services is increasing the need for digital identity solutions. Australia currently has a decentralised identity infrastructure and various building blocks to assist with digital identity solutions. However, it has not yet developed a detailed approach for the future of digital identities.

The Technology chapter also seeks information on the following topics:

• Priorities for regulatory amendments in relation to technology neutrality
• Government and regulatory mechanisms for responding to innovation
• Consumer and private sector access to data
• Cyber security information sharing, standards setting and crisis planning
• Digital identity roles and responsibilities for the private and public sector

International integration

Australia has benefited substantially from financial integration with the rest of the world, most notably from trade and accessing international capital markets over many decades. Benefits have also flowed from opening up Australia’s financial services market to foreign competition and from exporting financial services to other markets, although these exports have not been as significant.

Since the GFC, cross-border capital flows have declined globally and the international regulatory response to the crisis has in part aimed to reduce the interconnectedness of the global financial system and increase its resilience to shocks. Although the risks are real, there remain long-term benefits from financial integration.

The Inquiry supports efforts to drive greater financial integration with the rest of the world, provided it doesn’t compromise appropriate standards for financial stability and conduct in Australia. The Inquiry does not support tax subsidies, concessions or market intervention to enhance financial integration.

Given the anticipated development in Asian financial markets in coming decades, and the strength and significance of Australia’s trade relationships with the region, opportunities to access capital in Asia are likely to increase. Predictions are that Australian and Asian financial services firms will expand into each other’s markets and grow financial services exports and imports. Ongoing engagement with financial markets in North America and Europe will also continue to be important.

The Inquiry seeks to engage with stakeholders in more detail about the existence of impediments and the priorities for considering them, prior to the Inquiry’s Final Report.

Commercial issues and market conditions are often the most significant factors affecting the level and nature of financial integration; however, policy and regulatory settings are also important. These factors are especially significant in the financial services sector, both because it is heavily regulated and because, since the GFC, more standards are being set by international bodies and foreign regulation increasingly extends to activities occurring in Australia.

Mutual recognition by regulators facilitates greater integration, as do arrangements between central banks.

Although greater financial integration is not without risk, a number of inquiries have made recommendations to remove impediments to greater integration and foster mutual recognition, particularly within the Asian region. Government has generally responded positively to these recommendations, but implementation has been slow and not always well coordinated across Government, regulators and industry.

The Inquiry recognises that much of the success in enhancing financial integration will depend on commercial and market factors, as well as the financial sector’s willingness and capacity to drive greater integration.

¹ A number of non-prudentially regulated institutions did fail over this period. However, while these caused losses for individual investors, their broader effect was limited.