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Australia's financial system inquiry

Before the 2013 federal election, the 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).

Background and current status

The present inquiry, chaired by 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), has been tasked with making recommendations that "foster an efficient, competitive and flexible financial system, consistent with financial stability, prudence, public confidence and capacity to meet the needs of users".1

The Financial System Inquiry released its Interim Report on 15 July 2014. Since its release, the inquiry has received over 6,300 submissions and will provide its final report and recommendations to the Treasury in November of this year.

The interim report

The interim report is wide ranging and considers a range of options as to how to modify the regulatory framework to best cope with future challenges and provide a platform for future opportunities. At this stage, the inquiry has not sought to provide recommendations but, rather, has made a range of observations that reflect the inquiry's current judgment, based on the available evidence. The inquiry has encouraged feedback and evidence either supporting or contesting the observations made.

The inquiry has identified the following priority issues facing the financial system, each of which is discussed in greater detail below:

Growth and consolidation Post-GFC regulatory response Emerging trends
- Competition and contestability - Stability and the prudential framework - Retirement incomes and ageing
- Funding Australia's economic activity - Consumer outcomes and conduct regulation - Technology opportunities and risks
- Superannuation efficiency and policy settings - Regulatory architecture - International integration

An overview of the priority issues identified in the Interim Report

Growth and consolidation

(a) Competition and contestability: While the inquiry found that the banking sector as a whole is competitive, the application of capital requirements is not competitively neutral. Larger banks that use internal ratings-based risk weights have lower risk weights for mortgage lending than smaller authorised deposit-taking institutions that use standardised risk weights, giving the larger banks a cost advantage.

Similarly, the regulation of credit card and debit card payment schemes requires attention as systems that currently perform similar functions are regulated differently depending on their structure, which provides an unintended competitive advantage for some products.

(b) Funding Australia's economic activity: The inquiry noted that ongoing access to foreign funding has enabled Australia to sustain higher growth than otherwise would have been the case. The risks associated with Australia's use of foreign funding can be mitigated by having a prudent supervisory and regulatory regime and sound public sector finances.

In relation to funding more generally, the inquiry identified a number of structural impediments for small- and medium-sized enterprises trying to access finance, including information asymmetries and issues of regulation and taxation. In addition, it was noted that a more developed and accessible corporate bond market would provide corporates with more funding options and allow investors to better diversify their portfolios.

(c) Superannuation (pension system) efficiency and policy settings: The report observed that there is a lack of strong competition on fees in the superannuation industry, with operating costs and fees appearing high by international standards. In addition, the inquiry raised concerns about the potential for superannuation to become more leveraged in the future, leading to future vulnerabilities.

As a broader issue, the report highlights that there is currently an absence of a shared philosophy and set of objectives for superannuation. The inquiry identifies some options for change, including more compulsion to purchase longevity protection and increased use of defaults for how individuals take their retirement benefits.

Post-GFC regulatory response

(a) Stability and the prudential framework: The report noted that the Government can adopt a number of measures to reduce the perception that some financial institutions are too big to fail, including taking steps to make it more likely to achieve orderly failure without Government support and to lower the probability of failure in the first place by introducing higher regulatory capital requirements and pre-positioning arrangements and increasing the capacity of regulators to impose costs on an institution's creditors rather than taxpayers.

(b) Consumer outcomes and conduct regulation: The inquiry highlighted that the current disclosure regime produces complex and lengthy documents that often do not enhance consumer understanding of financial products and services, and impose significant costs on industry participants.

In addition, studies suggest there are significant issues with the quality of financial advice, which could potentially be improved by improving the standards of adviser competence and removing the impact of conflicted remuneration (which has been the subject of separate reforms).

(c) Regulatory architecture: The interim report canvasses a number of options for change to the regulatory architecture and the way ASIC operates, including providing for operational and budgetary independence and accountability measures. In addition, the report notes that the civil and administrative penalties available to ASIC are low in comparison to comparable peers internationally.

Emerging trends

(a) Retirement incomes and ageing: The inquiry found that the retirement phase of superannuation is currently underdeveloped and does not meet the risk management needs of many retirees, particularly in relation to longevity risk. The report canvasses a range of options to address this, including encouraging retirees to purchase retirement income products that help manage such risks, introducing default options for how individuals take their retirement benefits, or mandating the use of particular retirement income products.

(b) Technology opportunities and risks: Technological innovation is seen as a major driver of efficiency in the financial system and can benefit consumers; however, the Government and regulators need to balance these benefits against the risks. For example, the use of customer information may improve efficiency but this has to be balanced against privacy and data security concerns. The inquiry outlines a range of related options, including amending regulation that specifies using certain technologies with the aim of becoming technology neutral, and ensuring that future regulation is similarly technology neutral.

(c) International integration: Although elements of Australia's financial system are internationally integrated, a number of potential impediments have been identified. In particular, financial system developments in the region will require continuing Government engagement to facilitate integration with Asia. Since the release of the interim report there have been discussions regarding the need for Australian "Volker"-style reforms together with a continued focus on regulatory capital in the context of international developments.

Next steps

The inquiry will continue to undertake a range of consultation processes, including public forums and domestic and international stakeholder meetings. We plan to assess its final report and recommendations (to be provided to Treasury in November) in future editions of the Risk Note.

1 "Financial System Inquiry", Media Release issued by the Hon Joe Hockey MP, Treasurer, 20 December 2013.
Legal and Regulatory Risk Note