Financial System Inquiry - Interim Report

The Financial System Inquiry has identified several key themes, as well as nine priority issues facing Australia’s financial system.

The key themes and nine priority issues identified are:

Growth and consolidation

• Competition and contestability
• Funding Australia’s economic activity
• Superannuation efficiency and policy settings

Post-GFC regulatory response

• Stability and the prudential framework
• Consumer outcomes and conduct regulation
• Regulatory architecture

Emerging trends

• Retirement incomes and ageing
• Technology opportunities and risks
• International integration

We set out below our take on the observations and potential policy responses identified in relation to:

• Superannuation
• Financial services regulation
• Payment systems and technology
• Australian domestic bond market

Superannuation

The superannuation issues identified in the Report are addressed in a number of chapters and span four main themes:

1. the desirability of promoting investment by superannuation funds in specified areas.
2. the failure of competition to reduce costs in the superannuation system.
3. issues related to the growth in SMSFs.
4. the failure of the superannuation system to address the needs of retirees.

The Report also includes observations in relation to the prudential regulatory regime and the stability of policy settings.

Key observations and potential policy responses

Chapter 4 of the Report nominates three main observations and requests for further input:

1. There is little evidence of strong fee-based competition in the superannuation sector, and operating costs and fees appear high by international standards.  The Inquiry is not inclined to judge the success of the Stronger Super initiatives (including MySuper) at this point given its recent introduction but is seeking input on other potential mechanisms for reducing costs, including auctions for default fund status, adjustments to the three-day portability rule and more efficient means of facilitating intra-fund switching and inter-fund transfers.
2. The growth in direct leverage by SMSFs has the potential to create vulnerabilities for the superannuation and financial systems.  The Inquiry seeks input on whether to restore the general prohibition on direct leverage in superannuation.
3. Superannuation policy settings lack stability, which adds to costs and reduces long-term confidence and trust in the system. No specific input is sought on this point.

The Report also highlights the link between issues related to the quality of financial advice and the growth in SMSFs and requests input on whether the Inquiry should be concerned about the high operating costs of many (smaller) SMSFs  and whether there should be any limitations on the establishment of SMSFs.

Investing in different markets

The Report touches on the capacity and preparedness of superannuation funds to invest more extensively in a variety of markets, including:

• Small to medium sized businesses
• Infrastructure
• Impact investments
• Bank deposits and fixed income generally
• Corporate bonds.

In each case, the Inquiry seeks input on how to remove or reduce the impediments to investment in these areas, including by superannuation funds.

Retirement income system

The Report dedicates an entire chapter, Chapter 8, to issues related to the retirement income system. It seeks input on ways in which the retirement income system could be adjusted to assist individuals to meet their income and risk management needs, including:

• improving the provision of financial advice and removing impediments to product development.
• providing policy incentives to encourage retirees to purchase retirement income products that help manage longevity and other risks.
• introducing a default option for how individuals take their retirement benefits.
• mandating the use of particular retirement income products (in full or in part, or for later stages of retirement).

Regulatory architecture

In addition, the Inquiry seeks input on issues related to the regulatory architecture surrounding the superannuation system:

• Is the trust structure best placed to meet the needs of members in a cost effective manner?
• Consider the case for prudential versus conduct regulation of superannuation funds, and in particular whether the regulation of APRA-regulated superannuation funds ought to be aligned with the regulatory scheme applied to managed investment schemes.
• Consider the case to extend regulation to fund administrators and technology service providers of sufficient scale by requiring them to hold an AFSL.
• Introduce a mechanism to allow a heightened level of regulatory intensity to be applied where risk arises outside the conduct perimeter.
• Move the Australian Securities and Investments Commission (ASIC) and Australian Prudential Regulatory Authority (APRA) to a more autonomous budget and funding process.
• Conduct periodic, legislated independent reviews of the performance and capability of regulators.
• Clarify the metrics for assessing regulatory performance.
• Enhance the role of Statements of Expectations and Statements of Intent.
• Replace the efficiency dividend with tailored budget accountability mechanisms.
• Improve the oversight processes of regulators.

Financial services regulation

Disclosure – technology changes welcomed but no real wider solutions

(a) Better use of technology

Potential changes to the way in which disclosure is delivered to consumers and the use of technology would be welcome. Despite the ongoing emergence of technology since the Wallis Report, product issuers have found that the regulation of the distribution of disclosure documents has not been technologically neutral.

(b) Better disclosure

The Report identified that long and complex disclosure documents may contain irrelevant information and may not be effective to help consumers to understand risks and make informed decisions.  Some would say that lengthy and detailed disclosure documents are almost inevitable under the current PDS regime, but the Inquiry recognises that changing disclosure requirements may not be sufficient to ensure consumers are sufficiently informed about their financial decision-making. 

(c) Increasing product regulation

The Inquiry has flagged the potential to increase the regulation of financial products by imposing suitability requirements or limiting product design and giving ASIC powers to ban product features.

The regulators

(d) ASIC Funding – an industry levy

The Report observes that Australia has “strong, well-regarded regulators” but that there are areas of possible improvement in relation to independence. One area of focus is ASIC funding, which at present is said to diverge from the best-case funding models for financial regulators.

The Report cites recent reviews of Australia’s financial system and regulatory framework, where the Financial Stability Board and the IMF both raised concerns about ASIC’s lack of stable funding and inability to commit resources to longer-term projects.

The Report notes recent commentary from the IMF and from IOSCO which is generally supportive of a shift towards an industry-funding model. In this context, the Report calls for views on a proposal to move ASIC to a more autonomous budget and funding process.

(e) ASIC Enforcement – increasing penalties

The Report observes that regulators require a sufficient set of powers to execute their mandate and foster credibility with the market. As ASIC has highlighted in its recently published Report 387 Penalties for corporate wrongdoing, some civil and administrative penalties available to ASIC are low in comparison to those of peers internationally.

The Report comments that a stronger penalty regime could strengthen the impact of ASIC’s enforcement action and provide for a more effective deterrent to misconduct.

In this context, the Report calls for views on a proposal to review the penalty regime in the Corporations Act. More broadly the Report invites comment on whether the current enforcement regime is adequate and whether ASIC has adequate powers.

(f) Regulator Accountability

The Report comments that, particularly in light of proposals to increase regulator independence, there is room to further strengthen accountability mechanisms.

Three possibilities cited for such reform are:

conducting periodic, legislated independent reviews of the performance and capability of regulators;
clarifying the metrics for assessing regulatory performance; and
enhancing the role of Statements of Expectations and Statements Of Intent.
The Report also refers to the ongoing Senate inquiry into the performance of ASIC. The Senate Committee’s report was issued at the time this Report was being finalised, so could not be considered in this (interim) Report but will be “carefully examined” in the lead up to the Final Report.

(g) Regulatory mandates – a focus on competition

The Report observes that more could be done to emphasise competition matters in regulators’ mandates beyond mere consideration of efficiency in regulatory decision making.

An increased role in the promotion of competition is considered for both APRA and ASIC. The Report notes that submissions, including from ASIC itself, argue that ASIC should be given a mandate to promote competition, as is the case in the United Kingdom with the FCA. In this context, the Report calls for views on how to strengthen competition considerations through mechanisms other than amending the regulators’ mandates.

(h) Internationalisation of financial regulation

The Report observes that domestic regulatory processes could be improved to better consider international standards and foreign regulation. Policy and regulatory settings are cited as being important to the level and nature of global financial integration.

Two sources of this increasing international influence are mentioned:

1. First, standard setting by international setting bodies implemented domestically by Australian regulatory agencies.
2. Second, the extraterritorial effect of other countries’ legislation within Australia. The main issues identified in relation to this are the cost this imposes where foreign requirements are inconsistent with Australian requirements, and the practical compliance implications for Australian financial services providers.

The Report calls for views on how domestic regulatory processes could be improved to better consider international standards and foreign regulation. This includes processes for consultation about international standard implementation, and mutual recognition and equivalence assessment processes to ease compliance burdens.

Technology and payment systems

Technology and Innovation

The Interim Report observes that technological innovation is a major driver of efficiency in the financial system and that the benefit this brings to consumers must be balanced against the risks associated with emerging technology–enabled alternative business models, new entrants and new services. The Report also identifies the significant compliance and time cost, and restraint on innovation, that can be caused by regulatory requirements that do not meet the realities of modern technologically-enabled and rapidly changing financial services.

The Report notes some submissions refer to the need to enable business “to be carried out digitally end-to-end” and to update disclosure and consent requirements. In particular, to accommodate new technologies and changing consumer preferences.

Payment System Regulatory Issues

The Report covers the key issue of common regulation of all relevant players in the rapidly changing payments sector.

The Inquiry notes that the New Payments Platform (NPP) currently being developed may further reduce barriers to entry and drive payment service competition. New entrants are holding increasing amounts of customer funds and may not be subject to the same level of regulation and consumer protection as provided by more traditional players. The question posed is whether entities performing similar functions should be regulated in the same way, recognising the potential for onerous levels of regulation to stifle innovation unnecessarily.

The Inquiry’s preliminary assessment is that there is a role for the Government in this area to help industry agree on standards for interoperability or to cooperate on developing common infrastructure – referring to the RBA NPP initiative as an example of this.

The Inquiry’s preliminary assessment highlights the submissions supporting simplification of the current regulatory framework and the need to address the potentially uneven playing field for payment providers. Possible overlap, inconsistency and complexity in regulation is recognised, as is the need to ensure regulation provides suitable protection of customer funds and deals appropriately with technology innovation, including in light of issues arising in relation to stored value cards and systems and virtual currencies.

The Report notes that imposing regulation equivalent to ADI’s on some players “could be onerous, and a more graduated framework may be more appropriate” . The Inquiry contemplates a graduated framework aligning risk and scale of activities with compliance requirements and possible “tiers” and “thresholds for when an activity or participant becomes regulated”.

Customer Data, Privacy and Security

There are many examples of new players in the payment services sector leveraging their valuable customer databases to participate successfully in the delivery of financial services. With technological advances facilitating access to an increasing volume of customer data, the Inquiry observes this has the potential to improve efficiency and competition but heightens data security and privacy risks.

The Inquiry seeks views on a number of privacy issues, including implementing mandatory data breach notifications to both the affected individual and the relevant Government agency. Mandatory reporting exists in some parts of the world and has been raised before in Australia. The debate on this issue may be revived in the context of the FSI.

Australia’s Domestic bond market

The FSI Interim Report observes that while Australia’s domestic bond market is firmly established, it has failed to deepen because of a range of regulatory and tax factors.

The Report notes that the dividend imputation taxation system creates a bias to investment in domestic equities rather than bonds, which has contributed to curbing the development Australia’s domestic bond market. The additional disclosure requirements on corporate bond issues relative to equity offerings have also contributed to this bias towards domestic equities rather than bonds.

The policy options outlined in the Report in relation to strengthening Australia’s domestic bond market primarily focus on facilitating access to retail investors. The FSI seeks comments in respect of alternatives including:

1. making no change to current arrangements;
2. allowing listed issuers (already subject to continuous disclosure requirements) to issue ‘vanilla’ bonds directly to retail investors without the need for a prospectus; and
3. reviewing the size and scale of corporate ‘vanilla’ bond offerings that can be made without a prospectus where the offering is limited to 20 people in 12 months up to a value of A$2 million, or for offers of up to A$10 million with an offer information statement.

Noting the difficulties under the current regulatory regime in relation to the use of credit ratings, the Inquiry also seeks further information as to:

1. Whether enhanced transparency of transactions could improve liquidity in the over-the-counter Australian corporate bond market, including its attractiveness to retail investors?
2. What commercial or regulatory impediments are there to the potential development of improved transparency in the over-the-counter corporate bond market?
3. Whether alternative credit ratings schemes could develop in Australia and whether would this help improve the appetite for bonds, particularly those of growing medium-sized enterprises.
4. Whether alternative standards of creditworthiness could develop in Australia, what barriers there may be to such developments, and what policy adjustments would assist such developments?