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Financial System Inquiry

Shaping the future: Deloitte response to the Interim Report

The David Murray Inquiry has reviewed the Wallis framework for the financial system to see how well it is suited to current conditions, taking into account the lessons from the Global Financial Crisis. The challenge for the Inquiry is to develop a framework that has a 10 to 15 year vision for financial services, given trends in technology, globalisation and ageing.


Dr Ric Simes shares his initial reactions to the Financial System Inquiry Interim Report released on the 15 July 2014.

Key takeaways are:

  1. Competition is the cornerstone: For example empowering consumers in superannuation and insurance, and levelling the playing field in funding, regulation and payments
  2. Disclosure is not enough: The challenge is to find mechanisms to support the consumer in a cost effective way that does not add more layers of regulation given the profound differences between what people need
  3. Financial services are global: Organisations need to consider what changes will be required in the domestic regulatory framework to accommodate the international regulatory framework, and enable them to compete more effectively at home and abroad.

What has not been addressed

The Interim Report does not give a clear sense of how the system needs to change to be ready for the future including:

  • Changes in the boundaries of financial services
  • New business models and entrants
  • The advance of technology
  • The regulatory settings needed to provide consumers with confidence in the advice process.

Seismic changes

If some of the 136 proposed policy options eventuate there could be seismic shifts in Australia’s financial services landscape such as:

  • Too-Big-To-Fail: proposed options would increase the cost and the regulatory burden on the banks
  • SMSF leverage: banning leverage prospectively would affect the development of the SMSF sector
  • Competition in super and insurance: options could include for example tendering the default system to one provider.

Timeline

The Interim Report was released on the 15 July with responses due by 26 August and final report and recommendations due to Treasury by November 2014.

Your action

The Deloitte Financial System Inquiry team is ready to assist you think through the ramifications of this comprehensive Inquiry, and provides insights and suggests actions in the sections below.

Competition – The cornerstone

C

Themes

The Murray Inquiry nominates competition as, ‘the cornerstone of a well-functioning financial system’.

  1. It sets up a sound framework for assessing the current level of competition in any given sector and lays down principles for guiding competition policy in the financial system, consistent with the policymakers’ mantra of ‘supporting competition, not competitors’ and ensuring competitive neutrality
  2. The Interim Report considers the financial system to be reasonably competitive overall. And despite the general tendency to equate concentration with a lack of competition, it correctly notes that a range of indicators should be considered in determining how competitive a market is, including barriers to entry, profitability and switching behaviour
  3. It notes that in certain areas the playing field does not appear to be level and that current regulations may be contributing to outcomes that are not competitively neutral.

Implications

While the current state of competition in the industry is important, the Interim Report would have benefited from a lengthier discussion of future trends. Although the report acknowledges that government policy ‘should take into account how potential future trends in markets may affect the level of competition over time’, it limits its analysis to a brief summary of the potential impact of technology on competition, noting the need for technical neutrality.

Given new business models and technologies will continue to disrupt the financial services competitive landscape, the question of how well the existing regulatory framework will accommodate new entrants – particularly those from non-financial services sectors - remains. How will it continue to achieve the principles of encouraging market access, ensuring appropriate prudential standards are in place, and developing a consistent regulatory approach to functionally similar activities? 

The GFC disrupted the level playing field in financial services. Effects of this still linger. This is evident through perceptions of too-big-to-fail, differential regulatory capital requirements and the diminished market for residential mortgage backed securities (RMBS). While the Inquiry sees no market failures in RMBS, they are clearly concerned about too-big-to fail. The Interim Report suggests addressing this directly, with options to do so including:

  • Increasing the ability to impose losses on creditors of a financial institution in the event of its failure
  • Strengthening regulators’ resolution powers for financial institutions, and investing more in pre-planning and pre-positioning for financial failure
  • Further increasing capital requirements on the financial institutions considered to be systemically important domestically
  • Ring-fencing critical bank functions, such as retail activities.

This is a fundamental shift in attitude to what we saw at the height of the GFC with the potential to lead to major changes in the banking system. Competition was forced to take a back seat after the start of the GFC. However, the Inquiry does not explore the extent of this trade-off and what is required to get the balance right. The options raised tend to either maintain the current balance, or shift the scale further towards ensuring stability.

A common theme throughout the Inquiry’s analysis is the impact on the level of competition of consumers’ lack of willingness to switch providers – for example in insurance and superannuation. This could be attributable to behavioural economics issues (such as myopia and complexity) and a lack of information. Price signals are also weakened because consumers have difficulty comparing products with varying features and offerings.

Action

When providing comments on competition, stability and future trends businesses could:

  • Outline the benefits of the inclusion of RMBS as high-quality liquid assets in calculating the liquidity coverage ratio
  • Discuss barriers to entry faced by new players trying to enter the financial system
  • Quantify the likely impacts on their business of options proposed to address too-big-to-fail
  • For non-IRB banks seeking IRB accreditation, provide additional detail on the specific factors which make attaining accreditation difficult
  • Comment on the tension between customer benefits of a ‘Single Customer View’ with multiple products suites and the suggestions in the Interim Report that vertical integration could inhibit fee based competition particularly in the wealth management sector.  
Payments – It pays to be flexible

P

Themes

The Inquiry focuses its review of the payments system largely on card charges, regulatory architecture and technology. Key themes include:

  1. Reaffirming competitive neutrality as a policy objective, and taking appropriate action to ensure that regulations are consistent applied across similar economic activities
  2. Suggesting that a graduated framework in which the regulatory impost is appropriate to the nature and scale of risk to the financial system, will foster new entry and competition
  3. Regulators will need to be flexible to monitor fast-paced changes in technology and responsively regulate emerging risks without stifling innovation
  4. Technology neutrality will be important in addressing regulatory biases towards outdated technology and enabling innovation as technology continues to improve.

Implications

The pace and scale of technological change requires a regulatory approach that monitors developments and responds as necessary. 

Competitive and technology neutrality will be important. Interchange regulations apply to four-party schemes, but not companion cards. “No surcharging” rules still apply to some online payments, but are banned elsewhere. Recommendations to remedy these inconsistencies are likely in the final report.

A graduated framework would help ensure regulatory requirements are appropriate to the relative risk posed by non-ADIs and other alternative entrants. This would support the emergence of new business models in payments. However, the report has not set clear guidelines about how this might be achieved.

Actions

When considering these implications for the final recommendations businesses could comment on costs, benefits and trade-offs of the policy options including:

  • Achieving competitive neutrality in interchange regulation. It is likely that action will be taken to consistently regulate activities of similar economic substance. Various options for how this may be most appropriately achieved have been identified on which to provide input
  • How the graduated framework proposed in the Interim Report for non-ADI competitors would be achieved
  • Specific instances where regulation needs to be updated to remove existing biases towards specific technologies
  • Perspectives on how the new payments platform could be optimised
  • How to design access arrangements to payment platforms, including NPP so as to encourage competition and innovation in the payments system by striking an appropriate balance between encouraging new entrants and controlling risk.
Funding – Nothing radical

F

Themes

The Inquiry focuses its funding commentary on access to foreign funding, funding for SMEs and the development of a domestic bond market. Key themes include:

  1. The role of the government in RMBS issuance and the interplay between superannuation and funding
  2. The provision of credit to SME businesses, particularly structural impediments for SMEs’ access to finance
  3. Investor appetite for bonds, considering both the role of the corporate bond market to fund future credit growth and the linkage between superannuation and fixed income products.

Implications

The growth of assets in superannuation will increasingly affect the overall funding balance with ADIs, including the interplay between superannuation deposits, liquidity requirements and costs.

Like the Wallis Report, the Interim Report identified information asymmetries as a potential hindrance to SME finance, as funders have limited access to information on SMEs.

It also did not assess SME liquidity challenges in a wider context; the Interim Report could have explored if there are regulatory issues affecting the markets for SME securitisations, asset finance or trade receivable transactions, and funding sources which often benefit SME businesses.

Overall there were few radical proposals or changes to the existing status quo, and a somewhat blank canvas in terms of future-state. The lack of consideration of who is going to fund Australia through the 21st century, both domestically via superannuation and internationally, leaves the door open for innovators to determine how the funding environment and its current products will meet the requirements of the future.

Actions

When considering these implications for the final recommendation businesses could comment on:

  • The role of superannuation as a source of funding for the Australian economy (for example SME corporate bonds and infrastructure) and the inconsistency between portability and liquidity requirements and long term investment horizons
  • The risks involved with Australia’s heavy reliance on overseas funding and the impact on the regulatory environment
  • The opportunity cost from the limited development of Australia’s corporate bond market, including the impact on reliance on bank funding for corporate loans, and the role of superannuation investment flows, as the source if relevant of any market failures.
Superannuation - Focus on costs and recognition of challenges

s

Themes

The Interim Report acknowledges that we have a well-functioning superannuation system suggests there is room for improvement. Key opportunities identified are:

  • High costs of superannuation to members
  • Heavier weighting to ‘riskier’ assets, in particular equities
  • Delivering the products needed by retired Australians
  • SMSFs’ use of gearing
  • Provision of financial advice.

Implications

Although the themes won’t be a surprise, some may challenge the Interim Report’s conclusions.

Once you consider the differing administration and operating costs which funds around the world must bear - including legislatively required compliance and change costs, financial planning, member education services, choice of funds, investment strategy, and portability of accumulations costs – Australia may not be far from global benchmarks.

Further analysis is needed to identify those aspects of the system where costs may be comparatively high. If costs are to be bought down the answer is likely to be driven in part by technology (including digital) and easing the compliance burden on fund trustees, without compromising member security.

It should not be forgotten that Australia has led the world in the move to a compulsory defined contributed system. And whilst Australian funds have always had a heavy weighting to growth assets (which can be volatile), Australia has comparatively fewer retirees than more mature markets. Superannuation is a long term investment and growth assets are essential to assist a member’s super balance last longer.

Advice in superannuation is a critical component of the system but needs to be considered in the broader context of Financial Advice, which is covered in the regulatory section of the Report.

The real challenge is in Australia’s post-retirement market, which as the Interim Report rightly points out, still lacks adequate products to address retirees’ needs for income, risk management and flexibility. Here, annuities are flagged as potentially part of the solution.

However the adequacy of the system was not addressed, including the interaction between superannuation, the social security system and the taxation system.

In a market of member choice and control we need to make superannuation both easier to understand and more competitive. The Review notes that savings could be made through simpler products, a greater use of passive investments, and technology.

The Interim Report also raises two potentially significant areas of change:

  • On the back of its conclusions that the superannuation is expensive, it explores different options to do with default funds (including MySuper)
  • The Review argues against superannuation funds using leverage, which if carried through would have major implications for many SMSFs.

Actions

The Inquiry has taken a narrow focus on costs and fees in superannuation, which does not fully consider factors such as additional services provided by superannuation. In responding to the Inquiry, funds could:

  • Analyse and quantify the additional value created by superannuation funds for their members and the cost of providing this
  • Quantify and describe additional services provided to clients, including education and advice
  • Explore the implications of different options proposed for default funds
  • Analyse the implications of changes of leverage on SMSFs, explore possible options for regulating the nature of borrowings by SMSFs, and analyse the impact on the assets they invest in (including residential houses).
Regulation - Potentially significant changes

R

Regulatory topics are addressed in the Interim Report under the three broad sections of stability, consumer outcomes and regulatory architecture.

Themes and implications

1.  Stability
 

Too-Big-to-Fail The Interim Report includes an extensive discussion of the options that may be available to Australian regulators to address too-big-to-fail perceptions in a way that dispenses with the need for Government support.  The Report acknowledges that changes have been implemented since the GFC.

  • The establishment of robust recovery and resolution plans is already underway. In addition, from 1 January 2016, the four major banks will be required to hold additional risk-weighted assets in Common Equity Tier 1 (CET1) Capital. As a result an option is to wait to assess the effectiveness of these two initiatives after an appropriate period of operation
  • But as the Interim Report notes elsewhere there are options to go a lot further (see Competition).

Corporate governance The Interim Report also highlights the role that good corporate governance can play in managing risk and applying regulatory requirements. It raises the issue of creating clear separation between the roles and responsibilities of the Board and those of management.

2. Consumer outcomes
 

Product disclosure The Interim Report proposes a number of potential solutions to the current issue of lengthy, complex and expensive product disclosures, including ‘layered disclosure’, use of technology, risk profile disclosures and online comparators. Despite acknowledging the limitations of a disclosure based approach none of these proposals suggest a fundamental shift away from a disclosure regime.

Advice Given poor levels of financial literacy and the need for decisions on often complex financial matters people are likely to continue to rely on financial advice.  The Report acknowledges that variability in advice quality is a significant issue. However the linkage between the quality of advice and the ‘understandability’ of information disclosed on financial products was not adequately explored. The Report also clearly states that the existence of conflicted remuneration undermines consumers’ access to appropriate advice.

  • Any policy changes to disclosure requirements need to be accompanied by strengthened quality of financial advice.  

Conduct risk The Inquiry does not deal with conduct risk which is a key focus area for financial regulators in other jurisdictions.

  • As the Australian consumer protection framework currently contains aspects of conduct risk requirements (for example, FoFA, NCCP), the Inquiry needs a view on the applicability of broader conduct risk principles across a product lifecycle in Australia.

3. Regulatory architecture
 

Regulatory bodies The Interim Report notes that the current regulatory architecture is working well but there is room for enhancement in a number of areas. It does, however, categorically state that it is opposed to creating any new regulatory bodies.

To ascertain whether Australia’s regulatory burden is high compared with other jurisdictions, the Inquiry is waiting on a cost-benefit analysis of the extent of regulation in the financial system.  These findings will help the Commission shape its views and make further recommendations.

Deterrents The proposals to review the current civil and administrative penalties regime and the introduction of disgorgement in non-criminal proceedings to remove any financial benefit, aligns with ASIC’s view that it does not have the appropriate enforcement powers. A comparative analysis as to whether these (or other types of penalties) have had the deterrent effect when applied by regulators in other jurisdictions, such as the United States, would be informative.

Actions

When providing comments on costs, benefits and trade-offs of the policy options proposed by the Interim Report businesses could:

  • Consider the impact of relying on existing resolution and recovery policy and capital buffers to mitigate too-big-to-fail risk
  • Financial institutions will need to carefully consider and respond to the question of ‘to whom a director’s primary duty should be’. They should also consider how Boards would handle a move from a compliance based regime to one based on outcomes
  • Given the significant limitations, including the cost, of the current disclosure regime it is important for entities to discuss how best to assess the effectiveness of a PDS in communicating to consumers rather than as a means of reducing the risk of non-compliance
  • Submissions could also canvass the extensive challenges that have arisen around the definitional aspects of product banning powers. For example, in the UK there have been challenges around the meaning of ‘objectionable characteristics of a product.’
  • Product issuers should consider both whether a more outcome based, rather than compliance based approach to PDSs, higher qualified advisers and a clearer distinction between general and personal advice, would improve their long term customer relationships, and how to do it
  • All financial institutions should consider the impact of regulatory compliance on broader board governance and decision making
  • All financial institutions should consider whether higher financial penalties would change the deterrent effect within their organisations.
Digital, data and technology - The future is already here

D

Themes

  1. Customer/cost/products/delivery: Technology innovation is key to increasing customer engagement, driving cost efficiencies and enabling new product development and delivery
  2. Data: Pooling data sources is increasing, enabling better customer information and product/service development
  3. Cyber security: The regulatory approach is still evolving and given the relatively limited legislation there is considerable variability in how regulations are applied and enforced
  4. Regulatory: Digital requires a rethink of existing regulatory guidelines to accommodate new technologies e.g. mobile payments and other financial instruments and paper-based disclosures
  5. Competition/business model change: Competition and innovation is emerging from technology-enabled alterative business models.

Implications

Competitive neutrality: Under the desired principle of competitive neutrality the Interim Report concluded that it was the nature and scale of the risk, and who bears that risk, that should determine how the regulatory framework is applied to new entrants, including non-traditional entities e.g. PayPal, Apple, Skype, Stripe and Bitcoin. It is worth noting that if applied too stringently, the competitive neutrality principle could stifle innovation in the interest of improved system efficiency.  

CloMoSoDa (Cloud-mobile-social-data): Potential disruptive scenarios such as the growth of cloud services, digital (and mobile in particular), social media as an information source, and the phenomenon of ‘big data’ will require a regulatory framework which can flexibly respond to change.

Speed: As consumer attitudes change faster than bank processes, there is a danger that a consumer expectation gap is created. Central utilities could provide a whole of enterprise view of customer or customer identification protocols and security details, but there is a trade-off between efficiency and competition.  The Interim Report has noted these issues, but would benefit from additional consideration of potential developments and their impact on the financial system.

Outsource/offshore services and cross border banking capability, facilitated by digital and cloud technologies, was not covered in any great depth in the Interim Report.

Actions

When providing comments on costs, benefits and trade-offs of the policy options proposed by the Interim Report businesses could comment on:

  • How technology and new business models will change the financial landscape and the borders between regulated and non-regulated entities
  • The trade-offs between competitive neutrality, stability and innovation when considering the application of the financial services regulatory framework to new entrants
  • The impact of internationalisation on technology enabled processes, including those involving private and commercially sensitive data, such as intellectual property, tradable data and other market sensitive information.
Insurance – Little air time

I

Themes

Overall, insurance got little air-time, but some important themes included:

  • Consumer outcomes, notably underinsurance and affordability
  • Technology, especially the impact of risk-based pricing
  • Regulation, as a barrier to innovation and contributor to costs
  • Competition, and the role of aggregators and state statutory insurance schemes

The Interim Report notes that the insurance sector, and particularly general insurance, has similar levels of concentration and profitability to the banking sector, but infers that concentration is not having an adverse impact on competition, as evidenced by recent new entrants.

The report misses a proper framework for risk allocation in the economy as risks are shared between individuals, insurers and the community/government. The Interim Report did not adequately address the market distortion that results from government compensation without recourse, to people living in locations with a high risk of natural disaster, including fire, flood and cyclone.

Implications

The terms of reference for the Financial System Inquiry included developing a philosophy for how financial risk is allocated in the economy between different parties. This has not been addressed in the Interim Report.

  • For example the Report would benefit from a discussion of the allocation of risks in retirement between superannuation, life insurance, health insurance, aged-care insurance, government safety nets and individual savings.

There could be a push for increased competition in insurance, including through innovation, to try to bring down insurance premiums and create new products which cover uninsured risks. Another potential consequence is that governments mandate insurance.

Technology is a double-edged sword: more accurate risk-based pricing will lower the price for some but may exacerbate affordability issues for others. Aggregators are using technology to improve information. To take advantage of innovations such as peer-to-peer insurance, entry of non-insurers, telematics and micro-insurance solutions, we need the right regulatory settings.

Actions

When providing comments on costs, benefits and trade-offs of the policy options proposed by the Interim Report businesses could comment on:

  • How financial risk should be allocated between different parties
  • Whether or not there is an issue with underinsurance that warrants a policy response
  • Insurers may also wish to provide additional information on the distortion of markets and the costs to taxpayers that results from government compensation without recourse, to people living in locations with a high risk of natural disaster, given that this was not adequately addressed in the Interim Report
  • Suggestions for addressing the tension between pricing and regulation, affordability and soundness
  • Where regulation and prudential supervision has held back innovation.
Tax - Heavy lifting left to white paper

T

Themes

  • No recommendations on tax changes
  • A series of observations on aspects of the current tax system which may distort efficient allocation of capital in the financial system
  • Issues are mostly longstanding
  • No significant focus on taxation issues that may impede outbound investment
  • The heavy lifting is left to Tax White Paper.

Implications

The Interim Report flags the potential removal of interest withholding tax on all foreign funding of Australian banks. It is not as clear that it supports the removal of withholding tax which currently applies to debt funding provided by the foreign head office of Australian bank branches. If this is not supported, the lack of parity is evident.

The Report suggests support for removing the current cap on tax deductions for interest on funding of local branches of foreign banks. It also notes that the current application of withholding tax arising from clearing derivatives through a central clearing party is putting Australia at a competitive disadvantage.

There are no recommendations for change on the distortive effects of GST not being levied on most financial services. And given the recent political debate and lack of take-up on any changes to the GST (most notably raising the rate), it is highly unlikely that this aspect of the Interim Report will progress.

The Report suggests that the imputation credit system contributes to incentives to invest between debt and equity capital in Australia. Again, no recommendation is made in the Report and the removal of the imputation system or a wholesale rework is highly unlikely. Instead, one might expect the final report to focus more on reducing the taxing disincentives to super funds and individuals making debt investments.  

The Report did not discuss previous imputation reform suggestions such as allowing streaming of franked income streams to residents only, or potentially treating foreign tax as giving rise to imputation credits.

Superannuation organisations should consider:

  • Imputation Credits and Tax Free Superannuation – reconsidering the refund of imputation credits in the context of tax-free superannuation in retirement
  • SMSF Pension Concession – addressing preferential tax treatment of SMSFs over other funds in the retirement phase
  • Taxation of Lump Sums – incentivising superannuants to take income streams over lump sum benefits on retirement to manage longevity risks
  • Deferred Lifetime Annuities – as part of an overall income stream package.

Actions

  • Explore options for a tax system that supports alternative forms of saving for retirement in a more neutral fashion given the focus of the Interim Report on financing for retirement including challenges around annuities and differential tax rates
  • Consider the practicalities and costs of changing the treatment of GST for financial service.

 

Talk to us

Ric Simes Ric Simes
Partner
Deloitte Access Economics
Tel: +61 2 9322 7772 | Email
   
Paul Wiebusch Paul Wiebusch
Partner
Financial Services
Tel: +61 3 9671 7080 | Email
   
Michael Thomas Michael Thomas
Director
Deloitte Access Economics
Tel: +61 2 9322 7145 | Email
   
Rick Porter Rick Porter
National Leader
Financial Services
Tel: +61 3 9671 7922 | Email
   
Louise Denver Louise Denver
Director
Corporate Affairs &
Communications
Tel: +61 2 9322 7615 | Email

 

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