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.
The Interim Report does not give a clear sense of how the system needs to change to be ready for the future including:
If some of the 136 proposed policy options eventuate there could be seismic shifts in Australia’s financial services landscape such as:
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.
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.
The Murray Inquiry nominates competition as, ‘the cornerstone of a well-functioning financial system’.
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:
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.
When providing comments on competition, stability and future trends businesses could:
The Inquiry focuses its review of the payments system largely on card charges, regulatory architecture and technology. Key themes include:
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.
When considering these implications for the final recommendations businesses could comment on costs, benefits and trade-offs of the policy options including:
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:
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.
When considering these implications for the final recommendation businesses could comment on:
The Interim Report acknowledges that we have a well-functioning superannuation system suggests there is room for improvement. Key opportunities identified are:
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:
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:
Regulatory topics are addressed in the Interim Report under the three broad sections of stability, consumer outcomes and regulatory architecture.
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.
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.
Conduct risk The Inquiry does not deal with conduct risk which is a key focus area for financial regulators in other jurisdictions.
|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.
When providing comments on costs, benefits and trade-offs of the policy options proposed by the Interim Report businesses could:
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.
When providing comments on costs, benefits and trade-offs of the policy options proposed by the Interim Report businesses could comment on:
Overall, insurance got little air-time, but some important themes included:
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.
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.
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.
When providing comments on costs, benefits and trade-offs of the policy options proposed by the Interim Report businesses could comment on:
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:
Deloitte Access Economics
Tel: +61 2 9322 7772 | Email
Tel: +61 3 9671 7080 | Email
Deloitte Access Economics
Tel: +61 2 9322 7145 | Email
Tel: +61 3 9671 7922 | Email
Corporate Affairs &
Tel: +61 2 9322 7615 | Email