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'Sustaining confidence in the Australian financial system'
Launch of the Interim Report
Thank you to the National Press Club for the interest you have shown in today’s release of the interim report of the Financial System Inquiry.
Sustaining confidence in the Australian financial system has been central to the work of our Inquiry.
If we had been asked to review Australia’s financial system in 2007, before the financial crisis, we would have been likely to come to very different views about the challenges and vulnerabilities we face.
Given developments and lessons learned since the Wallis Inquiry and, in particular, the events of the financial crisis, it seems to us that we are embarking on a phase when confidence will have to be sustained in light of some new realities in the world.
As Professor Jennifer Hill1 notes in her 2012 review of Australia’s experience during the financial crisis:
The onset of the financial crisis in 2007 emphasized the fact that Australia was now connected with the rest of the world for better or worse in terms of global market risk. As the crisis showed, high risk housing loans in the United States could affect markets around the world, including Australia.
Notwithstanding the relatively sound exit of Australia from the financial crisis, future risks to citizens and users of the system will have to be managed over an extended timeframe if confidence is to be sustained and strengthened.
The report sets out our views on the objectives of the financial system and the principles that should guide its development. It discusses the financial system from nine different perspectives and makes 28 observations about how the system is working. These observations reflect the Inquiry’s current judgments, based on available evidence.
We welcome additional evidence from interested parties to support, challenge or give context to these observations.
Throughout the report, we canvass possible options for change. These options are not draft recommendations. We’ve generally identified a broad suite of options rather than selecting a single preferred solution. We’ve included the option of no change in each case because we want to be sure that any change we recommend will deliver a better balance of policy outcomes than the status quo.
In considering the status quo, one of our most important tasks has been to work out what has changed since the Wallis Report was released in 1997. In the 16 years since the Wallis Inquiry, the economy has performed well - this period being part of 21 years of uninterrupted growth.
Our economic profile has, however, not changed much over history - that of a small, open commodity based economy, active and successful at investment but making extensive use of foreign capital. We have opened up the economy to our benefit but that brings with it the risk of being buffeted by global events.
When Wallis discussed potential threats to financial stability, the assumption was that these would come from within Australia.
Our growing interconnectedness with the rest of the world has major implications for Australia’s financial system, especially the weight we need to attach to financial stability.
The financial crisis has changed the way we think about vulnerabilities.
By that I mean that the financial crisis highlighted the long-term economic damage that is caused by banking crises, including their impact on household wealth.
In Australia, the financial crisis produced a sharp fall in economic growth and an increase of nearly two percentage points in the unemployment rate.
Overseas, the impact was much more severe. Reinhart and Rogoff suggest that the average cost of a banking crisis is a decline in real GDP per person of 9 per cent and a 7 percentage point increase in unemployment. The equivalent impact on the Australian economy today would be approximately 860,000 more people out of work, and a decline in real GDP of approximately $6,000 per person.2
The financial crisis also highlighted:
- the importance of managing vulnerabilities associated with Australia’s use of foreign investment flows;
- the difficulties and cost involved in crisis management and resolution; and
- the importance of the Government’s balance sheet in backstopping the system.
Another change is that international standard setters and the decisions of foreign regulators have a much greater influence on our regulatory settings now than they did in 1997. International standards are no longer an optional extra, especially for a major capital importer like Australia.
Apart from these post crisis developments other major changes have been:
- growth of household indebtedness and exposure of banks to residential mortgages;
- shifts in the pattern of funding of banks and non-financial corporations;
- with rapid growth of superannuation assets, Australia has moved from a system dominated by banks to one where financial claims are held by both leveraged and un-leveraged institutions;
- relentless progress of technological applications from the digital world; and
- more pressure on people challenged by financial complexity and higher expectations of our Government and regulators.
In dealing with all this, Australia’s best interest will be attained with a system in which we have confidence.
In the short time we have today I would like to frame our report by addressing three areas where confidence is fundamental to users of the system:
- the soundness of the system;
- confidence in retirement outcomes; and
- confidence in the exchange of information and fair treatment of people.
In George Rae’s classic 1885 book on British banking, The Country Banker, the author writes:
If I had been writing the present book only a few years ago, I would have looked upon and omitted all mention of a run on a bank, as a thing long since obsolete, and as barbarous in its day as rick-burning or the wilful destruction of machinery. But the events of December 1878 effectually upset this complacent view of things.
The crisis that followed the collapse of Lehman Brothers has been similarly important for our Inquiry.
In his quote, George Rae was referring to the impact on the UK of the 1878 City of Glasgow Bank collapse.
Australia’s banking system was to experience a crisis of its own in the 1890s, due in part to the bursting of a property bubble. At this time, more than half the trading banks of note issue suspended payment and a large number of non-bank financial institutions failed.
Our report observes that it is not possible to rule out the risk of failure. Nor is it possible to rule out the use of taxpayer funds in extreme circumstances. In this respect, we are less doctrinaire than Wallis or some current overseas approaches.
However, the report suggests that there may be a case for Government and regulators to do more to reduce resultant disruption and the size of the potential call on taxpayers. Options for change include higher regulatory capital requirements to further reduce the risk of failure; pre-positioning arrangements and increased capacity of regulators to impose costs on an institution’s creditors rather than taxpayers.
The message is that, while we cannot eliminate so-called moral hazard, there is much that could be done to reduce it. By moral hazard, I mean the risk that perceptions of government support will lead to behaviour that increases the likelihood of such support being required.
By reducing moral hazard we can also reduce the significance of so-called implicit guarantees. The view of the Committee is that it is better to try and address the root causes of moral hazard than its symptoms.
A big issue for the Inquiry has been whether post-financial crisis prudential regulation has gone too far in Australia. We have heard suggestions, especially on regulatory capital, that Australia’s regulators have moved far ahead of the pack internationally and that we run the risk of stifling growth. The interim report questions some of these claims. In particular, Basel Committee data on actual bank capital ratios suggest that Australia’s banks are in the middle of the pack, not out in front.
It is for this reason the committee has asked for views on the pros and cons of higher capital ratios – to reduce taxpayer exposure to failure.
We have also looked at superannuation through the lens of financial stability; that is the soundness of the system.
We believe the existence of a large unleveraged pool of funds played a valuable role during the financial crisis in offsetting the risk of disruption within the leveraged banking system. Reflecting this view, the report raises some concerns about the potential for superannuation to become more leveraged in the future. While currently embryonic, growth in leverage may create future vulnerabilities.
The need for soundness has to be balanced against the need for efficiency and responsiveness.
In this report, we see competition as the cornerstone of a well-functioning financial system.
The interim report has two main messages on banking competition.
The first is that the market is still competitive, albeit more concentrated.
In the wake of the crisis, the focus of competition shifted from lending to funding.
Competition between the majors themselves has also become more important.
While the major banks increased their market shares in the wake of the crisis, their margins and profitability have not increased significantly. Major bank Net Interest Margins (NIMs) have remained around 2.3 per cent (compared with around 4 per cent at the time of Wallis) while their Return on Equity is a little lower than pre-crisis levels.
We note in the interim report that major banks have some significant commercial advantages over their smaller competitors including scale, brand and distribution. Of course, competition laws are not designed to prevent firms from having a strong position in a market or from pursuing efficiencies.
The second is that smaller banks face some regulatory disadvantages that reduce their competitiveness, especially higher risk weights for mortgages.
The report identifies a range of options to promote competitive neutrality. It also raises trade-offs between efficiency and financial stability.
Finally, the interim report notes the way superannuation funds, in competition with banks, provide an alternative source of funding in the Australian system.
Projections for growth in superannuation assets in Australia emphasise the significance of this sector to the overall system, hence our focus on superannuation in the interim report.
A well-functioning financial system benefits superannuants in three ways, each of which we have addressed in the report.
- It helps accumulate more in retirement by operating efficiently.
- It facilitates a mix of assets in portfolios that meet the risk/return trade-off relevant to each individual’s retirement expectations.
- And it provides a range of products in the retirement phase to manage lifestyle and longevity risk.
We have considered the efficiency of the system and made the observation that there is a lack of strong competition on fees and there is scope for improvement.
Operating costs and fees appear high by international standards, and our report notes the likely impact on retirees. As a guide, the Super System Review chaired by Jeremy Cooper found that a 40 per cent reduction in average fees for the entire superannuation sector would deliver a total saving to members, and additional funds to invest, of around $7 billion per annum.
In respect of the mix of assets we note that the system by international comparisons appears heavily weighted to riskier assets, mostly equities. This could be explained by a range of factors, including dividend imputation; the availability of the age pension; and historical returns from this asset class relative to others. The issue for the Inquiry is whether it is consistent with the risks faced by individuals as they transition from the accumulation to retirement phase.
The third question we have asked is whether the system actually delivers at the post-retirement stage. The interim report observes that the retirement phase of superannuation is under-developed and does not meet the needs of many retirees to manage longevity risk. We think there is an opportunity for innovation to deliver better outcomes for retirees and better meet the needs of an ageing population.
There is, however, a deeper issue here.
One of the things that struck us from submissions is the absence of a shared philosophy and set of objectives for superannuation. This is an issue given the size of the sector and its rate of growth.
The interim report sets out some options for change that may be viewed as quite radical by some. They include more compulsion to purchase longevity protection and increased use of defaults. These options will no doubt prompt a lot of debate between now and November.
So let me emphasise that they are simply options – not proposals. We are flagging them now to help us reach final recommendations. We want to be sure that we examine the full range of options because we are mindful of the rate of change in the superannuation system and its potential to undermine confidence in the system.
The final issue I want to talk about today is whether end users can have trust and confidence in the system. In this area we question some of the assumptions and conclusions of the Wallis Inquiry.
The Wallis Inquiry recommended a regulatory framework that relied heavily on mandatory disclosure. The assumption was that disclosure would be sufficient to safeguard consumer interests.
The interim report questions these assumptions, particularly the effectiveness of mandatory disclosure as a tool for safeguarding the interests of consumers. Further, we have set down a principle that rejects the notion that disclosure and literacy, while important, are sufficient to deal with the knowledge gap between buyer and seller. We observe in the interim report that the current disclosure-based framework has failed to adequately safeguard consumer interests while imposing significant costs on industry.
The interim report notes some concerns with the fairness of some non-monetary covenants in SME loan contracts. It also raises concerns with the quality of financial advice.
Our report was finalised before the Senate Economics Committee released its report on the performance of ASIC. However, we appear to have identified similar issues regarding ASIC’s mandate, skills, powers and funding model. This is part of a broader point on the importance of active industry supervision and need for strong, independent and accountable regulators.
Flowing from these observations, the interim report canvasses a number of options for change to the regulatory architecture and the way ASIC operates. Again, these are only options.
This is an area where there appears to be strong agreement on the existence of a problem. However, there are different views on how to proceed – particularly whether disclosure can be made to work or whether we need to base the regime on a different foundation – possibly one that create stronger incentives for financial institutions themselves to build trust with their clients.
The challenge for the Inquiry is to develop a viable alternative approach that is not simply more detailed rules.
A point that emerged in discussions with our International Advisory Panel is the question of Australia’s reputation as a place where financial promises will be honoured and what weight we should give this.
As a small, open, capital-importing economy, we want to ensure that Australians and foreigners can both have trust and confidence in our financial system. This is why we are travelling overseas to meet with foreign institutions and regulators.
We want to get views on Australia’s system from overseas market participants because many of the options discussed in the interim report have been considered, tried or are in the process of being implemented overseas. We want to get some views on what works and what doesn’t to inform the final report.
We will also have further discussions with our International Advisory Panel.
When we return, we will also hold public forums in Sydney, Melbourne, Perth and Brisbane. These forums will provide an opportunity for members of the public to ask questions and present views to the Committee.
The second round of submissions closes on 26 August.
To give some guidance to those making submissions, we would like to emphasise that Australians and their national interest will prevail if we balance individual interests and the public good in the design of the financial system. That is how we sustain confidence.
Once again, I would like to thank my fellow Committee members and the Secretariat for their dedication and effort in reaching this first milestone and invite your feedback and questions.
1 Hill, J., ‘Why did Australia fare so well in the global financial crisis?’, in E. Ferran, N. Moloney, J. G. Hill, and J. C. Coffee, Jr., The Regulatory Aftermath of the Global Financial Crisis, Cambridge University Press,2012.
2 Unemployment figure based on June 2014 seasonally adjusted labour force numbers. Decline in GDP based on seasonally adjusted National Accounts, year to March 2014.