The Inquiry's approach to financial system regulation

The starting point for the Inquiry’s approach to examining the role of Government in the financial system is the Wallis Inquiry’s philosophy of regulation.9 Insights provided by academic research and practical experience since then have advanced the Inquiry’s understanding of the financial system. Critically, this new understanding has reduced the Inquiry’s confidence in the inherent efficiency and stability of financial markets10 and increased its understanding of the financial system as a complex, adaptive network.11 Box 1: Implications of developments since the Wallis Inquiry summarises the implications of some developments since the Wallis Inquiry.

Box 1: Implications of developments since the Wallis Inquiry

Developments since the Wallis Inquiry Lessons for this Inquiry
The GFC has again demonstrated that financial systems are prone to instability and that the resulting financial failure can have a significant cost to taxpayers, economic output and employment. Australia remains susceptible to financial crises, including from the dislocation of international markets. A resilient system is required to bolster stability, prevent an increase in moral hazard and reduce risk to taxpayers.
The Australian financial system is part of a global economy increasingly influenced by Asia. It is affected by the increasing scope and complexity of cross-border financial regulation as well as other broader economic changes. Policy making should be coordinated, more accountable and better implemented to deal with changes in global regulation and in the financial systems of our major trading partners.
Behavioural biases undermine the assumption that individuals are ‘rational’. They limit the efficacy of disclosure as a regulatory tool and can lead to sub-optimal outcomes for consumers.12 Although disclosure remains a valuable tool to improve consumer outcomes, it should not be relied on in isolation.
Rapid technological innovation brings opportunities to improve user outcomes and system efficiency, but also raises new risks and challenges. Policy settings should facilitate innovation and accommodate market developments where these improve system efficiency and user outcomes.
General acceptance that, in a severe financial crisis, governments (and taxpayers) may play a role in protecting the real economy. To avoid moral hazard, regulatory settings should reduce the likelihood of Government support being required. However, Government should maintain a strong fiscal position with the capacity to provide this support in extreme circumstances.

The central role of market forces

Central to the Inquiry’s philosophy is that the financial system should be subject, and responsive, to market forces, including competition. This is based on the Inquiry’s view that the private sector is best placed to make decisions affecting the efficient allocation of resources.

Competition remains the cornerstone of a well-functioning financial system and is generally preferred to government intervention.13 Competition drives efficient outcomes for price, quality and innovation. However, the Inquiry recognises that competition alone does not always deliver the best balance between efficiency, resilience and fair treatment.

Government prerequisites

Competitive markets need to operate within a strong and effective legal and policy framework provided by government. The characteristics required for the financial system to contribute effectively to sustainable economic growth are:

  • Predictable rule of law with strong property rights, providing certainty of contract; protection from fraudulent, predatory and anti-competitive behaviour; and access to redress.
  • Freely convertible floating currency and general free flow of trade, investment and capital across borders.
  • Strong fiscal position.
  • Sound monetary policy framework, including an independent central bank.
  • Effective, accountable and transparent government.

Although these conditions are regarded as generally being met in Australia, Government should not underestimate their importance, and policy should be directed at their maintenance.

Sector-specific regulation in the financial system

The Inquiry believes the financial system requires sector-specific regulation, in addition to the above legal and policy prerequisites, for two reasons:

  1. More so than other sectors, the financial system has the ability to create or amplify economic shocks because of its use of leverage, its complexity and its interconnectedness with the rest of the economy.
  2. The significant harm to consumers that may result from complex financial decisions, or from dishonest and predatory practices, requires specialist regulation to promote fair treatment.

Sector-specific regulation is not unique to the financial system. Characteristics such as the high potential for harm and complexity result in specialist regulation in other industries, including aviation and pharmaceuticals. However, the Inquiry considers the potential effect on living standards or economic growth from mismanaging risk in the financial system requires more specialised regulatory oversight than that provided under general economy-wide trading rules.

Framework for policy intervention

The Inquiry’s approach to policy intervention is guided by the public interest. Given the inevitable trade-offs involved, deciding how and when to intervene in the financial system requires considerable judgement by policy makers.

Intervention should seek to balance efficiency, resilience and fairness in a way that builds participants’ confidence and trust. Intervention should only occur where its benefits to the economy as a whole outweigh its costs. Intervention should always seek to be proportionate and cost sensitive. However, in many cases, the assessment of costs and benefits will not be clear-cut and will require policy makers to exercise judgement — as has been the case for many matters considered by this Inquiry.14

Impediments to efficient market operations, such as information imbalances and principal agent conflicts, should be minimised.15 The Inquiry expects policy makers to set regulatory frameworks that encourage private sector competition and innovation by applying regulation on a functional basis, graduating regulatory obligations and assisting industry to overcome collective action problems. 16,17

A resilient financial system allows financial failure but manages it in a way that limits the cost to the general economy and taxpayers. The Inquiry believes policy makers should seek to minimise the chance of systemic crises, but have the right tools to manage such events when they do occur. As a last resort, Government should have the fiscal capacity to support the economy if required.

To encourage the fair treatment of participants in the financial system, policy makers should establish frameworks that ensure the orderly conduct of financial markets and minimise incidences of consumers buying financial products and services that do not meet their needs.

The Inquiry’s philosophy places great responsibility on policy makers, particularly regulators, to make decisions that best balance the desired outcomes of efficiency, resilience and fair treatment. Principles-based decisions will often depend on regulators’ professional judgement. Central to this approach is the need for appropriately skilled, effective regulators that are both independent and highly accountable for discharging their mandates.

Box 2: General principles for policy makers

Determining when to intervene

  • Intervention should be considered where it would improve the efficiency, resilience or fairness of the financial system, but only introduced if its benefit is judged to outweigh the costs to the economy as a whole.
  • Unless there is a clear public interest, policy makers should give competitive markets the opportunity to adjust to market signals and allow established legal remedies to be enforced rather than pre-emptively regulating.

Delivering efficiency

  • Policy makers should seek to remove distortions to the efficient allocation of funds and risks in the economy, and reduce unnecessary regulatory burdens.
  • Policy makers should seek to encourage competition by removing unnecessary barriers to domestic and international competition.
  • Policy settings should seek to encourage innovation by being technologically and competitively neutral in design.

Delivering resilience

  • Private sector risk-taking should be supported, allowing both success and failure.
  • Policy makers should seek to prevent a build-up of systemic risk. They should have systems in place to manage failing financial institutions in an orderly manner that protects the financial system’s critical functions and maintains financial stability while minimising risk to taxpayers.

Delivering fair treatment

  • Consumers should generally bear responsibility for their financial decisions, but should be able to expect financial products and services to perform in the way they are led to believe they will.
  • Policy makers should be aware of, and design regulatory frameworks that take into account, behavioural biases.

9 Commonwealth of Australia 1997, Financial System Inquiry Final Report, Canberra, Chapter 5 — Philosophy of Financial Regulation.

10 A recent survey of some of this research is provided by Brunnermeier, M, Eisenbach, T and Sannikov, Y 2013, ‘Macroeconomics with Financial Frictions: A Survey, in Acemoglu, D, Arellano, M and Dekel, E (eds.) 2013, Advances in Economics and Econometrics, Tenth World Congress of the Econometric Society, Volume II: Applied Economics, Cambridge University Press, New York, pages 4–94. See also Allen, F, Babus, A, Carletti, E 2009, ‘Financial Crises: Theory and Evidence, Annual Review of Financial Economics, volume 1, pages 97–116.

11 See, for example, Haldane, A 2009 Rethinking the financial network, speech to the Financial Student Association Amsterdam, 28 April.

12 See, for example, Kahneman, D 2011, Thinking Fast and Slow, Penguin Books Ltd, London.

13 Intervention is defined as including regulation, legislation, guidance, general supervision and enforcement.

14 Policy makers should use evidence-based approaches in policy analysis, including trials or pilots when feasible.

15 Principal agent conflicts occur if an agent (for example, a company executive) pursues their own self-interest rather than those of the principal (for example, a shareholder) who has provided them with resources and delegated responsibility to them for making decisions.

16 Functional regulation involves regulating similar economic functions in a similar way.

17 Graduated regulation involves providing lower-intensity regulation for businesses that pose lower risks to the system.