Characteristics of a well-functioning financial system

The financial system plays a vital role in supporting sustainable economic growth and meeting the financial needs of Australians. It does this by facilitating funding, liquidity and price discovery, while also providing effective risk management, payment and some monitoring services.

The Inquiry believes the financial system achieves this most effectively when it operates in an efficient and resilient manner and treats participants fairly. This occurs when participants fulfil their roles and responsibilities in a way that engenders confidence and trust in the system.

The financial industry makes a considerable contribution to employment and economic output in Australia. However, the Inquiry believes the focus of financial system policy should be primarily on the degree of efficiency, resilience and fairness the system achieves in facilitating economic activity, rather than on its size or direct contribution (such as through wages and profits) to the economy.


An efficient financial system is fundamental to supporting Australia’s growth and productivity. An efficient system allocates Australia’s scarce financial and other resources for the greatest possible benefit to our economy, promoting a higher and more sustainable rate of productivity, and economic growth. The Inquiry is concerned with three distinct, but interrelated, forms of efficiency:

  • Operational efficiency — where financial products and services are delivered in a way that minimises costs and maximises value. This largely depends on how effectively firms deploy labour, capital and technology, and the regulations with which firms comply. Strong competition, both from new entrants and incumbents, encourages firms to innovate and increase operational efficiency to survive and prosper. This can be seen in the ongoing industry focus on deploying new technologies in the Australian financial system to improve the quality and reduce the cost of products and services. Good policy-making can also assist operational efficiency by providing a stable regulatory environment and well-designed regulation that takes into account its likely effect on industry.
  • Allocative efficiency — where the financial system allocates financial resources to the most productive and valuable use. Central to achieving allocative efficiency is the ability of prices to adjust freely to give participants information about the value and risk of various financial products and services. Prices help allocate financial resources to productive uses. Prices also help allocate risks to those most willing and able to bear them, such as through insurance or derivative contracts. For prices to play this role, market participants require access to comprehensive information about the risks and expected returns of financial products. Allocative efficiency can be hampered by ineffective disclosure, government guarantees (explicit or implicit) and tax policies that distort price signals.
  • Dynamic efficiency — where the financial system delivers price signals that induce the optimal balance between consumption and saving (deferred consumption). At times, policy intervention may be required to overcome behavioural biases that impede an economy’s ability to allocate resources with dynamic efficiency. For example, Australia’s compulsory superannuation system was introduced, in part, to overcome the tendency of individuals to underestimate the value of deferred consumption for long periods, such as for retirement.


Resilience refers to the financial system’s capacity to adjust to both the normal business cycle and a severe economic shock. A resilient system does not preclude failure, nor necessarily imply price stability. Rather, a resilient system can adjust to changing circumstances while continuing to provide core economic functions, even during severe but plausible shocks. In a resilient system, individual institutions in distress should be resolvable with minimal costs to depositors, policy holders, taxpayers and the real economy.

Occasional episodes of financial instability are inherent in a market economy and are typically associated with asset price volatility, high levels of leverage, under-pricing of risks and mismatches between assets and liabilities. History suggests that events of instability will continue to occur, but their timing, severity and causes cannot be reliably predicted.

Although Australia’s experience of the global financial crisis (GFC) was not as acute as that of other countries — in part because of a strong Commonwealth fiscal position, effective monetary policy, ongoing demand for commodity exports and a prudent and well-managed financial system — Australia has not always been so well placed. Land and property speculation in the 1880s and 1890s led to an economy-wide depression, with real per capita GDP falling 20 per cent and around half of the Australian trading banks closing.3 During the 1930s depression, a number of financial institutions faced depositor runs.4 In the late 1980s and early 1990s, an unsustainable boom, primarily in the commercial property sector, combined with poor lending practices and associated loan defaults, resulted in aggregate bank losses equivalent to one-third of shareholders’ funds.5 This led to depositor runs on some institutions and was a contributing factor in Australia’s recession at that time.

Severe financial shocks have broad negative consequences, both for individuals and for the general economy. Depositors, policy holders, creditors and shareholders of affected institutions can lose money. Credit and risk management services may be scaled back. In extreme circumstances, payments mechanisms may break down. Confidence in the financial system can evaporate, causing contagion to spread from distressed institutions to the rest of the system. General economic growth slows, unemployment rises and standards of living fall.

Australia’s use of offshore funding, while beneficial to economic growth, makes the country vulnerable to sudden changes in international investor sentiment. Because of this, it is critical that the Australian financial system is resilient. As the cost of offshore borrowing is linked to the nation’s credit rating, it is also critical that both federal and state governments maintain strong fiscal positions.

Fair treatment

Fair treatment occurs where participants act with integrity, honesty, transparency and non-discrimination. A market economy operates more effectively where participants enter into transactions with confidence that they will be treated fairly.

Fair treatment does not involve shielding consumers from responsibility for their financial decisions, including for losses and gains from market movements. Some investor losses are an inevitable feature of a well-functioning market economy, which allows risk-taking in search of a return.

Behavioural biases and information imbalances6 can be detrimental to both financial system participants and system efficiency. Participants, including consumers, have a responsibility to accept the outcomes of their financial decisions, but financial firms should have regard to these information imbalances in treating their customers fairly.

Financial firms need to place a high degree of importance on treating customers fairly. This includes providing consumers with clear information about risks; competent, good-quality financial advice that takes account of their circumstances; and access to timely and low-cost alternative dispute resolution and an effective judicial system.

Roles and responsibilities of participants

Confidence and trust are essential ingredients in building an efficient, resilient and fair financial system that facilitates economic growth and meets the financial needs of Australians. However, confidence and trust cannot be prescribed in legislation. Rather, the Inquiry expects participants to fulfil the following roles and responsibilities in a way that engenders confidence and trust:

  • Consumers are generally best placed to make financial decisions that meet their financial needs and have a responsibility to accept the outcomes of those decisions when they have been treated fairly.
  • Businesses,7 both small and large, should be able to access funding and take productive risks to reap commercial rewards. The outcomes from these ventures should be shared according to well-defined and enforceable contractual terms. Businesses should not be prevented from failing, nor guaranteed access to private financial services on non market based terms.
  • Financial firms (banks, insurers, financial advisers, superannuation trustees, responsible entities, lenders, brokers etc.) should act in the interests of their legal beneficiaries. Financial firms should earn the confidence and trust of customers by complying with their legal obligations and considering community expectations, thus limiting or avoiding the need for more prescriptive or interventionist regulation.
  • Regulators are responsible for discharging their mandate and exercising their judgement to the standards of the civil service. To be effective, regulators should be independent and accountable, and have access to the appropriate regulatory tools and resources.
  • Governments are responsible for setting policy that enables the financial system to facilitate sustainable growth and meet the financial needs of Australians, while minimising risk to taxpayers’ funds. Governments have an obligation to act in the long-term national interest, rather than using the financial system for short-term political gain.8

Culture of financial firms

Since the GFC, a persistent theme of international political and regulatory discourse has been the breakdown in financial firms’ behaviour in failing to balance risk and reward appropriately and in treating their customers unfairly. Without a culture supporting appropriate risk-taking and the fair treatment of consumers, financial firms will continue to fall short of community expectations. This may lead to ongoing political pressure for additional financial system regulation and the undermining of confidence and trust in the financial system.

An organisation’s culture reflects its accumulated knowledge, beliefs and values in a way that sets norms for the behaviour of its employees and their decision making. Organisational objectives, business strategies and systems all influence employees’ behaviour, which reflects on an organisation’s culture. Leaders and their governing bodies determine organisational culture through their own conduct and design of objectives, strategies and systems. This creates competitive advantage.

The Inquiry considers that industry should raise awareness of the consequences of its culture and professional standards, recognising that, responsibility for culture in the financial system ultimately rests with individual firms and the industry as a whole. Culture is a set of beliefs and values that should not be prescribed in legislation. To expect regulators to create the ‘right’ culture within firms by using prescriptive rules is likely to lead to over-regulation, unnecessary compliance cost and a lessoning of competition. The responsibility for setting organisational culture rightly rests with its leadership.

3 Maddock, R 2014, ‘Capital markets’ in Ville, S and Withers, G (eds), The Cambridge economic history of Australia, Cambridge University Press, page 274.

4 Fisher, C and Kent, C 1999, Two depressions, one banking collapse, Research discussion paper, 1999-06, Reserve Bank of Australia, Sydney, pages 13–14.

5 Gizycki, M and Lowe, P 2000, ‘The Australian Financial System in the 1990s’, paper presented at The Australian Economy in the 1990s conference held by the Reserve Bank of Australia, Sydney, 24–25 July, page 181.

6 In economic terms, ‘information asymmetries’. These occur when two parties entering into a transaction do not have the same level of information, placing one at an advantage over the other.

7 This includes financial firms.

8 For a discussion of the potential for financial system policy to be influenced by political interests, see, for example, Calomiris, C and Haber, S 2014, Fragile by Design: Political Origins of Banking Crises and Scarce Credit, Princeton University Press, Princeton.