Themes of this report

Australia’s financial system has performed well since the Wallis Inquiry. Australia has a competitive financial system with sophisticated capital markets and firms that are quick to adopt new technologies that reduce costs or provide improved products and services.

Although Australia was not immune to the effects of the GFC, the financial system and institutional framework held up well compared with many financial systems elsewhere in the world. In particular, Australia’s regulatory frameworks proved robust during this period.

However, the Inquiry’s assessment is that Australia’s financial system is at risk of falling short of its potential to operate in a manner characterised by efficiency, resilience and fair treatment. This assessment led the Inquiry to focus on the seven themes in this report (summarised in Figure 1: Guide to the Financial System Inquiry Final Report).

The first general theme, the funding of the Australian economy, refers to the core function of the financial system. A number of important opportunities for improvement in funding relate to tax. While taxation is outside the terms of reference of this Inquiry, a number of observations on tax are summarised in Appendix 2: Tax summary.

The second general theme, competition, underpins a well-functioning financial system and is integral to a number of recommendations of this report.

The Inquiry has also made recommendations within five specific themes, each of which is covered in an individual chapter:

  • Strengthen the economy by making the financial system more resilient (Chapter 1: Resilience).
  • Lift the value of the superannuation system and retirement incomes (Chapter 2: Superannuation and retirement incomes).
  • Drive economic growth and productivity through settings that promote innovation (Chapter 3: Innovation).
  • Enhance confidence and trust by creating an environment in which financial firms treat customers fairly (Chapter 4: Consumer outcomes).
  • Enhance the independence and accountability of regulators and minimise the need for future regulatory intervention (Chapter 5: Regulatory system).

In addition, a number of other recommendations are summarised in Appendix 1: Significant matters.

Funding the Australian economy

The core function of the Australian financial system is to facilitate the funding of sustainable economic growth and enhance productivity in the Australian economy. This is the starting point for considering whether Australia’s current financial system is fit for purpose, which greatly influences the Inquiry’s view on specific recommendations within this report.

As outlined in the Interim Report, it is difficult to assess and quantify the most efficient allocation of funding for the Australian economy.18 In the view of the Inquiry, the framework for the issuance and trading of debt and equity in Australia is operating reasonably well. Australia has a well-functioning equity market, a sophisticated wholesale financial market, and a privately owned banking and insurance system that provides a range of competitive retail products and services. However, some funding markets in Australia, including the corporate bond and venture capital markets, appear underdeveloped compared with those of some international peers.

The Inquiry has taken a principles-based approach to funding policy. The Inquiry believes government’s role in funding markets should generally be neutral on the channel, direction, source and size of the flow of funds. Financial instruments, markets and forms of intermediation should develop, evolve and operate in ways that best reflect investor and borrower preferences and technological developments. Outside an extreme financial shock, there is generally little benefit in policy makers attempting to improve efficiency by insulating the economy from market forces. Instead, the Inquiry’s approach has been to seek to identify and remove distortions to the inefficient allocation of resources.

The Inquiry has heard four main concerns in relation to the flow of funding in the Australian economy. First, that some funding markets, including the corporate bond and venture capital markets, are too small. Second, that particular sectors of the economy, such as small and medium-sized enterprises (SMEs) or rural businesses, do not have sufficient access to funding. Third, that the major banks may face a ‘funding gap’ that would restrict economic growth in the future. Finally, stakeholder input and Inquiry research indicate significant potential tax distortions.

Regarding the relative size of various funding markets, the Inquiry’s approach is to seek to remove unnecessary regulatory settings that distort the flow of funds favouring the use of one market over another. In the case of the domestic corporate bond market, these include both tax and regulatory settings such as excessive disclosure requirements. The Inquiry does not believe mandating or subsidising a particular market in an attempt to increase its size (whether it be corporate bond, securitisation or venture capital markets) is an effective strategy in the long term. Instead, the size of a funding market should reflect market forces.

Some submissions also called on Government to influence the allocation of resources towards particular sectors of the economy perceived to have insufficient access to funding. For example, several submissions call on Government to encourage the investment of superannuation assets in infrastructure or to establish a Government-owned bank to direct funding to particular causes, such as rural businesses. The Inquiry does not support such approaches — to maximise the efficiency of the financial system policy makers should not set out to favour one particular funding destination over another.

The Inquiry has noted that SMEs have few options for external financing outside the banking system compared with large corporations. In part, this reflects unnecessary distortions, such as information imbalances and regulatory barriers to market-based funding. Appendix 3: Small and medium sized enterprises (SMEs) summarises the Inquiry’s recommendations relating to SMEs.

As discussed in the Interim Report, some submissions also argued that the major banks face a ‘funding gap’.19 These submissions suggest that in some circumstances banks would be unable to fund higher credit growth with new deposits, placing economic growth at risk. The Inquiry acknowledges that the ability of Australian banks to fund themselves is critical to their stability and is of great importance to the broader economy. However, on consideration of the relevant evidence and arguments, the Inquiry has concluded that Australia is not at risk from an emerging ‘funding gap’ for the following reasons:

  • To the extent that some banks cannot source sufficient funding on commercially attractive terms to meet demand, market mechanisms such as the price of credit will attract alternative providers of funds, for example superannuation funds and other investors lending directly, greater prevalence of market-based financing or peer-to-peer lending.
  • Such market mechanisms are also likely to increase the attractiveness of deposits as an investment vehicle under a high credit-growth scenario, thus increasing the supply of funding available to the banks (as occurred in Australia in the period following the GFC).20

The Inquiry takes a neutral approach to the mechanism through which Australia sources its funding, including funding from offshore markets. The flow of funds should be subject to market forces and be free to evolve to meet user demands and market conditions.

The funding-related issue that concerns the Inquiry most is that of distortions to the market allocation of resources, including through taxation, information imbalances and unnecessary regulation.21 If unaddressed, such distortions are likely to lead to lower productivity and lower longer-term living standards than otherwise would be the case.

A significant number of the distortions identified are tax-related, as summarised in Box 3: Major tax distortions. Reducing the distortionary effects of these taxes should lead the system to allocate savings (including foreign savings) more efficiently and price risk more accurately. This would increase aggregate productivity and limit the build-up of systemic vulnerabilities.

Throughout this report, the Inquiry has made a number of recommendations relating to funding:

  • The Tax White Paper should consider the reform of tax settings that distort the flow of funds (see Box 3: Major tax distortions).
  • Obstacles to the growth of the corporate bond market should be addressed, including regulatory barriers and tax distortions, particularly the non-neutral treatment of savings vehicles (see Appendix 2: Tax summary and Recommendation 33: Retail corporate bond market).
  • Reforms should be made to remove obstacles to SME financing, including facilitating crowdfunding and reducing information imbalances (see Appendix 3: Small and medium sized enterprises (SMEs)).
  • To strengthen Australia’s ability to continue to access funding, both domestically and from offshore sources, recommendations have been made to improve the resilience of the Australian financial system (see Chapter 1: Resilience).
  • A more efficient superannuation system should result in more funds for investment as well as more effective investment decisions and more efficient allocations of funds (see Chapter 2: Superannuation and retirement incomes).

Box 3: Major tax distortions

A more neutral tax treatment of savings vehicles would reduce distortions in the composition of household balance sheets and the broader flow of funds in the economy. Across savings vehicles, after-tax returns differ markedly. For example, interest income is relatively heavily taxed.22 To the extent that distortions direct savings to less productive investments, a more neutral treatment would increase productivity.

For assets that generate capital gains, the tax treatment encourages leveraged investment, which is a potential source of financial system instability. Investors are attracted by the asymmetry in the tax treatment of expenses and capital gains, where individuals can deduct the full interest costs of borrowing (and other expenses) from taxable income, but only half of their long-term capital gains are taxed. The tax treatment of investor housing, in particular, tends to encourage leveraged and speculative investment in housing.

The implications of dividend imputation are less clear. The introduction of imputation reduced firms’ cost of equity; however, the effectiveness of imputation in lowering the cost of capital arguably has declined as the economy has become more open. The tax benefits of imputation may encourage domestic investors to invest in domestic firms with domestically-focused investments, which would limit opportunities and increase risk from less diversified portfolios. To the extent that imputation distorts the allocation of funding, a lower company tax rate would be likely to reduce those distortions. A lower company tax rate would also enhance Australia’s attractiveness as a place to invest, which would increase Australia’s productivity and living standards.

Reducing the uncertainty and scope of taxes on cross-border flows would improve Australian entities’ access to offshore savings. Access to offshore funding markets provides Australian entities with cheaper funds than otherwise would be the case. Having access to more diverse sources of funding reduces the risk from dislocation in one or more funding markets. That said, the complex, ad-hoc tax treatment of cross-border transactions reflects, in part, Government’s desire to maintain the integrity of the tax base — from profit shifting and other tax avoidance strategies — in the face of continued financial innovation and internationalisation.

For non-residents, repatriated income from Australian investments is subject to a regime of withholding taxes. The application and rate of withholding tax varies with respect to a host of factors, including the type of funding, the country of the foreign entity and the relationship between the domestic and foreign entity. Withholding tax increases the required rate of return for non-residents, which reduces the attractiveness of Australia as an investment destination. In cases where the non-resident can pass on the cost, the cost of funding is raised in Australia.

Refer to Appendix 2: Tax summary for additional information on the Inquiry’s observations related to tax.

Competition

The Inquiry believes competition and competitive markets to be at the heart of its philosophy and sees them as the primary means of improving the system’s efficiency.

This section builds on the discussion in the Interim Report of the competitive strength in various sectors of the Australian financial system.23 It summarises the Inquiry’s recommendations regarding amendments to current competitive regulatory settings and strengthening competition in the future. These recommendations are spread across a range of chapters in this report.

Competition in the financial system is generally adequate at present. The Inquiry’s approach to encouraging competition is to remove impediments to its development. The Inquiry recommends making the following adjustments to current regulatory settings:

  • Narrowing the differences in risk weights between authorised deposit-taking institutions (ADIs) using internal ratings-based models and those using standardised models in mortgage lending (see Recommendation 2: Narrow mortgage risk weight differences).
  • Introducing a competitive process to allocate new default fund members to high-performing superannuation funds, unless the Stronger Super reforms prove effective (see Recommendation 10: Improving efficiency during accumulation).
  • Refining the payments regulation framework (see Recommendation 16: Clearer graduated payments regulation).
  • Supporting innovation and new entrants (see recommendations 14: Collaboration to enable innovation, 15: Digital identity, 18: Crowdfunding, 19: Data access and use, 20: Comprehensive credit reporting, 39: Technology neutrality and 30: Strengthening the focus on competition in the financial system).

In addition, the Inquiry notes that perceptions of implicit guarantees in the banking system can distort competition by providing a funding advantage to those banks believed to most benefit from such guarantees. Recommendations that increase the resilience of the banking sector, especially of the largest banks, will reduce these perceptions over time and help contribute to restoring a more competitive environment.24

Notwithstanding the above recommendations to amend current regulatory settings, high concentration and trends towards increasing vertical integration in some sectors of the financial system have the potential to limit the benefits of competition in the future.

The Inquiry acknowledges that no single solution will guarantee the ‘right’ level of competition in the future — competition is a dynamic concept, changing over time. Instead, policy makers should be proactive in reviewing levels of competitiveness and removing barriers to the emergence of disruptive competitors, including both international entrants and domestic innovators.25 In particular, the state of competition in the financial system should be reviewed every three years, including assessing changes in barriers to international competition (see Recommendation 30: Strengthening the focus on competition in the financial system).

Conduct and prudential regulators have a natural tendency to prioritise fairness or stability over competition and long-term efficiency. The long-term benefits of competition can be potentially difficult to identify or value, while the short-term costs of instability or unfair outcomes are immediately visible to regulators, governments and the general public. Therefore, the Inquiry has made a number of recommendations to ensure regulators are more sensitive to the effects their decisions have on competition:

  • A Financial Regulator Assessment Board should be established to advise Government, including on how regulators consider competition issues in designing and implementing regulation (see Recommendation 27: Regulator accountability).
  • An explicit requirement to consider competition should be included in the Australian Securities and Investments Commission’s (ASIC) mandate (see Recommendation 30: Strengthening the focus on competition in the financial system).
  • Regulators should more clearly explain in their annual reports how they have considered the effect of their decisions on competition and compliance costs (see Recommendation 27: Regulator accountability).

As discussed in the Interim Report, the Inquiry supports the implementation of the Council of Financial Regulators (CFR) recommendations on strengthening the financial market infrastructure (FMI) framework and Government’s review of the market licensing framework.26 This would create a framework under which competition and international financial integration in FMI could be increased.

As outlined in Box 4: International competitiveness, unnecessary barriers to international competitiveness and market access into Australia should be front of mind in designing and applying Australia’s regulatory frameworks. The free flow of capital in and out of Australia significantly benefits competition and those who use Australia’s financial system. For example, borrowers can lower their funding costs by directly accessing international bond markets, or they can borrow from Australian intermediaries that have lowered their funding costs by accessing less expensive foreign sources of capital.

Box 4: International competitiveness

Australia has relatively open financial markets: foreign financial services providers can generally provide retail services on the same terms as domestic competitors. Many wholesale markets are open to foreign providers, such as foreign ADI branches, without the need to comply with specific domestic regulatory frameworks — strengthening competition.

But Australia’s financial sector is less open and internationally integrated than it could be now — and than it will need to be in the future.27 More needs to be done to remove impediments to cross-border competition and other barriers to the free flow of capital across borders, such as tax impediments.

Developments and opportunities in Asia make change imperative. Financial system liberalisation and integration in our region creates an opportunity to mobilise surplus savings more efficiently and channel it to investment opportunities, supporting economic development and trade.

Where possible, policy makers should avoid adopting unique Australian regulatory approaches that are inconsistent with international practice. They should also remove impediments to recognising foreign frameworks for domestic purposes (either unilaterally or mutually). The Inquiry recommends:

  • Government and regulators should identify rules and procedures that create barriers to competition and consider whether these can be modified or removed. (see Recommendation 30: Strengthening the focus on competition in the financial system).
  • Government should also consider developing a mechanism to enable Australian fund managers to use collective investment vehicles that are more common overseas, such as a corporate vehicle (see Recommendation 42: Managed investment scheme regulation).

Government and regulators should develop and implement regulatory frameworks in ways that do not impose unnecessary costs on Australian firms operating offshore but support improved access to offshore markets.28

Tax impediments to the free flow of capital add to the cost of doing business in Australia. They limit the capacity for Australia’s financial system to exploit new and developing product areas, such as those for the Renminbi market, which would diversify financial solutions available in Australia.

Resilience

Australia weathered the GFC well relative to many international peers. However, it would be imprudent to assume the conditions that cushioned Australia during the crisis will exist when future shocks occur. Australia should heed the lessons learnt by other countries during the GFC. As a capital-importing country exposed to fluctuating terms of trade and characterised by a concentrated banking system, Australia needs to be better positioned than most.

Australia will experience future financial crises. However, their timing and sources are difficult to predict. As outlined in Box 5: Systemic and housing risk in Australia, in some circumstances, the Australian financial system is vulnerable to a number of sources of risk that could severely damage both the economy and individuals’ financial circumstances.

Box 5: Systemic and housing risk in Australia

A number of characteristics of the Australian economy and financial system present sources of potential systemic risk:29

  • As a large capital importer, Australia is susceptible to the dislocation of international funding markets or a sudden change in international sentiment towards Australia, which would reduce access to, and increase the cost of, foreign funding.
  • As an open economy, Australia is exposed to shocks in the economies of our major trading partners and subject to volatility in commodity prices.
  • Australia’s banking system is highly concentrated, with the four major banks using broadly similar business models and having large offshore funding exposures.30 This concentration exposes each individual bank to similar risks, such that all the major Australian banks may come under financial stress in similar economic and financial circumstances.
  • Australia’s banks are heavily exposed to developments in the housing market. Since 1997, banks have allocated a greater proportion of their loan books to mortgages, and households’ mortgage indebtedness has risen.31 A sharp fall in dwelling prices would damage household balance sheets and weigh on consumption and broader economic growth. It would also reduce the quality of the banking sector’s balance sheets and the capacity of banks to extend new credit, which would compromise the speed of a subsequent economic recovery.

A severe disruption via one of these channels would have broad economic and financial consequences for Australia. Indeed, interconnectedness within the financial system and the economy would be likely to propagate distress and heighten other risks and vulnerabilities.

Given Australia’s concentrated financial system, high household leverage and relatively high house prices, the Inquiry is particularly concerned about the banking system’s exposure to housing. Despite housing risk being generally well understood by both regulators and the financial industry, the Inquiry has specifically considered this risk when making its recommendations.

More can be done to strengthen the resilience of Australia’s financial system. Although no system can ever be ‘bullet proof’, Australia should aim to cultivate financial institutions with the strength not only to withstand plausible shocks but to continue to provide critical economic functions, such as credit and payment services, in the face of these shocks.

A number of aspects are critical to this strength, including an institution’s capital levels, liquidity, asset quality, business model and governance, and Australia’s sovereign credit rating. Of these, capital levels are particularly important, as they provide a safety buffer to absorb losses regardless of the source.

The Inquiry proposes a package of recommendations to enhance resilience in Australia’s financial system. This package would make institutions less susceptible to shocks and the system less prone to crises. It would reduce the costs of crises when they do happen and improve the allocative efficiency of the system generally by reducing perceptions of an implicit guarantee. The package aims to minimise the cost to taxpayers, Government and the broader economy from risks in the financial system. In doing so, the package seeks to balance trade-offs between system safety and competitiveness where they are in conflict, and aspires to have competitively neutral regulatory settings where possible.

The Inquiry has primarily focused on reforms to two aspects of Australia’s financial stability framework:

  • ADI capital levels should be raised to ensure they are unquestionably strong. Evidence from banks, regulators and others suggests that Australian banks are not in the top quartile of large internationally active banks. Regulatory changes in other countries may further weaken the relative position of Australian banks. The Inquiry believes that top-quartile positioning is the right setting for Australian ADIs (see Recommendation 1: Capital levels).
  • ADIs should maintain sufficient loss absorbing and recapitalisation capacity to allow effective resolution while mitigating the risk to taxpayer funds — in line with emerging international practice. Regulators’ toolkits are critical and should be enhanced to prevent distress and to resolve failing financial institutions (see Recommendation 3: Loss absorbing and recapitalisation capacity and Recommendation 5: Crisis management toolkit).

In the Inquiry’s view, raising capital requirements for ADIs would provide a net benefit to the economy. It would assist to avoid or reduce the severe and prolonged costs of future crises, including high levels of unemployment. The cost of raising capital would be reduced by competition in the market, including the effect of the recommendations in this report. Drawing on multiple sources of evidence, the Inquiry calculates that raising capital ratios by one percentage point would, absent the benefits of competition, increase average loan interest rates by less than 10 basis points which could reduce GDP by 0.01-0.1 per cent.32

Making the system more resilient also has efficiency benefits. Large or frequent financial crises create volatility and uncertainty that impede the efficient allocation of resources and harm dynamic efficiency by discouraging investment. In the resulting long periods of high unemployment, productive resources are under-utilised.

In addition, if implemented, this package of reforms should prevent the need for further structural reform in the industry, such as ring-fencing certain operations of the major banks. The Inquiry also believes that introducing the proposed reforms would reduce the need to pre-fund the Financial Claims Scheme (see Recommendation 6: Financial Claims Scheme).

Although stability settings aim to minimise the economic cost of financial institutions failing, it is not possible — or efficient — to eliminate failure altogether. Government must ensure its financial position remains sufficient to support the financial system in a future crisis. Macro-economic conditions can deteriorate rapidly in a crisis, and Government needs to remain alert to this. Maintaining a AAA credit rating would give Government the flexibility necessary to support the economy (although not necessarily the failed institutions) in such circumstances.

The GFC highlighted the benefits of Australia’s largely unleveraged superannuation sector. The absence of borrowing enabled the superannuation sector to have a stabilising influence on the financial system and the economy during the crisis. Restricting leverage in the sector will be important for mitigating future risks (see Recommendation 8: Direct borrowing by superannuation funds).

Superannuation and retirement incomes

Superannuation is now the second largest asset for many Australians. Its growing importance underlines the need for a regulatory approach that puts individual members at the very centre of the system — benefiting both individual Australians and the economy as a whole.

An efficient superannuation system is critical to help Australia meet the economic and fiscal challenges of an ageing population. While its importance for retirees and, to a lesser extent, taxpayers is self-evident, superannuation efficiency is also vital to sustaining long-term economic growth, given the system’s increasing importance in funding Australia’s prosperity.

Australia’s superannuation system has considerable strengths. However, the system lacks efficiency in a number of areas.

The lack of clarity around the ultimate objective of superannuation policy contributes to ad hoc short-term policy making, which imposes unnecessary costs on superannuation funds and members, reduces long-term confidence in the system and impedes efficiency. The Inquiry believes the purpose of the superannuation system is to provide an individual with an income in retirement (see Recommendation 9: Objectives of the superannuation system).

At retirement, superannuation assets are not being efficiently converted into retirement incomes. This contributes to a significantly lower standard of living for some Australians in retirement and during their working life. Efficiency can be improved by removing barriers to product development and encouraging the take-up of pooled longevity products by requiring superannuation trustees to pre-select a comprehensive income product in retirement, while maintaining member choice (see Recommendation 11: The retirement phase of superannuation).

Economic growth will benefit if the growing number of retirees are able to sustain higher levels of consumption. The superannuation system is not operationally efficient due to a lack of strong price-based competition. As a result, the benefits of scale are not being fully realised. Although it is too early to assess the effectiveness of the Stronger Super reforms, the Inquiry has some reservations about whether MySuper will be effective in driving greater competition in the default superannuation market.

Unless the Stronger Super reforms prove effective, the Inquiry recommends introducing a competitive process to allocate new default fund members to high-performing superannuation funds. This would improve the competitive dynamics of the sector, reduce costs for funds and reduce compliance costs for employers (see Recommendation 10: Improving efficiency during accumulation).

The superannuation recommendations in this report have the potential to increase retirement incomes for an average male wage earner by around 25 to 40 per cent (excluding the Age Pension).33 While these estimates are illustrative and based on models that cannot fully reflect the unique circumstances of different individuals, the Inquiry is confident that significant increases in retirement incomes can be achieved.

To protect the best interests of members the Inquiry has also made recommendations to improve the governance of superannuation funds (see Recommendation 13: Governance of superannuation funds) and remove restrictions on some employees choosing the fund that receives their Superannuation Guarantee contributions (see Recommendation 12: Choice of fund).

Innovation

For the financial system, technology-driven innovation is transformative. Opportunities for innovation are abundant as, fundamentally, the system revolves around recording, analysing and interpreting transactions, and managing associated information flows. With no physical products to manage, these processes readily lend themselves to improvements via digital technologies.

In Australia, the effect has been significant, particularly as Australian consumers are fast adopters of technology compared to consumers in many other countries.

The Inquiry cannot be certain of how future developments in technology will affect the financial system. Innovation is by its nature evolving and dynamic, and primarily driven by private sector commercial incentives and customer expectations. Instead, the Inquiry has focused on ensuring policy settings accommodate technological change to facilitate a dynamic, competitive, growth-oriented and forward-looking financial system.

The Inquiry has focused on reforms to Australia’s innovation architecture. It recommends:

  • Government should review the costs and benefits of increasing access to, and improving the use of, data. As increasing amounts of data are collected and more sophisticated analytical techniques emerge, data can be used to develop alternative business models, products and services that improve user outcomes and system efficiency (see Recommendation 19: Data access and use).
  • A national strategy for a federated-style model of trusted digital identities should be developed to set a framework and common standards to support the development of a competitive market in identity services that enhances consumer choice, privacy and security, and balances these objectives with financial system efficiency (see Recommendation 15: Digital identity).
  • Government and regulators should remove unnecessary impediments to innovation by applying graduated functional frameworks in a range of areas, including the payments system. The Inquiry supports simplifying and clarifying payments regulation to facilitate innovation; lowering interchange fees to
    reduce costs for merchants and prices for customers; and preventing merchants from over-surcharging customers paying with debit and credit cards (see Recommendation 16: Clearer graduated payments regulation and Recommendation 17: Interchange fees and customer surcharging).
  • Graduating the regulation of market-based financing will increase opportunities for small businesses to seek finance from the general public. The Inquiry supports facilitating crowdfunding and other innovative sources of finance (see Recommendation 18: Crowdfunding).

The Inquiry’s recommendations seek to provide more facilitative settings that enable financial firms to innovate — increasing competitive tension, delivering greater efficiency and enhancing user outcomes.

Consumer outcomes

To build confidence and trust, and avoid over-regulation, the financial system should be characterised by fair treatment.

In terms of fair treatment for consumers, the current framework is not sufficient. The GFC brought to light significant numbers of Australian consumers holding financial products that did not suit their needs and circumstances — in some cases resulting in severe financial loss. The most significant problems related to shortcomings in disclosure and financial advice, and over-reliance on financial literacy. The changes introduced under the Future of Financial Advice (FOFA) reforms are likely to address some of these shortcomings; however, many products are directly distributed, and issues of adviser competency remain.

Consumers should have the freedom to take financial risks and bear the consequences of these risks. However, the Inquiry is concerned that consumers are taking risks they might not have taken if they were well informed or better advised.

The Inquiry deliberated on a spectrum of approaches, from regulating core product features to introducing appropriateness and suitability tests for complex products, which are features of some international jurisdictions. The Inquiry has developed an approach that streamlines and complements the current framework and strengthens the accountability of product issuers and distributors. The Inquiry recommends the following package of reforms:

  • The design and distribution of products should be strengthened through improved product issuer and distributor accountability, and the creation of a new product intervention power to allow ASIC to take a more proactive approach in reducing the risk of significant detriment to consumers (see Recommendation 21: Strengthen product issuer and distributor accountability and Recommendation 22: Introduce product intervention power).
  • Standards of financial advice should be improved by lifting adviser competency (see Recommendation 25: Raise the competency of advisers), better aligning the interests of firms and consumers and enhancing banning powers (see Recommendation 24: Align the interests of financial firms and consumers).
  • Regulatory impediments to industry use of technology should be removed (see Recommendation 39: Technology neutrality) and more innovative forms of disclosure developed (see Recommendation 23: Facilitate innovative disclosure).

The Inquiry expects these changes will reduce the likelihood of future losses similar to those experienced in recent financial investment collapses. Previous collapses involving poor advice, information imbalances and exploitation of consumer behavioural biases have affected more than 80,000 consumers, with losses totalling more than $5 billion, or $4 billion after compensation and liquidator recoveries.34 The changes outlined in this report should also significantly improve consumer confidence and trust in the financial system.

The Inquiry considers that the additional regulatory elements of the package will rebuild consumer confidence and trust in the financial system in the long term, and should help to limit the need for more interventionist regulation in the future. For reputable firms with a strong customer focus, the Inquiry expects that costs involved in changing practices in response to the recommendations will be low. The Inquiry notes that success will require a greater level of regulator judgement, necessitating high-quality, accountable regulators with adequate funding.

The Inquiry also supports continuing industry and government efforts to increase financial inclusion and financial literacy to improve customer outcomes.

Regulatory system

The roles and performance of financial system regulators have an important effect on system efficiency. Strong, independent and accountable regulators assist in maintaining confidence and trust in the financial system.

The Inquiry considers that Australia’s current regulatory architecture does not need major change. Although minor refinements are necessary, the roles of the three major financial regulators — the Reserve Bank of Australia, the Australian Prudential Regulation Authority (APRA) and ASIC — remain appropriate.

The Inquiry’s philosophy places a high level of trust in regulators to make judgements that balance the efficient, stable and fair operation of the financial system. While acknowledging that regulators often have a difficult task, there is room for improvement. In particular, the current arrangements lack a systematic mechanism for Government to assess regulators’ performance relative to their mandate. Instead, scrutiny tends to be episodic and focused on particular issues or decisions. A new Financial Regulator Assessment Board should be established to conduct annual performance reviews of regulators and provide advice to Government (see Recommendation 27: Regulator accountability).

Regulators also need to have the funding, expertise and regulatory tools to deliver on their mandates effectively. APRA and ASIC would benefit from more funding certainty, more operational flexibility and a greater ability to compete with industry for staff (see Recommendation 28: Execution of mandate). ASIC should be able to recover the costs of its regulatory functions from industry, and its powers need strengthening in some areas (Recommendation 29: Strengthening Australian Securities and Investments Commission’s funding and powers).

Regulators should also undertake periodic, forward-looking capability reviews to ensure they are fit for purpose and have the capability to address future regulatory challenges.

Levels of financial regulation

Internationally, the pace of change in financial system regulation has surged since the GFC, with some of these regulatory changes yet to be fully agreed and implemented. As a capital-importing country, Australia has had little choice but to introduce many of these changes. This is on top of a range of fundamental changes in the domestic regulatory framework in the last decade, such as the Stronger Super, FOFA and national consumer credit reforms.

The Inquiry commissioned Ernst & Young (EY) to assess the cost effectiveness of certain regulatory changes implemented in the last decade.35 Although the assessment highlighted broad agreement with the policy that led to the intervention, it also highlighted shortcomings in how policy makers and regulators approach regulatory design and implementation. These included gaps in consultation processes and optimistic time frames for implementation.

The Inquiry is very conscious that unnecessary and inappropriate regulation has the potential to reduce the financial system’s efficiency. It therefore supports ongoing Government efforts to review and remove unnecessary regulation in the financial system and has not sought to duplicate this process.36 The Inquiry makes recommendations to remove unnecessary regulation or improve regulatory processes (see Recommendation 31: Compliance costs and policy processes and Recommendation 39: Technology neutrality).

That said, the Inquiry recognises that many of its recommendations involve new regulation or changes to existing regulation. The Inquiry considers that these recommendations will both strengthen the financial system now and prevent excessive regulatory responses in the longer term. A more competitive and innovative financial system with minimal distortions will improve allocative efficiency and drive sustainable growth. A more resilient financial system will manage future financial shocks at a lower cost to the taxpayer and the real economy. A fairer financial system will avoid the need for more interventionist regulation in the future. In particular, the Inquiry is seeking to avoid rushed regulatory reactions motivated primarily by the political environment.

Of course, this Inquiry cannot guarantee that there will not be further unnecessary or poorly designed regulation in the future. The quality of new regulation will depend on the actions of industry, regulators and governments.


18 Commonwealth of Australia 2014, Financial System Inquiry Interim Report, page 2-44.

19 Commonwealth of Australia 2014, Financial System Inquiry Interim Report, page 2-78.

20 For a description of the interaction between the provision of credit and holding of deposits by banks, refer to McLeay M, Radia A and Thomas R, 2014 ‘Money creation in the modern economy’ Bank of England Quarterly Bulletin Quarter 1, pages 14–27.

21 Refer to Chapter 1: Resilience for a discussion on distortions related to perceptions of implicit guarantees.

22 Commonwealth of Australia 2014, Financial System Inquiry Interim Report, Canberra, page 2-49.

23 Commonwealth of Australia 2014, Financial System Inquiry Interim Report, Canberra, Chapter 2.

24 This approach has been recognised by the Financial Stability Board. See Financial Stability Board (FSB) 2014, Adequacy of loss-absorbing capacity of global systemically important banks in resolution, Basel, page 6.

25 The Inquiry supports the approach outlined in the draft report of the Competition Policy Review, suggesting a new Australian Council for Competition Policy be empowered to carry out market studies of competition in particular sectors. See Commonwealth of Australia 2014, Competition Policy Review — Draft Report, Canberra, Recommendation 39, page 57.

26 Commonwealth of Australia 2014, Financial System Inquiry Interim Report, Canberra, page 2-37.

27 For a discussion of international integration of the Australian financial system, refer to Commonwealth of Australia 2014, Financial System Inquiry Interim Report, Canberra, Chapter 10.

28 A recent example is the financial services component of the China-Australia Free Trade Agreement, Department of Foreign Affairs and Trade 2014, China-Australia Free Trade Agreement — Key Outcomes, Canberra, viewed 19 November.

29 A disruption to the financial system could be considered systemic if it was so widespread or severe that it caused material damage to the economy.

30 International Monetary Fund (IMF) 2012, Australia: Financial System Stability Assessment, IMF, Washington, page 10.

31 Commonwealth of Australia 2014, Financial System Inquiry Interim Report, Canberra, page 2-56.

32 For details of this estimate, please see Chapter 1: Resilience. This is a conservative estimate that does not account for a number of important benefits, including reducing perceptions of an implicit guarantee, or factors that mitigate the cost, such as the effect of competition and monetary policy settings.

33 Estimates prepared by the Australian Government Actuary for the Inquiry, using input from Treasury models. Over 10 percentage points of the estimated increase in retirement income reflects the benefits of lower superannuation fees and savings from maintaining only a single superannuation account over a person’s working life. The remaining portion (and range) reflects the use of a comprehensive income product in retirement; in particular, different combinations of an account-based pension and either a deferred life annuity or group self annuitisation product. The estimates are also sensitive to assumptions regarding the level of contributions, time in the workforce and the drawdown rate for the account-based pension. The major driver of the increase in retirement income is the benefit of pooling in retirement, which comes at a cost of smaller bequests from superannuation and reduced flexibility. For further details, see Chapter 2: Superannuation and retirement incomes.

34 This estimate includes losses involving Storm Financial, Opes Prime, Westpoint, Great Southern, Timbercorp and Banksia Securities.

35 Refer to Chapter 5: Regulatory system for further information on this research.

36 The Commonwealth’s whole-of-Government deregulation agenda is outlined in Department of the Prime Minister and Cabinet 2014, Whole of Government deregulation agenda, Commonwealth of Australia, viewed 14 November 2014.