1: Overview

Objectives and principles

This Inquiry’s objective is to assess, and make recommendations on, how the financial system can most effectively help the Australian economy be productive, grow and meet the financial needs of Australians.

The financial system provides funding and liquidity, allows effective risk management, delivers payment services, facilitates price discovery and provides some monitoring services. Although tested during the global financial crisis (GFC), Australia’s financial system performed well in most respects relative to its international counterparts.

However, the Inquiry considers there are policy issues that need close examination given developments since the Wallis Inquiry and the lessons of the GFC, as well as the opportunities and challenges that lie ahead.

The view of the Inquiry

The Inquiry considers the financial system needs to satisfy three principles: efficiently allocate resources and risks, be stable and reliable, and be fair and accessible.

It must do so in the context of Australia’s circumstances. Australia is a small, open and market-based economy with a large services sector, a relatively small population, a large land mass and a significant endowment of natural resources. It uses both domestic and foreign investment to fund development. The financial system is predominantly privately owned and based on market principles that support risk taking and allow both success and failure.

A number of pre-requisites underpin a well-functioning financial system, including a predictable rule of law with strong property rights (providing certainty of contract and access to redress), a freely convertible floating currency, sustainable fiscal policy, a sound monetary policy framework and a stable political system. The Inquiry believes independent monetary policy, prudential supervision and conduct regulation remain the preferred approach over direct Government control of prices and quantities in the financial system.

Competition remains the cornerstone of a well-functioning financial system. It is vital in driving efficient outcomes for price, efficiency, quality and innovation.

However, the behaviour of financial markets and the financial system is complex, reflecting the consequences of information asymmetries, network effects and human psychology.

Asset prices are prone to volatility, which can be exacerbated by the natural momentum of markets and/or the intervention of governments. This can result in asset values deviating from fundamental values and instability, particularly with the use of leverage. The GFC entrenched perceptions that some institutions are too-big-to-fail. Governments have a role in both preventing the build-up of systemic risk and creating a framework in which financial failure is managed in an orderly and cost-effective manner.

Consumers of financial products and services can be subject to information imbalances and behavioural biases that are detrimental to them and the efficiency of the system. Effective disclosure, sound advice and improved financial literacy are necessary, but often incomplete, remedies to these information imbalances. In addition, conduct and disclosure requirements need to be effectively supervised and enforced.

Wherever possible, the financial system should be subject and responsive to market forces. It should not be politicised to the extent that the Government sets prices, or mandates non-commercial financial decisions to resolve Government fiscal problems such as requiring banks to hold Government debt. Market discipline, through competition or self-regulation, is generally preferred to Government intervention.

Where there is compelling evidence for Government intervention, the Inquiry considers the intervention should seek to best balance efficiency, stability and fairness. Inevitably, policy decisions facing the Government require some trade-offs.

The system has evolved in response to consumer needs, competitive pressures, tax settings, demographic changes, new technology, and ongoing change to global economic and financial developments.

The Inquiry is aware that the legal and governance obligations of financial entities, such as fiduciary duties, can be a driving force in determining the culture of Australian businesses, their decision making and financial outcomes for Australians.

It is also the Inquiry’s view that financial system regulators need sufficient powers, independence and resourcing, but they should also be subject to rigorous accountability mechanisms. Regulation should be cost-effective, transparent, targeted, forward-looking and competitively and technological neutral. Ultimately, however, governments and ministers remain responsible and accountable for the regulation of the financial system.

Principles for government intervention1

The Inquiry has not seen evidence to suggest a need to reform radically the way Government intervenes in or regulates the financial system. However, as noted in the terms of reference, the current framework is in need of a refresh to enable the system to meet future challenges.

The Wallis Inquiry’s approach to regulatory philosophy broadly considered unfettered financial markets would generally lead to resources being allocated efficiently. In the Wallis Inquiry’s view, the role of Government was only to intervene where market imperfections inhibited efficiency.2

The financial system has undergone significant change since the Wallis Inquiry. It is now larger and more concentrated, particularly the banking and superannuation sectors. The GFC demonstrated that the Australian financial system was exposed not only to domestic but international shocks. Since the Wallis Inquiry it has also become clearer that financial market outcomes can sometimes depart markedly from outcomes suggested by the theoretical ideal. Over the coming decades, the financial system will also face a number of challenges and opportunities. These include: exposure to potential future crises; allocating finance to best facilitate productivity growth; the effects of changing technology and ongoing international integration.

Figure 1.1 shows selected major events affecting the financial system since the Wallis Inquiry, and local and international governments’ responses to these events.

Figure 1.1: Selected major developments since the Wallis Inquiry

This chart shows the timeline of developments and responses in the financial system from 1997. This includes the period of growth and consolidation where assets of financial institutions, including banking and superannuation, and   household wealth have all grown significantly and the financial system has become more concentrated and integrated. Next comes the post-GFC regulatory response as a result of dislocation of credit markets, heightened volatility, and collapses of large financial institutions in some overseas locations. Finally it notes some emerging trends in the context of low productivity growth and fiscal challenges, which include our ageing population, new technology and ongoing  international integration.

View image enlarged

The Inquiry acknowledges the Government has a role in the financial system, but considers it important that this intervention is consistent and predictable. Consistency of approach reduces opportunities for preferential treatment, encourages predictability and reduces risks associated with economic decisions by the private sector.

Although advances in network theory, understanding of the consequences of imperfect information and behavioural economics are useful developments that assist in better understanding the behaviour of the financial system, no widely accepted philosophy of optimal government intervention has emerged from this research.

A refreshed approach

In the first instance, the Inquiry takes the view that the status quo is the appropriate starting point for policy discussion. This is not to suggest the financial system as it currently operates is perfect; rather, policy makers should focus on how the current system can be improved from its current state.

This approach acknowledges there are realities in the Australian and international financial system that dictate or influence certain outcomes and should not or cannot easily be changed. For example, as an open market economy using foreign savings, Australia must accept key aspects of internationally driven financial regulation, while adapting it appropriately to meet national conditions wherever possible. The Inquiry has also noted the importance of ethics, incentives and governance arrangements, and the influence these factors can have on financial system outcomes.

Like the Wallis Inquiry, this Inquiry considers there remains a role for Government to intervene to remove impediments to the market working more efficiently, including intervention to manage information asymmetries3 and principal-agent conflicts.4

In addition to efficiency, the Inquiry believes both stability and fairness should have prominence in policy design when the Government considers intervention in the financial system. Importantly, these characteristics build confidence and trust in the financial system.

    • The potential costs of instability to the economy during the GFC underlined the need for Government action to both minimise the chance of a systemic crisis and mitigate its costs if it does occur. This includes ensuring that certain critical financial functions continue to be provided, even during a crisis.
    • Moreover, fairness is an important policy objective of the financial system. Unfair outcomes discourage participation and ultimately economic efficiency, increasing political pressure for unnecessary regulatory change. Fairness is also a principle underpinning several aspects of financial system law, including regulation of financial markets and services.

Fairness involves fair treatment by applying the concepts of integrity, honesty, transparency and non-discrimination (entities with the same characteristics are treated in the same manner) which go to building trust in the financial system.

Of course, these policy objectives can be conflicting and add complexity to policy decisions. Some of the most difficult policy decisions facing the Government occur where there is a trade-off between these objectives, including many of those discussed in this report. Where intervention is necessary, the Inquiry considers it should not unduly add to the complexity of regulatory arrangements.

There is no simple empirical calculation that provides the answer on when or how the Government should intervene (or remove a previous intervention) in the financial system. Case-by-case judgement is required, and both the costs and benefits of a policy change should always be carefully considered.

The Inquiry emphasises the importance of market forces and competition in any cost-benefit analysis. The financial system has the ability to evolve successfully in response to market signals without Government intervention in many situations. In many cases, the best outcome may be for the Government to allow market forces to operate. The removal of unnecessary Government regulation and interventions that do not meet this cost-benefit test should remain a priority where they are identified.

The Inquiry suggests the following principles (Table 1.1) to guide the actions of Government and regulators. Although sometimes conflicting, the Inquiry considers Government and regulators should take account of these principles when regulating or considering regulation for the financial system.

Table 1.1: General principles of government intervention
Outcome-focused Regulation and actions by regulators should reflect the outcomes sought by policy. This is not to suggest regulation should be simple or complex — but appropriate for the policy outcome desired.
Forward-looking The regulatory framework must have the flexibility to cope with changing institutional and product structures, including in response to regulatory settings, without losing its effectiveness.
Cost-effective Regulation should impose the least possible aggregate cost to the regulated business, its customers and the regulator, while still achieving the desired outcome. The costs of regulation should be allocated to those that enjoy the benefits or impose the costs.
Competitively/technologically neutral The regulatory framework affects all entities providing products or services with the same characteristics equally, regardless of technological approach.
Targeted and proportionate Ideally, regulation should only constrain the behaviour of those who will otherwise act inappropriately or make decisions without taking into account social costs. Regulation should be targeted to minimise adverse effects on those entities for which it is not needed and be as simple as possible to achieve the policy outcome desired.
System-wide approach A system-wide view of the interdependence, interconnectivity and feedback relationships between different parts of the financial system and other sectors of the economy, including internationally, is required. Very often the externalities, overlaps and gaps, hidden connections and dynamic feedbacks create risks and distortions to efficiency that are not recognised by either markets or siloed regulators
Transparent The actions and purpose of Government (or regulators) should be obvious to participants in the financial system, both before and after the event. The actions of Government or regulators should also be consistent and predictable.
Accountable/independent Regulators should have clear mandates determining their objectives. In achieving these objectives, regulators should operate independently and have sufficient funding. Regulators must be held to a high level of accountability for their actions and be subject to regular public reviews of their performance relative to their mandate.

1 Intervention can occur through regulation, tax, the social safety net, guarantees or other specific policies such as superannuation.

2 Commonwealth of Australia 1997, Financial System Inquiry Final Report, Melbourne, First key finding of Chapter 5 — Philosophy of Financial Regulation.

3 Information asymmetry or information imbalance occurs when the two parties entering into a transaction do not have the same level of information.

4 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 resources and delegated responsibility for making decisions.