Themes and major issues

Taking into account the input of submissions, regulators and international perspectives, the Inquiry’s initial assessment is that the Australian financial system has performed reasonably well in meeting the financial needs of Australians and facilitating productivity and economic growth.

Indeed, many areas of the financial system are operating effectively and do not require substantial change. This Inquiry has not focused on these areas.5

However, a number of policy issues have been raised that the Inquiry believes should be considered further. The remainder of this chapter provides context for why the Inquiry has chosen to concentrate on the issues covered in this Interim report.

Table 1.2 outlines the Inquiry’s view of the nine priority issues facing the Australian financial system and its key observations. It is followed by an explanation of the evidence supporting each issue. The following chapters of the Interim Report address each of these issues in more detail, including presenting potential policy options.

Table 1.2: Priority issues
Theme one: Growth and consolidation
Competition and contestability The banking sector is competitive, albeit concentrated. The application of capital requirements is not competitively neutral.
Regulation of credit card and debit card payment schemes is required for competition to lead to more efficient outcomes. However, differences in the structure of payment systems have resulted in systems that perform similar functions being regulated differently, which may not be competitively neutral.
Funding Australia’s economic activity Ongoing access to foreign funding has enabled Australia to sustain higher growth than otherwise would have been the case. The risks associated with Australia’s use of foreign funding can be mitigated by having a prudent supervisory and regulatory regime and sound public sector finances.
There are structural impediments for small- and medium-sized enterprises to access finance. These impediments include information asymmetries, regulation and taxation.
Australia has an established domestic bond market, although a range of regulatory and tax factors have limited its development.
Superannuation efficiency and policy settings There is little evidence of strong fee-based competition in the superannuation sector, and operating costs and fees appear high by international standards. This indicates there is scope for greater efficiencies in the superannuation system.
If allowed to continue, growth in direct leverage by superannuation funds, although embryonic, may create vulnerabilities for the superannuation and financial systems.
Superannuation policy settings lack stability, which adds to costs and reduces long-term confidence and trust in the system.
Theme two: Post-GFC regulatory response
Stability and the prudential framework During the GFC, significant government actions in a number of countries, including Australia, entrenched perceptions that some institutions are too-big-to-fail. These perceptions can be reduced in Australia by making it more credible to resolve these institutions without Government support.
A number of jurisdictions have implemented new macroprudential toolkits to assist with managing systemic risks. The effectiveness of these for a country like Australia is not yet well established and there are significant practical difficulties in using such tools.
Australia has implemented some aspects of global prudential frameworks earlier than a number of jurisdictions. It has also used national discretion in defining capital ratios. When combined with other aspects of the prudential framework and calculated on a consistent basis, Australian banks’ capital ratios (common equity tier 1) are around the middle of the range relative to other countries. However, differences such as those in definitions of capital do limit international comparability.
To contribute to the effectiveness of the financial system, sound corporate governance requires clarity of the responsibility and authority of boards and management. There are differences in the duties and requirements of governing bodies for different types of financial institutions and, within institutions, substantial regulator focus on boards has confused the delineation between the role of the board and that of management.
Consumer outcomes and conduct regulation The current disclosure regime produces complex and lengthy documents that often do not enhance consumer understanding of financial products and services, and impose significant costs on industry participants.
Affordable, quality financial advice can bring significant benefits for consumers. Improving the standards of adviser competence and removing the impact of conflicted remuneration can improve the quality of advice. Comprehensive financial advice can be costly, and there is consumer demand for lower-cost scaled advice.
Regulatory architecture The regulatory perimeters could be re-examined in a number of areas to ensure each is targeted appropriately and can capture emerging risks.
Australia generally has strong, well-regarded regulators, but some areas for improvement have been identified to increase independence and accountability.
During the GFC and beyond, Australia’s regulatory coordination mechanisms have been strong, although there may be room to enhance transparency.
Regulators’ mandates and powers are generally well defined and clear; however, more could be done to emphasise competition matters. In addition, the Australian Securities and Investments Commission (ASIC) has a broad mandate, and the civil and administrative penalties available to it are comparatively low in relation to comparable peers internationally.
Theme three: Emerging trends
Ageing and retirement incomes The retirement phase of superannuation is underdeveloped and does not meet the risk management needs of many retirees.
There are regulatory and other policy impediments to developing income products with risk management features that could benefit retirees.
Technology opportunities and risks Technological innovation is a major driver of efficiency in the financial system and can benefit consumers. Government and regulators need to balance these benefits against the risks, as they seek to manage the flexibility of regulatory frameworks and the regulatory perimeter. Government is also well-positioned to facilitate innovation through coordinated action, regulatory flexibility and forward-looking mechanisms.
Access to growing amounts of customer information and new ways of using it have the potential to improve efficiency and competition, and present opportunities to empower consumers. However, evidence indicates these trends heighten privacy and data security risks.
The financial system’s shift to an increasingly online environment heightens cyber security risks and the need to improve digital identity solutions. Government has the ability to facilitate industry coordination and innovation in these areas.
International integration Although elements of Australia’s financial system are internationally integrated, a number of potential impediments have been identified. Financial system developments in the region will require continuing Government engagement to facilitate integration with Asia.
Government efforts to promote Australia’s policy interests on international standard setting bodies have been successful. Domestic regulatory processes could be improved to better consider international standards and foreign regulation.
Coordination of Australia’s international financial integration could be improved.

Growth and consolidation

Two of the most striking developments in the financial system since the Wallis Inquiry have been the growth and consolidation of the financial system.

  • Financial system assets have grown from the equivalent of two years of nominal GDP in 1997 to more than three years of nominal GDP today.6 In particular, superannuation assets have grown substantially (Chart 1.1). Australia’s financial sector accounts for 8 per cent of GDP and is relatively large internationally.7, 8 However, the focus of this Inquiry is not the size of the financial system but how effectively it distributes funding and risk in the Australian economy.
  • The Australian financial system has become more concentrated and integrated since the Wallis Inquiry. In particular, each of the four major banks has expanded its operations into life insurance and wealth management. These developments have prompted concerns about competition in the market.

    Chart 1.1: Assets of financial institutions

    This chart shows assets of financial institutions since 1997. Significant growth is shown by both authorised deposit-taking institutions and superannuation funds which are the largest components at $3.1 trillion and $1.2 trillion respectively in 2013. Registered financial corporations, general insurance and other managed funds have increased modestly over this time. Securitisation vehicles have grown from very low numbers in 1997, to a peak of $207 billion before falling away after the GFC. 

    Note: Refers only to domestic operations and does not include assets of banks’ overseas subsidiaries and branches. Registered financial corporations include money market corporations (for example, merchant banks) and finance companies (for example, debenture issuers).

    Source: Reserve Bank of Australia.9

Competition and contestability

Competition is important because of its ability to lower prices and improve quality of financial products, services and markets.

High levels of market concentration can raise concerns about the level of competition in a market, but it is not sufficient to look at this measure alone. Competition can be strong between players in a concentrated market. In addition, the threat of new entrants can exert competitive pressures on incumbents.

Competition in banking

Australia’s banking market has become more concentrated since the GFC, with declines in the share of credit provided by credit unions, building societies and the non-bank sector. The crisis drove concentration by pushing out smaller lenders as the cost of funding rose, which reflected the higher price of risk following the GFC.

Australia’s larger banks have a number of commercial competitive advantages over their smaller domestic rivals, including scale of operations, funding costs, product breadth and brand recognition. On balance, the Inquiry considers that the banking sector is competitive, reflecting a number of indicators. Australian banks’ net interest margins have almost halved since the early 1990s10 and the Reserve Bank of Australia (RBA) submits that returns on equity are comparable to those achieved by other large Australian companies.11

The Inquiry notes existing capital requirements are not always competitively neutral. Larger banks have satisfied the criteria to use an advanced approach when implementing the Basel II capital requirements, but smaller authorised deposit-taking institutions (ADIs) have to charge more to achieve the same return on equity for a mortgage.12 Some submissions hold the view that, particularly for their mortgage book, smaller banks would have lower capital requirements if they were able to employ internal ratings-based approach (IRB) models.

Some submissions argue that the larger banks also benefit from a funding advantage from being perceived as too-big-to-fail. However, it is the Inquiry’s view that the best way to deal with any competitive advantage arising from these perceptions is to address directly the systemic risks posed by large banks.

Funding is critical to ADI and non-bank lenders’ ability to compete. The use of residential mortgage-backed securities (RMBS) was a key factor in growing the market shares of smaller banks and non-bank lenders before the GFC. The crisis significantly increased the cost of this type of funding, thereby reducing the competitive position of smaller ADIs and non-bank lenders. Although the RMBS market has started to recover, the relative cost of fund raising via this method remains higher than before the GFC.

The ‘four pillars’ policy, which prevents mergers between the big four banks, has been in place, with some modifications, since 1990. Allowing a merger between the large banks would likely reduce competition, and this may offset any advantages that flow from larger scale. No submissions supported removing this policy.

Competition in payment systems and markets

The payments industry is characterised by significant economies of scale and strong network effects, with the challenge for new payment system operators to build scale through acceptance by consumers and merchants.

A lack of transparency has required regulatory intervention to provide consumers and merchants with clearer price signals and more choice in responding to them. Without regulation, customers who use lower-cost payment methods, such as cash, may cross-subsidise those who use other forms of payments.

Some submissions argue that, while the regulated caps on credit card interchange fees may have reduced costs for merchants and customers at the checkout, they have also lowered the value to cardholders by limiting reward points and potentially making credit card fees or interest rates higher than they would have been.

There are separate standards or access regimes for eftpos, scheme debit cards, scheme credit cards and automated teller machines (ATMs). Due to this, some payment system operators are subject to relatively intensive regulation, while others are less heavily regulated. Several submissions ask for more consistency in the way different schemes are regulated.

Funding Australia’s economic activity

As discussed above, the Australian financial system has grown substantially. However, the Inquiry recognises that a larger financial system is not necessarily beneficial to economic growth and a system that is too large may pose greater risks to economic growth.13 The Inquiry is focusing on the efficiency with which Australia’s financial system allocates funding and risk in the economy, rather than on its size or direct contribution to economic activity.

Australia has been a user of foreign funding for much of its post-European settlement history. It has typically had more abundant domestic investment opportunities than could be funded from historic levels of national saving. By using these foreign funds productively, Australia’s growth potential has been raised, benefiting both residents and foreign investors.

The continued inflow of foreign funding reflects the confidence foreigners have in Australia’s growth prospects. Although Australia’s use of foreign funding is not without risks, these can be mitigated by ensuring these funds are directed to their most productive use, as well as maintaining a prudent regulatory regime and a sustainable fiscal position. Based on evidence presented in submissions, the Inquiry notes some distortions that may interfere with the allocative role that prices perform.

In particular, the Inquiry identifies distortions affecting household financial decision making and structural impediments to small- to medium-sized enterprise (SME) lending. It also recognises the effects of the taxation system on outcomes in the financial system.

Housing and household leverage

Taxation distorts households’ saving and borrowing decisions towards housing and salary-sacrificed superannuation, and encourages higher levels of household leverage to fund purchases of dwellings.

Since the Wallis Inquiry, household leverage has almost doubled.14 This has been accompanied by a significant increase in housing prices relative to income over the past decade.15 Higher household indebtedness and the greater proportion of mortgages on bank balance sheets mean that an extreme event in the housing market would have significant implications for financial stability and economic growth.

SME financing

Australia’s 2 million SMEs employ almost 70 per cent of the workforce.16 SMEs and new ventures source some of their business equity from their own personal wealth; however, they also require external sources of finance. The Inquiry notes that, compared to their larger counterparts, the price and terms of SME loans can be more restrictive. For example, many lenders now require more security, usually residential property, for business loans.17 In large part, this is due to the lack of information lenders have on the financial behaviour of SMEs and their owners.

Other taxation issues

As Australia becomes increasingly integrated with global capital markets, there is also a question of whether the corporate tax regime, particularly the dividend imputation system, is effective in reducing the cost of capital in Australia. The dividend imputation system creates a bias for individuals and institutional investors (including superannuation funds) to invest in domestic equities, and it may be a contributing factor to the lack of a deep domestic corporate bond market in Australia.

Interest withholding tax (IWT) may also be distorting the funding decisions of financial institutions and placing Australia at a competitive disadvantage internationally. A number of submissions call for IWT to be removed or reduced.

The Goods and Services Tax (GST) is not levied on most financial services. This affects the size of the financial services industry relative to other industries where GST is levied, and affects the composition of the end-users who ultimately consume those financial services. However, levying a GST on financial services is difficult.

A more neutral taxation of savings vehicles and assets across the economy is desirable. It is not this Inquiry’s role to make recommendations on tax issues; however, the Inquiry will provide its observations to the Government’s forthcoming Tax White Paper.

Superannuation efficiency and policy settings

A major development since the Wallis Inquiry is the rapid expansion in superannuation assets. Superannuation assets have grown from around $300 billion to $1.8 trillion today.18, 19 Continued high rates of growth are expected for the foreseeable future and will be driven by the increase in the Superannuation Guarantee rate to 12 per cent by 2022, superannuation tax concessions, and investment returns. Industry Super Australia predicts that superannuation assets will exceed those of the banking system by around 2030.20

The structure of the system has also changed significantly. The number of Australian Prudential Regulation Authority (APRA)-regulated funds (excluding small APRA funds) has fallen from more than 4,700 to 299 since 1997,21 and the number of self-managed superannuation funds (SMSFs) has grown rapidly. SMSFs now make up the largest segment of the superannuation system in terms of the number of entities and the size of funds under management (Chart 1.2).22

Chart 1.2: Superannuation assets by fund type, percentage of GDP

This chart shows, as a percentage of GDP, the value of superannuation funds by fund type. Industry, public sector, retail and SMSF funds have increased since 1997, with the exception of a period in 2008/2009 when they showed a decline. The assets of these funds range in value from retail funds at 17 percent of GDP to SMSF funds at 35 per cent of GDP. Corporate funds have shown a steady decline since 1997, and now have assets worth less than 5 per cent of GDP.

Note: Excludes the balances of funds of life offices; the assets of small APRA funds are negligible. Industry and public sector series break in September 2003 due to coverage changes; public sector excludes some exempt schemes. Corporate reclassification of superannuation entities and data revisions resulted in material changes for corporate funds from 2004.

Source: Reserve Bank of Australia.23

The Australian superannuation system has become an important source of funding for the rest of the economy, particularly for long-term fixed capital formation. However, some evidence raises questions about the efficiency of the sector. Australian superannuation fund operating costs are among the highest in the Organisation for Economic Co-operation and Development (OECD).24 The Grattan Institute estimates that fees have consumed over one-quarter of returns since 2004, despite increases in scale.25 Direct leverage in superannuation funds is embryonic but growing. The number of SMSFs using geared products grew by more than 11 per cent to 38,000 over the year to April 2014.26 A number of submissions point to the stabilising influence of the superannuation sector during the GFC. The current ability of funds to borrow directly may, over time, erode the superannuation system’s ability to act as a stabilising influence on the financial system during times of stress.

Post-GFC regulatory response

In the years since the Wallis Inquiry there have been several international financial crises and major institution collapses, including the Long-term Capital Management collapse, Asian financial crisis, Enron and WorldCom collapses, Russian and Argentine currency crises and dot-com crash, and then the global financial and European sovereign debt crises.

However, the GFC has had a lasting effect on Australia’s financial system. After a period of favourable economic conditions in the major economies, investors worldwide began to take more risks than was prudent.

The catalyst for the crisis was the deterioration of the United States housing and mortgage market, which caused a liquidity and confidence crisis in the financial markets of developed countries. The contagion was transmitted via the interconnectedness of global financial institutions and markets, including through the growth of complex securitisation structures. A number of financial institutions in the United States and Europe collapsed. In response, governments became involved in stabilising their financial systems through guarantees, direct equity measures, and large fiscal and monetary stimulus measures.

Although Australia’s financial system performed reasonably well through that period of acute stress,27 the Government intervened in the form of wholesale and deposit guarantees, and provided support for the securitisation market. Deposit guarantees and direct support for markets departed from the Wallis Inquiry principle that the Government should not provide guarantees in the financial system.

Regulatory responses

In response to the GFC, Australian regulators and the Government have taken steps to increase the resilience of the financial system. International bodies responsible for making standards on financial regulation have also become increasingly active. Within the G20, for example, governments and regulators in Europe and the United States have led efforts to strengthen regulation and oversight — including taking a more active regulator role in identifying and addressing the build-up of systemic risks.

An issue for Australia is the extent to which it should implement new global standards. A significant consideration for Australian authorities has been the need for our banks to maintain the confidence of external investors and credit rating agencies, given their exposure to foreign funding markets.

Australian regulators have sought to influence the design of the global framework to take into account Australia’s circumstances. Further, regulators have applied the framework in a manner and timeframe to best suit Australian market circumstances, as a capital importer within a global market.

Stability and the prudential framework

Australia has had a relatively stable financial system for most of the past two decades. In particular, Australia’s financial system weathered the GFC relatively well. This stability is the result of a number of factors, including a stable macroeconomic environment; prudent risk management by financial institutions themselves; and a traditional, comparatively low-risk commercial banking model remaining profitable.

A factor contributing to Australia’s resilience during the GFC was its strong prudential framework. Australia’s prudential rules, often tighter than minimum international standards before the GFC, together with a proactive approach to supervision, helped maintain a healthy and stable financial sector domestically.28

International financial history indicates that financial crises and financial instability are not uncommon.29 Instability has substantial costs to the economy. It limits the financial system’s capacity to allocate funds, facilitate payments, transfer risk and create liquidity. Instability can result in losses for savers or policyholders, lower economic growth, and damage to the financial sector’s ability to serve the economy. As shown by the GFC, it can also have severe negative effects on the economy, including low growth and high unemployment, and can result in policy options that lead to higher Government debt.

Internationally, governments’ responses to the GFC sought to minimise these costs. These actions were often appropriate, and illustrated the potential need for government intervention in the financial system in very extreme circumstances. The GFC, both here and overseas, highlighted the link between governments and the financial sector. It demonstrated that fiscal responsibility is an important ingredient to maintaining a resilient financial system.

However, any expectation that government will support a failing financial institution creates a moral hazard in the longer term. This may reduce market discipline and encourage riskier behaviour. Although the perception that some institutions are too-big-to-fail cannot be eliminated entirely, there is much the Government can do to minimise moral hazard and the problems associated these perceptions.

As markets continue to develop, financial and technological innovations are emerging rapidly, which may bring new risks. The GFC highlighted that focusing on the soundness of individual institutions without stepping back to consider the overall financial system is not sufficient to ensure financial stability. Australia has a well-established system for monitoring systemic risk. However, risks outside the prudential perimeter can be more difficult to identify due to limited oversight and a lack of data.

To help address these risks, significant reforms such as improving the transparency of over-the-counter (OTC) derivatives have been introduced since the GFC. However, this has also moved derivatives from banks into the shadow banking sector. Globally, the increasing use of shadow banking has the potential to generate systemic risks. However, because of the small size of the shadow banking sector in Australia, risks to stability in Australia remain limited.

Consumer outcomes and conduct regulation

Although there were no significant prudentially regulated institution failures during the GFC in Australia, the crisis resulted in significant losses for some individuals. Fraud, mis-selling, product unsuitability, lack of information and lack of financial literacy were all factors in poor financial outcomes for some Australians.

Since the crisis, the emerging theory of behavioural economics has recognised that most individuals do not always act in an economically rational way. Behavioural biases can reduce the effectiveness of many traditional consumer protection approaches, which rely on the assumption that consumers will seek out and understand all relevant information before purchasing a financial product.

Consumer disclosure

Australia’s regulatory framework relies heavily on disclosure to protect and empower consumers.

Submissions support a view that the disclosure framework is not achieving its objectives. The current disclosure regime produces complex and lengthy documents that do not always enhance consumers’ understanding of financial products and services, and impose significant costs on industry participants.

Reasons that disclosure does not always inform consumers include low levels of financial literacy, disengagement due to lack of time or motivation, behavioural biases, and the length and complexity of disclosure documents. This situation makes it difficult for consumers to compare products, understand risks and make informed decisions.

Financial advice

Retail investment failures following the GFC, including high-profile cases such as Storm and Trio, highlighted concerns with financial advice regulation.

Recent reforms have sought to improve the quality of financial advice and increase trust and confidence in the financial advice industry by introducing a best interests duty and a requirement to put the interests of the client ahead of those of the adviser. These reforms have provided greater clarity over the expectations and requirements of financial advisers. Reforms on conflicted remuneration have also sought to better align the interests of financial advisers and consumers.30 The Inquiry considers the principle of consumers being able to access advice that helps them meet their financial needs is undermined by the existence of conflicted remuneration structures in financial advice.

Financial advisers provide advice on a range of products including investment, debt management, tax management, superannuation and insurance. The total number of financial advisers in Australia is around 54,000, with 3,000 organisations holding an Australian Financial Services Licence to provide personal financial product advice.31 However, less than 42 per cent of the Australian adult population has ever used a financial adviser.32 Good financial advice is increasingly important given growing household wealth and mandated superannuation investment.

Evidence suggests that the quality of financial advice could be improved significantly. For example, ASIC’s shadow shopping study of retirement advice concluded:

  • More than a third of the advice examples were poor in quality (39 per cent)
  • There were only two examples of good quality advice (3 per cent)
  • The majority of advice examples reviewed (58 per cent) were adequate33

Regulatory architecture

The GFC tested regulatory arrangements globally and domestically, and Australia’s twin peaks model has proven robust and effective. A number of overseas jurisdictions have looked to Australia’s model, or versions of it, to address weaknesses the GFC exposed in their financial systems.

Evidence suggests there is no case to make significant changes to Australia’s regulatory framework.

However, submissions and stakeholders suggest a wide range of refinements. Reflecting this, the Inquiry observes a number of issues relating to regulatory architecture:

  • Regulatory burden: Following the GFC, the considerable international policy response included new and increased regulation for financial system entities. A number of submissions are concerned about the burden of implementing new regulations. The Inquiry has commissioned further analysis of the costs and benefits of regulation, including the relative impact of the fixed cost of regulation on institutions of varying size.
  • Regulatory perimeters: As the financial system environment changes, the way Australia considers the regulatory perimeter may need to change. In this context, regulation should be examined pertaining to superannuation funds, retail payments systems, securities dealers and certain technology service providers of sufficient scale.
  • Independence and accountability: Australia generally has strong, well-regarded regulators, but some areas of possible improvement have been identified to increase independence and accountability.
  • Regulator structure and coordination: The GFC demonstrated the importance of strong regulatory coordination mechanisms. Submissions were strongly supportive of the Council of Financial Regulators, endorsing it as the right body for high-level coordination. Some submissions recommended expanding and strengthening its role, although regulators consider it effective.
  • Execution of mandates: Australia’s regulators have mandates that place a similar emphasis on competition to international peers; however, more could be done beyond mandates to emphasise competition. ASIC’s mandate is broad, having grown considerably over the last two decades, generally in response to major reform processes and reviews.
  • Enforcement powers: Strong enforcement powers underpin an effective regulatory framework. Enforcement sends a message of deterrence to industry and is an important aspect of the consumer regulatory framework.

Emerging trends

The financial system must continue to be flexible and to adapt quickly to whatever developments unfold in the future. Although the Inquiry does not intend to try and predict the future, it recognises that the financial system can play an important role in helping the economy respond to several opportunities and challenges. With the need to lift low productivity growth and ease fiscal pressures, these challenges are likely to include our ageing population, changes in technology and Australia’s international integration.

The need for higher rates of productivity growth to ensure continuing improvement in living standards is a major challenge facing Australia, in particular given the need to support an ageing population.

The unprecedented increase in the terms of trade, which drove the improvement in living standards over the past decade, is believed to have ended and the terms of trade are expected to decline over coming years. On its current trajectory, productivity growth will not be able to sustain the same rate of growth in incomes that Australia has experienced over the past decade (see Chart 1.3 below).

Chart 1.3: Contributions to annual per capita income growth

Note: Contributions to income growth in the period 2013-25 are consistent with the forecasts and projections detailed in the 2014-15 Budget Statement. The shaded grey area represents the additional labour productivity growth required to achieve long-run average growth in real gross national income per capita. Net foreign income is the differential between incomes payable to Australians by foreigners and incomes payable to foreigners by Australians, in real terms.

Sources: Australian Bureau of Statistics and Treasury.34

The financial system has an important role to play in facilitating higher productivity growth through allocating funding in the economy more efficiently. Closer financial and economic ties with other jurisdictions can also improve productivity by allowing foreign firms to enter Australia and by supporting more competition and innovation. The financial system also enables Australian firms, both financial and non-financial, to expand offshore.

Associated with these expected developments, the Commonwealth and state governments face a fiscal challenge. The ageing population is expected to contribute to a deterioration of the Government’s fiscal position. By 2050, these demographic developments are expected to result in a net cost to Government of 3 per cent of GDP (see Chart 1.4 below).

Chart 1.4: Net fiscal cost of ageing to Government 2011-12 to 2059-60, as percentage of GDP

This chart shows the projected fiscal gap as a percentage of GDP, which in 2011-12 is -1.4, returns to zero by 2014-15 and rises to 1.1 by 2016-17. It then steadily declines, reaching zero again in 2021-22 and then  declining to -4 by 2059-60.

Note: The fiscal cost is defined as the primary balance, which is the difference between Government revenues and expenditures in any given year excluding interest payments on debt.

Source: Productivity Commission.35

The financial system can help, or hinder, governments in relieving some of this fiscal pressure. For example, an appropriately designed retirement income system can assist in reducing the fiscal costs of the ageing population by providing products to deliver retirement incomes from superannuation balances. Conversely, policies that subsidise or incentivise imprudent or excessive risk taking may lead to adverse long-term consequences for the economy and further pressure on government spending.

Retirement incomes and ageing

Australia faces a significant demographic challenge. The ageing population and higher life expectancy are likely to result in lower workforce participation rates (Chart 1.5), which could lower the long-run growth in the economy and may result in higher costs for governments.

Chart 1.5: Labour force participation rates

This chart shows actual labour force participation rates rising from 60 per cent in 1979-80 to 65 per cent in 2012-13. There are then two projected scenarios. The first is labour force participation rates with no ageing which rise to 68 per cent by 2030 and then level off. The second is the projected participation rates with ageing which decline steadily over time, reaching 60 per cent by 2060.

Source: Productivity Commission.36

But the ageing population also presents an opportunity for the financial system. Individuals require a different set of financial products and services to enable them to manage their income and risks in retirement.

The current retirement income system provides limited choice for managing risks in retirement. The system lacks a sufficient range of financial products to help provide retirees with income and flexibility and to manage risks, particularly longevity risk.

Furthermore, current policy settings and the incentives they generate do not support product development. Australia is unusual compared to its peers in not having a well-functioning market for products that manage longevity risk. Australia’s annuity market is much smaller than that of comparable countries when measured as a proportion of GDP.37

The structure of retirement income products may also affect the allocation of funding in the economy and productivity growth. As the stock of superannuation assets in the retirement phase increases, demand for defensive assets such as fixed income products can be expected to increase.

Technology opportunities and risks

Technology-driven innovation is a major driver of efficiency in the financial system and can benefit consumers. It is changing the financial products and services available to consumers, as well as the delivery channels and providers of the products and services.

Financial services boundaries are shifting as technology enables new competitors from inside and outside the sector, new business models and new services. Trends, such as the increasing adoption of cloud technology and financial institutions using growing amounts of data, provide opportunities for increasing financial system efficiency.

Australians are showing themselves to be rapid adopters of technology with 7.5 million Australians accessing the internet via their mobile phones in 2013, an increase of 33 per cent from 2012.38 More Australians shop online for insurance and financial services than their counterparts in the United States and major European economies.39 This has contributed to the swift growth of services such as mobile banking and electronic payments.

Although there are many benefits, technological innovation also poses challenges for Government and regulators, in particular, how to trade off potential benefits against risks. To facilitate innovation, Government and regulators should seek to be flexible in regulatory approach and technology neutral in regulation. This is not always the case currently; for example, some Federal and state-based legislation and regulations require (implicitly or explicitly) the use of certain forms of technology.

Increasing collection of data by financial institutions raises privacy-related risks. Submissions highlighted issues including that data might be used in ways a customer might not like and might reveal information about persons other than the consenting customer, such as their friends, family or clients. Other submissions note that some segments of the community, such as senior Australians, are particularly sensitive to privacy, safety and security issues.

Cyber attacks are no longer only a potential threat; they are occurring on an increasingly frequent basis. For example, in 2013 cyber crime affected 5 million Australians at an estimated cost of $1.06 billion.40 As well as these direct costs, cyber crime may erode consumer and business trust and confidence in the financial system. The financial system’s shift to an increasingly online environment also heightens the need to improve digital identity solutions. Trusted digital identities are important in helping prevent identity-related crime and fraud.

International integration

Changes are also occurring in global financial and capital flows that are affecting the interaction of Australia’s financial system with the rest of the world. Since the GFC, cross-border capital flows have declined globally, and the international regulatory response to the crisis has in part aimed to reduce the interconnectedness of the global financial system and increase its resilience to shocks. Although the risks of connectedness with economies experiencing volatility are real, there remain long-term benefits from financial integration.

The pattern of international financial and capital flows will continue to change with forecast financial development and economic growth in the region (see Chart 1.6).

Chart 1.6: Share of world output over time

This chart shows the share of world output as a percentage of world GDP for various areas and countries between 1950 and now, and provides predictions to 2050.It shows:· Advanced economies falling from 68% in 1950, to 66% at the time of the Campbell Inquiry (1980), 64% at the time of the Wallis Inquiry (1997), 48% now and forecast to fall to 34% by 2050· Asia from about 12% in 1950, 18% at the time of the Campbell Inquiry, 27% at the time of the Wallis Inquiry, 39% now and forecast to rise to about 52% by 2050· China from about 4% in 1950, 2% at the time of the Campbell Inquiry, 7% at the time of the Wallis Inquiry, 18% now and forecast to rise to about 26% by 2050· India rising from 2% in 1950, 3% at the time of the Campbell Inquiry, 5% at the time of the Wallis Inquiry, 7% now and forecast to rise to about 13% by 2050

Source: Treasury.41

A particularly significant change is the planned gradual liberalisation of foreign exchange and capital controls for major economies in this region. Currently, Australia’s trade flows and overseas commercial presences in financial services are North Atlantic-focused, whereas physical flows are Asia-focused. (See Figure 1.2.) In future, trade flows, capital raising and investment by economies in our region are likely to increase, in addition to activity in our traditional European or North American financial corridors.

Figure 1.2: Financial and physical outward flows

This chart shows the physical, and finance and insurance trade flows from Australia to selected regions. In particular it shows that while the physical and finance and insurance trade from Australia to the UK, NZ and USA are comparable, there is a large difference between physical and finance and insurance trade from Australia to Asia, with the physical trade flow from Australia to Asia being significantly larger than the finance and insurance trade flow from Australia to Asia.

Note: Includes Australian exports of financial and insurance services, as well as financial and insurance services provided by Australia’s foreign affiliates abroad.

Source: Australian Bureau of Statistics.42

Australia has benefited substantially from financial integration with the rest of the world, most notably from trade and accessing international capital markets over many decades. Benefits have also flowed from opening up Australia’s financial services market to foreign competition and from exporting financial services to other markets, although these exports have not been as significant.

However, the Inquiry observes potential impediments to further international integration. Previous Government inquiries and private sector reviews have identified tax settings that are interfering with international flows, and regulatory and other impediments. To address impediments and effectively respond to changes in the region, coordination across Government, regulators and industry could be improved.

In addition, the Australian financial system is increasingly affected by international standards and foreign regulation. Submissions have raised concerns that domestic regulatory processes need to better accommodate the scale and complexity of increasing international influence on the regulatory environment.

5 For the purposes of this Inquiry, the Committee considers private health insurance to be out of scope. Private health insurance is closely linked to the operation of the health system and government plays a significant role in approving products and premiums. In addition, it does not pose a systemic risk to the financial system.

6 Reserve Bank of Australia 2014, First round submission to the Financial System Inquiry, page 15.

7 Reserve Bank of Australia 2014, First round submission to the Financial System Inquiry, page 17.

8 Australian Bureau of Statistics (ABS) 2013, National system of accounts 2012/13, cat. no. 5204.0, ABS, Canberra. Note: Uses gross value added at basic prices (total industrial value added).

9 Reserve Bank of Australia (RBA) 2014, B1 Assets of financial institutions, RBA, Sydney, 2 June.

10 Treasury 2014, First round submission to the Financial System Inquiry, page 34.

11 Reserve Bank of Australia 2014, First round submission to the Financial System Inquiry, page 165.

12 Australian Prudential Regulation Authority 2014, First round submission to the Financial System Inquiry, page 75.

13 For a discussion of this issue, see for example Cecchetti, S and Kharroubi, E 2012 Reassessing the impact of finance on growth Bank for International Settlements Working Paper No 381, BIS, Basel.

14 Reserve Bank of Australia 2014, First round submission to the Financial System Inquiry, page 22 (ABS, APRA and RBA data). Note: since 1997, household leverage has increased from debt equivalent to around 0.8 years of gross disposable income to around 1.5 years of income in 2008 — household leverage has since stabilised at around this level. Disposable income is after the payment of tax and before the deduction of interest payments.

15 Reserve Bank of Australia (RBA) 2014, Home Prices and Household Spending research discussion paper 2013-14, RBA, Sydney.

16 Australian Bureau of Statistics (ABS) 2013, Counts of Australian businesses, including entries and exits Jun 2009 — Jun 2013, cat. no. 8165.0, ABS, Canberra.

17 Reserve Bank of Australia 2011, Submission to the Inquiry into Access of Small Business to Finance. Cited in Export Finance and Insurance Corporation 2014, First round submission to the Financial System Inquiry, page 5.

18 Australian Prudential Regulation Authority (APRA) 2007, Insight: Celebrating 10 years of superannuation data collection 1996-2006, Issue 2, Special Ed., APRA, Sydney.

19 Australian Prudential Regulation Authority 2014, Statistics: Quarterly superannuation performance (interim edition), Sydney, March.

20 Industry Super Australia 2014, First round submission to Financial System Inquiry, page 117.

21 Australian Prudential Regulation Authority (APRA) 2007, Insight: Celebrating 10 years of superannuation data collection 1996-2006, issue 2, Special Ed., APRA, Sydney; Australian Prudential Regulation Authority 2014, Statistics: Quarterly superannuation performance (interim edition), APRA, Sydney, March.

22 Australian Prudential Regulatory Authority (APRA) 2014, Statistics: Quarterly superannuation performance (interim edition), APRA, Sydney, March.

23 Reserve Bank of Australia 2014, data supplied to Financial System Inquiry from APRA, ATO and RBA, 13 June 2014.

24 Reserve Bank of Australia, First round submission to the Financial System Inquiry, page 178 (OECD data).

25 Minife, J 2014, Super sting: How to stop Australians paying too much for superannuation, Grattan Institute, Melbourne.

26 Investment Trends 2014, SMSF Investor Report, April. Note: Based on a survey of 2,163 SMSF trustees.

27 Davis K 2011, ‘The Australian Financial System in the 2000s: Dodging the Bullet’, in Gerard, H and Kearns, J (eds), The Australian Economy in the 2000s, Proceedings of a Conference, Reserve Bank of Australia, Sydney, pages 301–48.

28 International Monetary Fund (IMF) 2011, Australia 2011 Article IV Consultation, IMF country Report No 11/300, IMF, Washington DC.

29 Although noting the extent to which this is an inherent feature of financial markets or the result of government interventions (or a mixture of both) remains a matter of debate.

30 Note: the Government has recently announced some changes to the Future of Financial Advice (FOFA) laws, see Cormann, M (Minister for Finance) 2014, The Way Forward on Financial Advice Laws, media release, 20 June, Canberra, viewed 2 July 2014

31 Australian Securities and Investments Commission 2014, First round submission to the Financial System Inquiry, page 202. Note: these are not exact numbers as there is currently no register of advisers.

32 Roy Morgan Research 2012, data provided to Financial System Inquiry, 18 June 2014.

33 Australian Securities and Investments Commission (ASIC) 2012, Report 279 Shadow shopping study of retirement advice (REP 279), ASIC, Sydney.

34 Australian Bureau of Statistics (ABS) 2011, Australian system of national accounts, cat. no. 5204.0, ABS, Canberra; and Treasury.

35 Productivity Commission (PC) 2013, An ageing Australia: Preparing for the future, Commission Research Paper, PC, Canberra, page 165.

36 Productivity Commission (PC) 2013, An ageing Australia: Preparing for the future, Commission Research Paper, PC, Canberra, page 92.

37 Organisation for Economic Co-operation and Development (OECD) 2013, ‘Survey of Annuity Products and their Guarantees’, paper presented at the Insurance and Private Pensions Committee meeting, 5–6 December. Note: the OECD defines size as the amount of assets backing products (where dedicated or separated accounts back the products) or technical provisions or reserves.

38 Australian Communications and Media Authority (ACMA) 2013, Communications report 2012–13, ACMA, Melbourne.

39 The Boston Consulting Group (BCG) 2013, 2013 Global Consumer Sentiment Survey, BCG, Boston.

40 Symantec 2013, 2013 Norton Report: Total Cost of Cybercrime in Australia amounts to AU$1.06 billion, media release, 16 October, Sydney.

41 Based on IMF and Conference Board data, as well as Maddison, A 2010, Statistics on world population, GDP and GDP per capita, 1-2008 AD, Historical Statistics, Groningen Growth and Development Centre, viewed 21 June 2014, <>. Based on purchasing power parity adjusted GDP.

42 Australian Bureau of Statistics (ABS) 2010, Australian Outward Finance and Insurance Foreign Affiliate Trade, 2009-10, cat. no. 5485.0 and International Trade in Goods and Services, Australia, 2009-10, cat. no. 5368.0, ABS, Canberra. Asia includes China, Hong Kong, Singapore, Japan, Indonesia and Thailand