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Unravelled: Financial System Inquiry: where are we at?

5 August 2015

Written by Partner Michelle Levy

Federal Treasurer Joe Hockey released the Financial System Inquiry report on 7 December 2014, saying that:

[the] report I release today delivers on our election commitment and lays out a blueprint for the financial system over the next decade.

And he is right – the Government did, as promised, commission an inquiry and the report does set out recommendations for how the financial system 'could be positioned to best meet Australia's evolving needs and support Australia's economic growth'. But the electorate may have hoped for more than a report and a blueprint. Of more interest will be whether the blueprint will be implemented. And here, the Treasurer has been more circumspect.

There will be no single response from the Government. Rather, it has promised to respond, piecemeal, over the course of 2015. It is difficult to avoid the conclusion that the Government is responding to the bits it likes while saying nothing about the bits it doesn't. To some extent, it may not matter because there is lots in the report that can be implemented by regulators without legislative change or government funding. Nevertheless, a comprehensive response from the Government would give this member of the electorate greater confidence that the FSI will in fact provide the blueprint for the financial system over the next decade.

The recommendations

You will recall the FSI's recommendations were in five chapters: resilience, superannuation and retirement incomes, innovation, consumer outcomes and regulatory system. I have used the same categories to look at what has happened so far.


The recommendations to build resilience were largely about the strength of the banks, with the headline recommendation being that the capital levels for banks be set at such a level that 'capital ratios are unquestionably strong' and in the top quartile of internationally active banks.

The big banks have argued that they already hold enough capital and the Government hasn't responded, but in the end this is a matter for APRA and APRA has been doing some work to try to work out what the true capital position of Australia's banks is compared with their overseas counterparts. In its letter of 13 July 2015 to the banks, APRA said that its review:

Support[s] APRA's view that the Australian major banks are well-capitalised, but [it] would not place the banks in the top quartile of their international peers, as proposed by the FSI.

APRA says that, on average, the banks would need to increase their common equity tier 1 capital (CET1) by about 0.70 per cent to position their CET1 capital ratios at the bottom of the fourth quartile of internationally active banks and that the major banks would need to increase their capital ratios by a much greater amount to reach that quartile on all four measures of capital adequacy.

APRA's conclusion is that:

While APRA is fully supportive of the FSI's recommendation that Australian ADIs should be unquestionably strong, it does not intend to tightly tie that definition to a benchmark based on the capital ratios of foreign banks. APRA sees fourth quartile positioning as a useful ‘sense check' of the strength of the Australian capital framework against those used elsewhere, but does not intend to directly link Australian requirements to a continually moving benchmark such that frequent recalibration would be necessary.

APRA has already announced that it requires an increase in required capital for residential mortgage exposures of the major banks as recommended by the FSI. For the rest, APRA says it is waiting for the Basel Committee's recommendations, which are not expected before the end of the year. Don't hold your breath.

The FSI recommended that the work started by the previous Government on APRA's crisis management powers and a special resolution regime for clearing and settlement facilities and trade repositories (financial market infrastructures) resume. The Government released a consultation paper in February 2015 asking for submissions on a potential crisis resolution regime for financial market infrastructures. The consultation period is closed now. You can read more in Matthew McLennan's and David Harris's article in the May edition of Unravelled: Protecting the financial system from cross-border contagion.

Superannuation and retirement incomes

The FSI recommended, like the Cooper Inquiry before it, that the objectives of the superannuation system be agreed (you may be surprised to learn they aren't) and enshrined in legislation. Assistant Treasurer Josh Frydenberg had the following to say at a Financial Services Council breakfast on 15 April:

My view is that a carefully drafted objective – with bipartisan support – would have positive benefits for the stability and accountability of the system and those who play a role in it.

It's noteworthy that the view is personal – despite what appears to be such an obviously sound idea, the Government has not formally responded to date. By not doing so, it raises the spectre of more fiddling with superannuation, and that is universally agreed to be a very bad idea.

The FSI report devoted quite a bit of space to efficiency and competition in superannuation. It recommended a more competitive process to allocate new default fund members to MySuper products unless, by 2020, a review concludes that the current system has significantly improved competition and efficiency, by which they are largely referring to fees and costs. Here, the FSI report really goes out on a limb and recommends some pretty active Government intervention in the selection of default funds. The recommendations are not very popular with the Government and have been only indirectly addressed. To quote Mr Frydenberg again in the same speech:

Another of those settings is superannuation transparency, and the Government has committed to making improvements in this area. We want consumers to be able to compare the relative performance of superannuation funds, so they can choose the product that is right for them. A further important regulatory setting is competition – and that's why the Government wants to open up the default superannuation market so that there is more choice.

This is despite the FSI saying that competition has failed to improve after-fee returns for members and that the members of the inquiry are not optimistic that MySuper will do the job. On transparency, the industry is still waiting to see the law for the mandatory disclosure on websites of superannuation assets and the investment performance for investment options and ASIC is making a meal of the rules for disclosing fees and costs.

The Government has been much more enthusiastic about the FSI's recommendation that superannuation trustee boards be required to have a minimum number of independent directors and the Government has released an exposure draft Bill that will, if passed, abolish equal representation rules for superannuation trustees and require a third of the directors of trustee boards to be 'independent' by 1 July 2019. This is, as Mr Frydenberg says, a promise made by the Government in 2013 and really has little to do with implementing the FSI's recommendations. It is also the subject of much criticism and strong lobbying.


The report is, in my view, at its weakest in this section, and is possibly a reflection of the authors' experience and expertise. The recommendations are pretty broad – innovation is a great idea and we should encourage it and encourage investment in it, but they are not really sure how, nor are they really sure what the Government's role is. Crowdfunding and peer-to-peer lending are very much terms of the moment and the FSI's recommendation to relax current requirements for fundraising is very popular with the Government and the media. The Government released a discussion paper in February 2015 and promises draft equity crowdfunding legislation later in the year.

ASIC has said that it is keen to work with the industry to work out how it might need to modify its policies to help and has very recently released class orders permitting electronic disclosure.

Consumer outcomes

As well as concluding that competition has failed in superannuation, the FSI thinks that the market has failed consumers. It says that financial services providers must treat customers fairly and has recommended product suitability and intervention rules, better disclosure and improvements to the conduct and competency of advisers.

Some of these recommendations are hot potatoes for the Government. At the FSC breakfast mentioned earlier, Mr Frydenberg also said:

The Inquiry… considers the alignment between consumer outcomes and the corporate culture of financial firms should begin when a product is designed. So, it has recommended the introduction of a product manufacturer obligation and a product intervention power for ASIC. I appreciate that these proposals represent a substantial change from our current arrangements, and that some may view them as potentially giving rise to a range of unintended consequences. While consumer protection is a goal no-one would argue with, the benefits, potential costs and possible unintended consequences of regulatory interventions must always be carefully considered.

The unintended consequence was very popular with Sir Humphrey Appleby from memory.

Nevertheless, like the capital adequacy recommendations, there is a lot that can be done to implement these recommendations without legislative change. The Corporations Act 2001 (Cth) already requires financial services licensees to provide financial services efficiently, honestly and fairly. And while there has been a view that this is a compendious obligation, there is recent case law that suggests otherwise. The courts and ASIC could give this obligation lots of work to do, using it to impose a legal requirement that products be suitable for their intended audience. Existing duties that apply when a person provides financial product advice already have a lot to say about product distribution.

As to financial product advice and advisers, the Government has been quick to endorse measures to improve professional standards and a register of financial advisers is now being maintained by ASIC.

In life insurance, the FSI noted some serious shortcomings in the advice provided to consumers and recommended a level commission to stop the most egregious mis-selling. In response, the Association of Financial Advisers (AFA) and the FSC commissioned an inquiry led by the former APRA member, John Trowbridge. Like the FSI, Mr Trowbridge recommended level commissions. In response, the industry has come up with its own proposal, which does not include level commissions, but does promise lower upfront commissions. Mr Frydenberg says that the Government welcomes 'significant reform package' from the AFA, the Financial Planning Association of Australia and the FSC. You can read more about this in this edition of Unravelled.

Regulatory system

Finally, the FSI recommended giving more powers and greater funding to ASIC. ASIC's report card hasn't been terrific and so, while it is lobbying hard, it is not perhaps surprising that these recommendations have not been embraced by the Government. Instead, it has commissioned a 'Capability Review' of ASIC. The review will consider how ASIC uses its resources and powers now and 'assess ASIC's ability to perform as a capable and transparent regulator'. Mr Medcraft has spoken a lot about the importance of culture in financial services institutions; the Capability Review is very likely to have a look at the culture within ASIC. The review is to be completed by the end of this year.

As to the rest, we need to keep waiting for the Government's response.

Other articles in this edition of Unravelled

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Broadening approved product lists – would it really achieve anything?
In his report earlier this year on retail life insurance advice John Trowbridge recommended that every advice licensee include at least half of the 13 relevant life insurers on its approved product list. The Assistant Treasurer has since indicated the Government may 'consider measures to widen APLs by 1 July 2016'. Read more>>

Regulating bonuses: will Australia be next?
The UK's Financial Conduct Authority and Prudential Regulation Authority released rules, in June this year, to further tighten what are already fairly onerous restrictions on the payment of bonuses to staff in banks, building societies and certain big investment firms. The world's financial regulators have, for some time, been trying to crack down on what they consider to be inappropriate remuneration structures and it begs the question – will Australia be next? Read more>>

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