The interim report of the Financial System Inquiry

Welcome to a special edition of Unravelled

The Financial System Inquiry (FSI) Interim Report (the report) was issued today. There are few surprises in the options and comments, although there are some significant omissions. There does not appear to be any push for a significant shift in policy or in the regulation of the financial system. There will be adjustments and some specific areas targeted for change. But the four pillars policy looks like it is here to stay. There will be no significant opening up of competition for the banks and no impediments to further consolidation in the superannuation industry. For superannuation there are some radical ideas, but whether they will get any broad support is questionable. Tax changes are clearly on the agenda – but not for the FSI. The report raises negative gearing, concessional capital gains tax, capital gains tax on the family home, superannuation tax concessions and dividend imputation as all matters that should be looked at by the Tax White Paper. Obstacles to increasing exports and imports of financial services in the region and globally are blamed on commercial issues, market conditions and possibly the ATO, rather than regulatory settings.

The specific areas where change is likely to be recommended have all been considered before – changes to encourage better retirement income products, product suitability and design rules, changes to disclosure rules, a split between financial product sales and financial advice and greater powers for regulators to tailor their oversight and regulation of companies, including those currently outside their regulatory reach (such as payment system providers) as they play a bigger part in the industry. According to the report: 'One option would be to allow for the permeability of the prudential perimeter' so that 'some mechanism allows for affected institutions or activities to be brought within APRA's remit and subjected to more intensive regulation and supervision'.

The omissions are perhaps more telling – competition is a big part of the report, but the vertical integration by banks of wealth managers and financial planning is only included as a peripheral issue. There is no discussion of what increasingly appears to be a crisis in the life insurance and reinsurance market. Investment in infrastructure by superannuation funds is also not really explored, although 'impact investing' is given quite a lot of attention.

It is a brave new world with the report providing a glimpse of a future where our technology provider will provide each of us with access to a perfectly tailored home loan, credit card, insurance, and savings and retirement products without leaving home. But it also raises the spectre of the increasing polarisation over a life time between those of us who have access to well-designed and tailored financial products and those of us who don't. The report acknowledges that the use of big data in the insurance industry may mean that groups of people will not be able to obtain insurance. Big data might also be used to exclude groups of people from financial services and products more broadly.

Below we consider some of the specific options considered in the report in more detail. Our next edition of Unravelled will also be devoted to some of the more interesting ideas in the report.

As always, we look forward to your feedback. 

The Financial Services Regulation Team

Regulatory Capital Requirements

The report acknowledges that the application of capital requirements is skewed in favour of banks which are able to use internal risk models (currently the four major Australian banks and Macquarie Bank) (IRB Banks). These banks have lower risk weights for mortgage lending than the other banks.

A number of submissions requested that APRA lower standardised risk weights for mortgages, but it does not seem likely that this will be recommended in the final report, as it is viewed as lowering the incentive for banks to improve risk management.

One option flagged in the report is the development of a tiered system of standardised risk weights that incorporates some of the components of the modelling from the IRB Banks. Whilst the implementation of such a system would be complex, it would ensure a more even playing field and would inherently be more accurate than current standardised risk weights used by non-IRB Banks.

Domestic Corporate Bonds

The report says the development of Australia's domestic bond market has been limited by regulatory and tax factors. In order to deepen the 'vanilla' corporate bond market, the following options are being considered:

• Allow listed issuers (already subject to continuous disclosure requirements) to issue ‘vanilla’ bonds directly to retail investors without the need for a prospectus.
• Review the size and scale of corporate ‘vanilla’ bond offerings that can be made without a prospectus where the offering is limited to 20 people in 12 months up to a value of $2 million, or for offers of up to $10 million with an offer information statement.

Both options would provide a significant boost to the domestic bond market, and it is difficult to see that investors would be significantly hampered by the reduced disclosure requirements. It is also a sign that the domestic bond market may provide a viable alternative financing option for SMEs.

Superannuation and retirement income

There is lots about the size and importance of the superannuation system in the report, but leaving aside retirement income, not many options for change. There is some discussion about superannuation being an important funding source for the rest of the economy and its place in Australia's three pillar retirement system (age pension, compulsory superannuation contributions and voluntary savings) and the report raises the very significant issue of there being no clear statement of the purpose and objective of the superannuation system. It is hard to make recommendations without both. The FSI seems to adopt the objectives proposed by Australia's Future Tax System Review – the superannuation system should be broad and adequate, provide an adequate retirement income, be able to meet investment, inflation and longevity risk, be simple and approachable as well as sustainable. Given the very small average balance most Australians retire with, there is a long way to go.

A focus on after-fee returns

Much of the report's (significant) focus on superannuation centres on the lack of evidence of 'strong fee-based competition' in the superannuation sector and the associated high fees and operating costs of our superannuation system in an international context. While the report acknowledges that there are a range of mainly structural reasons for this (and implicitly acknowledges that the higher fees of the Australian superannuation system have little to do with profiteering by superannuation providers), this is clearly an issue which the FSI would like to see addressed.

A number of possible regulatory responses to the issue are raised for consideration including:

• At the most extreme, requiring all default superannuation contributions to be made to a single (likely Government controlled) fund, which would be run by one or more superannuation providers selected solely or mainly on price;
• Introducing an RBA liquidity facility that funds would have access to (with the idea being that this would ensure funds could hold fewer liquid assets) – although this idea seemed not to gain much support from the FSI; and
• Changing the recently introduced three business day portability rule for transfers between super funds to either lengthen the time permitted for transfers or allow a more principled-based system for transfers (again, with the idea being to reduce the need for super funds to hold excess liquidity to support the current short turnaround times on transfer requests).

Borrowing by SMSFs

The report seems to suggest that the days of non-recourse borrowing by SMSFs may be numbered. In particular, the report highlighted the systemic risks associated with what it sees is the growing (though 'embryonic') trend for super funds (although almost exclusively SMSFs) to take advantage of the non-recourse borrowing rules introduced in 2007 (and expanded in 2010) and suggests that a return to a total ban on leverage could be warranted.

Regulatory settings – Too much tinkering and too generous at the same time?

In comments that will be far from a revelation to those involved in the superannuation industry, the report acknowledges that superannuation policy settings 'lack stability' and that Governments could be accused of making short-term policy decisions in respect of superannuation over changes that promote the objectives of the superannuation system. Nonetheless, the report goes on to identify that some of the key tax settings of the current regime, including the tax-free nature of superannuation in retirement and the ability of super funds to access imputation credits, are likely to need to be reassessed in order to shore-up the long term viability of the superannuation system from a tax perspective.

Infrastructure financing – Opportunity not appetite the issue

In an echo of what many industry groups have been saying for years, the report acknowledges that there seems to be little concern about the availability of capital for infrastructure financing. Rather, the report focuses (if only briefly) on the need to develop different models for the bidding and financing of greenfield infrastructure projects and a somewhat cryptic comment about the need to develop 'liquid, tradeable claims on infrastructure projects'.

Retirement

The report says that the focus of the superannuation system on the lump sum payable on retirement is flawed – instead, it should be on providing an adequate retirement income. An adequate retirement income should provide an income for life, protection from longevity, investment and inflation risks and flexibility permitting lump sum withdrawals if needed. The account-based pensions that account for 94 per cent of all current pension assets provide flexibility only. Risk is addressed by the age pension system. Options include extending default products into retirement, mandating or providing incentives for retirees taking an income stream rather than a lump sum and new products that allow retirees to combine a flexible income product with protection against longevity risk. Products that are suggested include deferred lifetime annuities – the annuity is bought today but payments are deferred; group self-annuitisation – participants pool their superannuation with lifetime income streams paid to surviving participants and government-issued longevity insurance. A combination of products might also be used to meet the needs of retirees. There are difficulties though which changes to regulation will not address – capital requirements and uncertainty make these products difficult to offer and sell and the most intransigent problem – the inadequate superannuation balances most of us retire with. While the report rightly calls for a focus on retirement incomes – it is hard to do this without addressing the low superannuation account balances of most fund members.

Advice and distribution

The report appears to endorse the view that conflicted remuneration and other conflicts of interest weaken the quality of financial advice. This may have been helped by FoFA, but the report is careful not to take a view on the government's most recent FoFA regulations. Nevertheless, the questions asked and options proposed in the report do not suggest that the FSI will call for any structural change to the vertically integrated wealth management sector. At most, advisers may have to make their independence (or otherwise) clear to their clients and those providing only 'general advice' about their institution's products may not be able to call themselves 'advisers' at all.  Instead, the report focuses on improving competency standards for financial advisers and ensuring consumers have access to 'low cost' advice, through 'scaled advice' or advice given by computers.

Disclosure and product regulation

Perhaps the most significant departure from the principles that were established following the Wallis inquiry is the report's acknowledgements that disclosure on its own is not an effective consumer protection mechanism. In Murray's speech today to the National Press Club, he said:

This is an area where there appears to be strong agreement on the existence of a problem. However, there are different views on how to proceed – particularly whether disclosure can be made to work or whether we need to base the regime on a different foundation – possibly one that create stronger incentives for financial institutions themselves to build trust with their clients. The challenge for the Inquiry is to develop a viable alternative approach that is not simply more detailed rules.

But it is not clear that the FSI supports ASIC's preference for more power to regulate product design and impose product suitability rules. This is going to be a hotly debated issue.

Consumer loss and compensation

The FSI noted that the overall view of stakeholders was that dispute resolution systems are working well. However, despite this some consumers have experienced significant financial loss. While the FSI recognised that consumers should take responsibility for the risk and reward of financial decisions, it expressed the view that some losses in the managed investments sector reflected 'poor business models, poor advice or fraud' and 'raises the issue of whether the framework for regulating managed investment schemes adequately safeguards the rights of investors, especially compared with companies'. The indications are that the Inquiry is not attracted to a statutory compensation scheme. However, the FSI has sought comment on what other options exist for addressing the issue of consumer loss.

ASIC's enforcement powers

The FSI appears to accept ASIC's assessment of its enforcement powers, in particular while criminal penalties for breach of the legislation it enforces are in line with international standards, the civil and administrative penalties are low. It also noted the absence of broader remedial tools, such as disgorgement orders. The FSI recognised that the Senate had recently examined the performance of ASIC, with the Senate Report being issued at the time the report was published, and stated that the FSI would carefully examine the Senate Report's findings in the lead-up to its final report. The FSI does not take a position in respect of any specific changes to ASIC's enforcement powers, instead listing a number of options. However, given the consistency in view between the Senate and the FSI that ASIC's enforcement powers may be underweight, it seems likely that we will be seeing recommendations for a review of the type and size of the penalties ASIC has available to it. The addition of disgorgement orders to ASIC's toolkit, in particular, has the potential to change the enforcement landscape significantly.

Governance

A somewhat surprising issue raised by the Inquiry is the difference between duties of directors of different parts of the financial system – referring to the differences between the duties of directors of banks and insurers and trustees of superannuation funds by way of example. There are indications that the Inquiry is sympathetic to concerns expressed about the increasing burdens being placed on boards but the issue is not explored in detail and the Inquiry's concluding position is a somewhat equivocal query about whether the differences in duties in are appropriate and asks 'who should directors' primary duty be to'. 

Regulation of Managed Investment Schemes

In our June edition of Unravelled we suggested that the FSI promote some of the changes to the regulation of managed investment schemes raised by the Corporations and Markets Advisory Committee (CAMAC) in its 2014 discussion paper. We are pleased to see that the FSI has not let CAMAC's 2014 paper, nor its 2012 report, languish, but is asking for industry's views on the costs, benefits and trade-offs of amending the existing regulatory framework for managed investment schemes.

Understandably, the report does not attempt to deal with the matters covered by CAMAC in any detail, and instead identifies a list of six sample issues.  These are not necessarily the most fundamental proposals raised by CAMAC, and FSI does not address (or challenge) the key principle underlying CAMAC's views, namely that the regulatory regime for managed investment schemes should be aligned with that for companies unless there are compelling reasons for treating schemes differently. 

We think it is important that the FSI not make final recommendations based on CAMAC's recent work too hastily, but recommend that further work be undertaken with industry to build on CAMAC's efforts, with a view to considered amendment of the current regime, where this is appropriate.

International integration

The report highlights the importance of international integration of our financial system, particularly in light of anticipated growth in the Asian region over the next decade. The FSI identifies a number of potential impediments to financial integration, most notably taxation settings in Australian that distort international financial flows. Many of these issues have been raised in previous reviews into the financial system (including the 2009 Johnson report, Australia as a Financial Centre). There is a sense of urgency in the interim report that significant progress needs to be made to remove the taxation, and other, impediments to integration.
 
The FSI also notes that, in addition to removing impediments, proactive Government action will also be required. For example, the interim report refers to the Asia Region Funds Passport, which is being developed to lower barriers to offering Australian managed investment schemes to investors in Asia. This is described as a significant first step to better integrating the funds management industry in the region. While we agree, this is another example of the need to ensure that any tax impediments are addressed in parallel to the development of the passport regime. The taxation of non-resident investors will need to be amended before Australian-managed funds (which must apply withholding tax on non-resident investors) are able to compete with funds managed in Hong Kong or Singapore (which apply no, or only very limited, withholding tax).
 
One of the authors of the 2009 Johnson report, Mark Johnson, expressed some frustration with the ATO in his submission to the FSI, which may indicate that, while international integration is a desirable end, like Rome, it will not be built in a day.

Technology

The report includes alot about technology and the important role it plays and will increasingly play in financial services regulation. It considers privacy, data security, cloud technology and issues relating to digital identities. The report observes that technological innovation is a major driver of efficiency in the financial system and can benefit consumers. However, access to growing amounts of customer information and new ways of using it heighten privacy and data security risks. The shift to an increasingly online environment also heightens cyber-security risks and the need to improve digital identity solutions.

The report raises the following notable policy options:

• the establishment of a central mechanism or body for monitoring and advising government on technology and innovation;
• implementation of mandatory data-breach notifications; and
• the development of a national strategy for promoting trusted digital identities.

Although a number of submissions to the FSI discussed peer-to-peer lending, crowdfunding, and virtual currencies (such as Bitcoin) as potentially disruptive new technologies, the report did not comment on any of these in detail. On peer-to-peer lending, the report noted that that ASIC was working with peer-to-peer lenders to develop appropriate regulation; and that submissions from peer-to-peer lenders were generally supportive of the current regulatory regime. On crowd-sourced equity funding, the report pointed to the recent report of the CAMAC on the subject without adding any further commentary. The report's discussion of virtual currency was limited to identifying some high-level risks, including their highly speculative nature.

Tax

The FSI identifies a number of aspects of the Australian tax system that:

• distort the allocation of funding and risk in the economy; and
• may adversely affect outcomes in the financial system.

The report recommends that the following matters be considered as part of the Federal Government's Tax White Paper : 

• the differentiated tax treatment of savings vehicles and the impact that this has on household asset composition and the flow of funds in the economy;
• negative gearing and capital gains and whether the asymmetric treatment of interest costs and other expenses and capital gains encourages leveraged and speculative investment;
• the basis for dividend imputation and whether it is affecting the development of the corporate bond market;
• the fact that Mutuals cannot distribute franking credits, which could be affecting competition in banking;
• improving and simplifying the tax treatment of venture capital limited partnerships;
• the tax treatment of superannuation funds and legacy products;
• the impact that interest withholding tax has on distorting funding decisions and whether it is placing Australia at a competitive disadvantage;
• the impact of the GST not being levied on most financial services; and
• accessing research and development tax credits and the tax treatment of offshore banking units, social impact bonds and Islamic finance.

These matters indicate the difficulty for changing regulatory settings in a piecemeal fashion.