Bold and sometimes radical - the final Murray report

Introduction

Dear clients and colleagues

We haven't tested this with 'Word Cloud', but we think the report can best be encapsulated in the word 'however'. The financial system has held up well, 'however, ...'. And what follows the 'however' is often bold and sometimes radical.

There are five chapters and just 44 recommendations – compare this with the Cooper Review's 177 recommendations. But this helps – the messages are clear and the recommendations plain, although much of the implementation is left to the imagination:

• Consumers need to be treated fairly by financial institutions.
• The superannuation system needs to deliver higher retirement incomes.
• Banks need to be safer.
• Small to medium businesses should be able to access funding more easily.
• And the system should promote innovation.

To achieve this, ASIC needs more power, barriers to international funding and investment need to be removed and the tax system overhauled. 

We consider each of these in this special edition of Unravelled. 

The Financial System Inquiry would like less regulation, not more, and calls on the industry to improve its conduct so that consumers can have trust and confidence in the financial system. But it also recognises that more regulation will be needed. 

There is a lot missing from the report, if it is tested by the range of matters raised in the interim report. Besides superannuation, there are no specific recommendations about governance – although there is lots of discussion about the need to improve culture in financial institutions and that it is the leaders and their own conduct that will determine organisational culture. There is also nothing on vertical integration – the suggestion is that with improved culture and obligations to act in the interests of customers, vertical integration won't pose the mis-selling risk it might otherwise do. At the end of Unravelled, we have included a table comparing the main policy options from the interim report with the final report. 

We hope you enjoy reading Unravelled and we look forward to discussing the report with you.

Consumer outcomes

The report's mantra is that the financial system will perform best when it is efficient, resilient and fair. The inquiry says that financial firms including banks, insurers, financial advisers, superannuation trustees, responsible entities, lenders and brokers should act in the interests of their 'legal beneficiaries'. And they are not talking about the shareholders. 

Product regulation

But the Inquiry does not recommend any positive duty to individuals be imposed by legislation – instead it recommends that regulation move beyond the point of sale to the product issuer and the design phase, and then through distribution and advice. The proposal is to introduce a 'targeted and principles-based product design and distribution obligation'. The proposal echoes aspects of the European Commission's Markets in Financial Instruments Directive (MiFID II) and, like MiFID II, the recommendation is that product issuers be required to identify target markets, taking into account the intended risk/return profile of the product and its other characteristics (even though the Inquiry considers its approach less prescriptive). They should consumer test their products, agree with distributors how the product will be sold and periodically review the product to ensure it still meets the needs of the target market and whether its risk profile is consistent with its distribution. 

The difficulty with a 'principles-based' obligation is that while it can be simply stated, what it requires is likely to be unclear – and abstract norms are much easier to weave into claims by consumers.

Product intervention

The product issuer's responsibilities will be backed by a recommendation that ASIC have the power to prevent the issue or distribution of a financial product (or a class of financial products) where there is a 'risk of significant consumer detriment'. This will allow ASIC to take industry-wide enforcement action to prevent the sale of products it thinks are harmful to consumers, and we know that Mr Medcraft already has some strong views about what they are. 

The Inquiry appears to have accepted ASIC's ambit claim for a product intervention power without any critical examination of its merits or its basis (or otherwise) in fact – and product intervention could make FOFA feel like a beating with a peacock feather.

Resilience and banks

Coming quickly on the heels of the disallowance of the FOFA Streamlining Regulation, the recommendations in this part of the report will be more unwelcome news for the big banks.

Capital requirements – more Common Equity Tier 1

The Inquiry recommends strengthening the financial system by increasing the capital requirements for authorised deposit-taking institutions, bringing them into the top quartile of internationally active banks (the Inquiry says that they are not there now). Increases in capital ratios should take the form of increases in Common Equity Tier 1 since this will provide the greatest level of protection against a bank failing. The Inquiry estimates that a one percentage point increase in capital ratios would only result in an increase in lending interest rates of less than 0.10 per cent per annum.

Narrowing the gap – mortgage risk weightings

The Inquiry also recommends that the gap between the average internal ratings-based mortgage risk weightings used by the big four banks and Macquarie and the average standard mortgage risk weightings for the remaining ADIs be narrowed. And it recommends that the narrowing should be achieved by increasing the weightings used by the internal ratings-based model rather than by relaxing the risk weightings that apply under the standard model. The Inquiry says that allowing banks to develop their own risk weightings pays insufficient attention to the risk mortgages play across the industry. Narrowing the gap will also increase competition. 

A framework for loss absorption and recapitalisation to be developed by APRA

The Inquiry does not recommend the bail-in of deposits; indeed it 'strongly supports' continuing the existing guarantee of deposits of up to $250,000 by the Financial Claims Scheme.

Instead APRA should develop a framework for loss absorption and recapitalisation – higher minimum capital requirements will reduce the risk of failure and the loss absorbing and recapitalisation framework will reduce the cost of failure. The framework should be consistent with international practice, set out which instruments are eligible for inclusion in the loss absorbing and recapitalisation requirement, and seek to ensure that only investors who can afford the loss can hold eligible instruments (this points to recommendations about the design and distribution of financial products). 

As to what the eligible instruments will be – they should include both equity and debt instruments – but nothing specific is suggested. The Inquiry notes that additional Tier 1 and Tier 2 capital instruments with conversion and write off features can provide loss absorbing and recapitalisation capacity. 'If constructed carefully, a new layer of contractual instrument in the creditor hierarchy between Tier 2 and unsecured senior debt would have similar benefits to Tier 2, at a lower cost.'

A leverage ratio backstop

These recommendations are supported by the further recommendation that a leverage ratio be introduced that will act as a 'backstop' to ADIs' risk weighted capital provisions. It will provide a floor to their risk-weighted capital requirements. 

Concluding thoughts

As if pre-empting the backlash, the Inquiry devotes a lot of space in the report to defending its recommendations, referring to the risks that are unique to Australian banks – their dependence on foreign investment and their substantially similar business models. Both mean that systemic failures are likely to hit all banks, the economy and the community.

It is fascinating that in his press release the Treasurer, Mr Hockey, said that several of the Inquiry’s recommendations, including those on bank capital, 'are for APRA and the RBA to consider as independent regulators'. One would hope that in due course the elected Government will also consider them.

Superannuation and retirement incomes

Some of the most radical recommendations in the final report relate to superannuation and retirement incomes. The Inquiry's aversion to Government intervention, so evident in relation to other areas of the financial system, is conspicuously absent here.

The Inquiry has maintained its view, expressed in the interim report, that the superannuation system is not operationally efficient due to a lack of 'strong price-based competition'. Superannuation assets are not being efficiently converted into appropriate retirement incomes due to a lack of risk pooling and an 'over-reliance on account-based pensions'. Tax concessions in the superannuation system are not well targeted. 

The Inquiry's recommendations to deal with these problems are bold.

Objectives for the system

Quite rightly, the Inquiry says that clear objectives for the superannuation system must be set. Doing this will improve policy settings and make them more stable. The Inquiry's suggested objective for the system is: 'To provide income in retirement to substitute or supplement the Age Pension'. Once an objective has been agreed, it should be enshrined in legislation.

Accumulation phase

A formal competitive process is probably needed to allocate new default fund members to MySuper products. It is too early to tell whether Stronger Super will improve outcomes for default members. Implementing the competitive process should await a review by the Productivity Commission of the effectiveness of the Stronger Super changes, sometime between 2017 and 2020. However, the Inquiry is sceptical about how much difference Stronger Super will make. Consistent with this, the Inquiry does not endorse the idea that an employer should be free to contribute to any MySuper product.

As the Inquiry observes, its recommendation would, if implemented, remove the role of the industrial relations system in selecting default funds. It would ultimately obviate the need for members to consolidate accounts or exercise choice when they change employers. The Inquiry accepts that the competitive process would need to be carefully designed, but it thinks design concerns can be addressed; they are not insuperable.

Retirement phase

Superannuation trustees should be required to 'pre-select' a comprehensive income product for retirement. (The Inquiry calls this a 'CIPR', not the most user-friendly term, but at least they have not called it 'MyPension'.) This is a default in that the trustee would select something. However, it is not really a default because the selected retirement product would not start automatically. It would only start if the member opted for it. The member could choose to do something else with their retirement benefit.

It is not clear whether a CIPR would be a single product or a bundle of products. It appears to involve a combination of an account-based pension and a pension which helps to manage longevity risk. The Inquiry says the Government should set some key required features for CIPRs. 

Taxation

The Tax White Paper (which, incidentally, is the repository of many of the Inquiry's hopes and dreams when it comes to international competitiveness and integration – see below) should consider removing the difference in the tax treatment of earnings on superannuation assets as between the accumulation phase and the pension phase. At the moment, the headline rates are 15 per cent and 0 per cent respectively. The Henry tax review recommended a flat rate of 10 per cent across both phases. The Inquiry has not suggested anything specific and leaves it to the Tax White Paper to do so.

Gearing and independence

The Government should stop direct borrowing by superannuation funds – leverage poses risks to the financial system and is inconsistent with the purpose of superannuation. Existing borrowing arrangements should be able to continue.  

And finally, trustees of publicly-offered superannuation funds should have majority-independent boards including an independent chair.

Innovation and technology

New 'Innovation Collaboration' committee

While the report is averse to recommending new bodies to deal with issues in the financial system, in the area of technology it recommends the establishment of a committee dubbed 'Innovation Collaboration'. It will comprise Government and private sector participants and provide a forum for the industry to interact with regulators and Government policy makers. The committee should allow Government and regulators to understand changes in technology more quickly as they emerge, and respond with appropriate regulation. The report notes that the regulators currently have low risk appetites and have strong 'safety' mandates, both of which inhibit timely response to technological change.

Technology neutrality

In relation to Government policy generally, the Inquiry advocates a move towards regulation that is technology neutral (such as in the area of disclosure – currently the subject of an ASIC consultation paper), and recommends an industry working group to identify 'priority areas of regulation to be amended for technology neutrality'.

Digital identification

The report recommends that Government develop a 'national identity strategy based on a federated-style model' under which public and private sector identity providers would compete to provide digital identification services. This is in contrast to a 'syndicated model' in which the Government provides a single credential for use by both Government and private sector – a proposal already rejected in Australia on two occasions. The provision of these services by multiple providers should generate competition and innovation, while reducing costs for Government and for the private sector as reliance on paper-based identity verification declines.

Payment systems

There is a significant amount of discussion about the regulation of retail payments. The report advocates a 'graduation' of regulation of payment systems, including narrowing the application of the Australian financial services licence regime, and a two-tier prudential regime for purchased payment facilities with reduced requirements on low value payments providers. The Inquiry expects new providers to emerge in this area, especially for online payments, and reduced regulatory obligations should help facilitate competition. At the same time, the report advocates extending the currently voluntary ePayments Code to all service providers to improve consumer protection.

Interchange fees and surcharges

The report's recommendations in relation to interchange fees and surcharges imposed on customers for using various payments methods would result in increased regulation of both to reduce fees charged to merchants and customers. It says that interchange fee caps should be reduced, and they should be 'hard caps' (rather than the three-year weighted average cap currently utilised). The surcharges imposed on customers, according to the report, should better reflect the costs of the various types of payment systems being used.

Crowdfunding

The report also recommends that the regulation of fundraising should facilitate crowdfunding for both debt and equity. It notes the emergence of crowdfunding globally as a major source of funding, especially for SMEs, while also noting that Australia is already lagging other jurisdictions in facilitating crowdfunding (the UK and New Zealand both introduced securities-based crowdfunding regimes in 2014). The risks associated with the reduced regulatory requirements could be mitigated somewhat by limiting the size of investments and communicating risks appropriately.

Data access and use

There is also a recommendation for Government to commission the Productivity Commission to review the costs and benefits of increasing access to data held both by the private and public sectors, and encouraging the improved use of the data available. Again, this reflects trends in other jurisdictions, with both the UK and US implementing open data policies. Privacy concerns would need to be addressed as part of any regulatory change proposal. The report also recommends that Government continue to support industry efforts to expand credit data sharing, and intervene if participation by credit providers is inadequate.

Other 'significant matters'

The Inquiry groups a series of miscellaneous recommendations together under the banner 'significant matters'. (This seems to be the result of the Inquiry dispensing with the nine 'priority issues' approach that was used in the interim report.) They include:

• Reducing disclosure requirements for large listed corporates issuing ‘simple’ bonds and encourage industry to develop standard terms for ‘simple’ bonds.
• Renaming ‘general advice’ and requiring advisers and mortgage brokers to disclose ownership structures – the alternative label for general advice is not identified, but it should be 'replaced with a more appropriate, consumer-tested term to help reduce consumer misinterpretation and excessive reliance on this type of information'.
• Supporting the Government’s review of CAMAC’s recommendations on managed investment schemes, giving priority to matters relating to consumer detriment (including illiquid schemes and freezing of funds) and regulatory architecture impeding cross-border transactions and mutual recognition arrangements.
• Introducing a mechanism to facilitate the rationalisation of legacy products in the life insurance and managed investments sectors – a product issuer who uses the mechanism should be subject to 'a cost recovery mechanism, such as an application fee'.

International integration

An important theme identified in the interim report was international integration, and the need for changes to distorting tax rules to allow Australian financial services firms to compete with regional (and global) competitors. Possibly because of that tax angle, which is outside the Murray Inquiry's scope, this theme is more muted in the final report. Instead, the report devotes an appendix to listing the tax matters that the Inquiry thinks should be considered as part of the Tax White Paper. We wager that the Tax White Paper is likely to be a catalyst for further change, not least in the structure of managed investment schemes, which have received little attention in the Inquiry's report.

FSI Final Report – comparison with Interim Report

Banks – competition and stability

Financial services and fundraising

Superannuation and retirement incomes

Disclosure and product regulation

Advice and distribution

Technology

Taxation