Author: Martin North

Having summarised the main observations from the 460 page Financial System Inquiry (FSI) interim report yesterday, today we start to delve more deeply into some of most important issues raised. In a number of areas, we believe the work to date could be sharpened.
Lender’s Mortgage Insurance. The report rightly highlights that for banks with advanced capital models, there is now no benefit to underwriting risks to an LMI entity, as they already receive a 20% weighting, whether or not they are LMI insured. Therefore, LMI may become sidelined, and be used by smaller banks only, reducing volumes and increasing underlying portfolio risks.
However, whilst the report recognises that about 25% of new loans are underwritten by LMI, and the borrower pays, it does not reflect on the fact that the insurance is not portable, so consumers forfeit the premium they pay if they move later; that consumers are confused by the cover provided (protects the banks, not the household) and LMI encourages higher LVR lending. We think the role of LMI should be considered more broadly.
Industry Concentration. The report comments “Some submissions argue that the increasing concentration and integration of the major banks is harming competition. They submit the major banks can cross-subsidise products to drive out competitors in some markets. Submissions also argue that the major banks’ market power has led to oligopolistic competition and higher prices for consumers. The major banks have market power across a range of markets. However, it is not clear they are abusing this power. The ACCC has taken relatively little action against the major banks in recent years. The Inquiry would welcome views on the level and exercise of market power across the various markets in which the major banks operate.”
The major banks have become financial services conglomerates, extending their reach across retail, business and commercial banks, as well as wealth management, wealth management platforms and insurance. In addition, they have become more vertically integrated, with the accumulation of mortgage brokers, financial planners and other advisors businesses, and are extending services into online channels as well as branch networks. There are important implications, first consumers often find the brand they transact with does not clearly indicate its relationship with the parent bank. Second, as players control more of the value chain there is more opportunity for price control and reduced competition. For example, a mortgage broker working for one of the large players may recommend an in-house mortgage, so long as it is not unsuitable.
The report says “Vertical integration of mortgage broking may create conflicts of interest, which could hamper competition. Mortgage brokers can improve competition by enabling smaller players to access a broader range of consumers than their standard distribution networks would allow. However, vertical integration may have the potential to distort the way in which mortgage brokers direct borrowers to lenders. The extent of this issue is not clear. The Inquiry welcomes views on this issue.”
More broadly there is a case for greater transparency in the proportion of industry segments which players occupy. No consolidated data is provided by the regulators, across business streams. In addition, ACCC tends to look at specific transactions, not necessarily setting them in the broader cross segment context. We need an overall industry concentration metric, and regular reporting.
The Implications of Four Pillars. The report noted that “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.”
“The Inquiry views this as appropriate and does not plan to recommend changes. The banking sector is already concentrated; further significant concentration has the potential to limit competitive pressure in the market and reduce the choices available to Australian individuals and firms. Although general competition law may prevent a merger between the major banks, the Inquiry sees merit in retaining the four pillars policy.”
Now, I agree that further consolidation in the industry amongst the major banks should be resisted, however, the unintended consequence of this policy is that the banks can complete quite happily on the basis of inefficient processes and systems. This in turn flows on to higher fees and charges. So, with competition dampened by four pillars, what mechanisms should be established to ensure that Australia Inc. does not pay more than it should for banking and financial services products? At very least, we need an objective cost benchmark, against players in analogous markets overseas, to ensure that the four pillars does not artificially support higher margins and fees.
Innovation in Financial Services. The report recognises that innovation, often enabled by new technology is significant and important. “Government and regulators face challenges from the expected pace of change in technological developments. By its nature, regulation lags market developments. Consequently, Government and regulators need effective mechanisms for monitoring emerging trends, a flexible approach, and the ability to adapt and design regulation in a changing environment. Where new, technology-enabled business models, products and delivery mechanisms emerge, regulators need to consider whether and how to regulate such developments. They may also need to be flexible in how they apply existing frameworks.”
The latency between developing new business models, and regulation needs to be reduced. For example, Peer-To-Peer lending, is now on ASIC’s radar, and regulatory mechanisms are being developed.
So the report is considering “Developing a comprehensive Government strategy, in consultation with industry, to ensure the regulatory framework supports technological innovation, while managing risks.” One option mooted is to “Establish a central mechanism or body for monitoring and advising Government on technology and innovation. Consider, for example, a public–private sector collaborative body or changing the mandate of an existing body to include technology and innovation”.
Our recent experience is that the currently constituted bodies are populated predominantly with people who live within the current mode of operation in financial services. There is the need to break the mould, and inject innovation into the heart of the financial services environment. This would indeed require a different model of engagement. In addition, the pace of change, as individuals adopt new devices, and smart mobile becomes the norm, this is important, and urgent.
Next time, we will look at some of the other important area.

The draft report was released today. In a layered document, it sets out a series of 28 observations, and possible options for ongoing consideration. The main observations are set out below:

• The banking sector is competitive, albeit concentrated. The application of capital requirements is not competitively neutral. Banks that use internal ratings-based (IRB) risk weights have lower risk weights for mortgage lending than smaller authorised deposit-taking institutions (ADIs) that use standardised risk weights, giving the IRB banks a cost advantage.
• 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.
• 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.
• 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.
• 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 responsibilities 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.
• 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 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.
• Technological developments have the potential to reduce insurance pooling. This will reduce premiums for some consumers; however, others will face increased premiums, or be excluded from access to insurance. Underinsurance may occur for a number of reasons, including: personal choice, behavioural biases, affordability, and lack of adequate information or advice on the level of insurance needed.
• 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 of possible 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, ASIC has a broad mandate, and the civil and administrative penalties available to it are comparatively low in relation to comparable peers internationally.
• To be able to perform their roles effectively in accordance with their legislative mandate, regulators need to be able to attract and retain suitably skilled and experienced staff.
• 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.
• 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.
• 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, including processes for collaboration and consultation about international standard implementation, and mutual recognition and equivalence assessment processes.
• Coordination of Australia’s international financial integration could be improved.

A number of important areas are highlighted, but at this stage its too early to read the potential impact. We are pleased to note that macroprudential measures and lending to smaller businesses are highlighted, as well as the impact of technology. Further consultation is to follow. According to the media release, the closing date for second round submissions is 26 August 2014.