FSI – Page 3 – Digital Finance Analytics (DFA) Blog

FSI – SMSFs Banned From Leveraged Property Investment

The FSI report recommends the removal of the exception to the general prohibition on direct borrowing for limited recourse borrowing arrangements by superannuation funds. This would stop property investments via SMSFs, a growing trend, or shares. Other than this, SMSF’s received an endorsement, as a legitimate savings vehicle for retirement (but not necessarily as a broader wealth generating mechanism).

Government should restore the general prohibition on direct borrowing by superannuation funds by removing Section 67A of the Superannuation Industry (Supervision) Act 1993 (SIS Act) on a prospective basis. This section allows superannuation funds to borrow directly using limited recourse borrowing arrangements (LRBAs). The exception of temporary borrowing by superannuation funds for short-term liquidity management purposes (contained in Section 67 of the SIS Act) should remain. Direct borrowing in this context refers to any arrangement that funds enter into where the borrowing is used to purchase assets directly for the fund.

The rationale for this recommendation is to prevent the unnecessary build-up of risk in the superannuation system and the financial system more broadly and fulfil the objective for superannuation to be a savings vehicle for retirement income, rather than a broader wealth management vehicle

Further growth in superannuation funds’ direct borrowing would, over time, increase risk in the financial system. As discussed in the Interim Report, the Inquiry notes an emerging trend of superannuation funds using LRBAs to purchase assets. Over the past five years, the amount of funds borrowed using LRBAs increased almost 18 times, from $497 million in June 2009 to $8.7 billion in June 2014. The limited recourse nature of these arrangements is intended to alleviate the risk of losses from assets purchased using a loan resulting in claims over other fund assets.

Borrowing, even with LRBAs, magnifies the gains and losses from fluctuations in the prices of assets held in funds and increases the probability of large losses within a fund. Because of the higher risks associated with limited recourse lending, lenders can charge higher interest rates and frequently require personal guarantees from trustees. In a scenario where there has been a significant reduction in the valuation of an asset that was purchased using a loan, trustees are likely to sell other assets of the fund to repay a lender, particularly if a personal guarantee is involved. As a result, LRBAs are generally unlikely to be effective in limiting losses on one asset from flowing through to other assets, either inside or outside the fund. In addition, borrowing by superannuation funds implicitly transfers some of the downside risk to taxpayers, who underwrite adverse outcomes in the superannuation system through the provision of the Age Pension.

Superannuation funds use diversification to reduce risk. Selling the fund’s other assets will concentrate the asset mix of the fund — small funds that borrow are already more likely to have a concentrated asset mix.79 This reduces the benefits of diversification and further increases the amount of risk in the fund’s portfolio of assets.

The GFC highlighted the benefits of Australia’s largely unleveraged superannuation system. The absence of leverage in superannuation funds meant that rapid falls in asset prices and losses in funds were neither amplified nor forced to be realised. The absence of borrowing benefited superannuation fund members and enabled the superannuation system to have a stabilising influence on the broader financial system and the economy during the GFC. Although the level of borrowing is currently relatively small, if direct borrowing by funds continues to grow at high rates, it could, over time, pose a risk to the financial system. The RBA states that “The Bank endorses the observation that leverage by superannuation funds may increase vulnerabilities in the financial system and supports the consideration of limiting leverage”. In addition, such direct borrowing could also compromise the retirement incomes of individuals. APRA was of the view that “… the risks associated with direct leverage are incompatible with the objectives of superannuation and cannot adequately be managed within the superannuation prudential framework”. Borrowing by superannuation funds also allows members to circumvent contribution caps and accrue larger assets in the superannuation system in the long run

Direct borrowing by superannuation funds could pose risks to the financial system if it is allowed to grow at high rates. It is also inconsistent with the objectives of superannuation to be a savings vehicle for retirement income. Restoring the original prohibition on direct borrowing by superannuation funds would preserve the strengths and benefits the superannuation system has delivered to individuals, the financial system and the economy, and limit the risks to taxpayers.

Many submissions support this recommendation. Some propose alternatives to address the risks surrounding borrowing, including imposing a maximum cap on fund assets that can be invested in a single asset other than cash or bonds. These alternatives would limit the risk associated with borrowing by superannuation funds, and provide funds with more flexibility to pursue alternative investment strategies. However, these options would also impose additional regulation, complexity and compliance costs on the superannuation system.

In implementing this recommendation, funds with existing borrowings should be permitted to maintain those borrowings. Funds disposing of assets purchased via direct borrowing would be required to extinguish the associated debt at the same time.

FSI – SME’s Little To Cheer About

Continuing our analysis of the FSI Report, we have been looking at comments and recommendations relating to SME’s. Australia’s SME’s are a critical though undervalued sector of the economy, accounting for some 3 million business, and 5 million jobs. We hoped there would be substantial focus on initiatives to kick-start this sector (given the growth mandate in the terms of reference), but we were largely disappointed. The Inquiry has noted that SMEs have few options for external financing outside the banking system compared with large corporations. In part, this reflects unnecessary distortions, such as information imbalances and regulatory barriers to market-based funding . But the key SME-related recommendations are collected in an appendix and are not really convincing.

A number of the Inquiry’s recommendations are designed to reduce structural impediments to SMEs’ access to finance. Such impediments include information imbalances between lenders and borrowers, and barriers to market-based funding. Other recommendations would help reduce costs for SMEs and support innovation.

The Inquiry encourages industry to expand data sharing under the new voluntary comprehensive credit reporting (CCR) regime. More comprehensive credit reporting would reduce information imbalances between lenders and borrowers, facilitate competition between lenders, and improve credit conditions for SMEs. Although CCR relates to individuals’ data, personal credit history is a major factor in credit providers’ decisions to lend to new business ventures and small firms.

The Inquiry supports a facilitative regulatory regime for crowdfunding, while recognising the risks involved. A well-developed crowdfunding sector would give SMEs more funding options and increase competition in SME financing. The Inquiry supports Government’s current process to graduate fundraising regulation to facilitate securities-based crowdfunding. Government should use these policy settings as a basis to assess whether broader fundraising and lending regulation could be graduated to facilitate other forms of crowdfunding, including peer-to-peer lending.

Information imbalances, among other factors, have led to numerous and onerous non-monetary terms in some lending contracts. The Inquiry supports Government’s current process for extending consumer protections for unfair terms in standard contracts to small businesses. Although such protections would not prevent unfair terms in non-standard contracts, the Inquiry believes this approach may improve broader contracting practices. The Inquiry also encourages the banking industry to adjust its codes of practice, to require banks to give borrowers sufficient notice of an intention to enforce contract terms and give borrowers time to source alternative financing.

Recommendations to reform the payments system would benefit SMEs. The Inquiry’s proposals to lower interchange fee caps would reduce the fees paid by all businesses and reduce the difference in fees paid by small and large businesses. As technology evolves, greater access to data and innovations in data use are likely to benefit all businesses, particularly SMEs. For example, more extensive access to quality datasets would improve business decision making. Globally, payment providers are developing new ways to assess SMEs’ creditworthiness and extend credit to SMEs. The Inquiry recommends that the Productivity Commission review how data could be used more effectively, taking into account privacy considerations.

The Inquiry considers that financial system innovators which challenge the existing regulatory structure should have better access to Government, and that Government and regulators should have greater awareness and understanding of financial system innovation. This would enable timely and coordinated policy and regulatory responses to innovation. The Inquiry recommends that Government establish a permanent public–private sector collaborative committee, the ‘Innovation Collaboration’, consisting of senior industry, Government, regulatory, academic and consumer representatives.

Better targeted tax settings for start-ups and innovative firms would facilitate innovation. Simplifying the tax rules for Venture Capital Limited Partnerships, and streamlining Government administration of the regime, would reduce barriers to fundraising. More flexible access to research and development tax offsets could help reduce firms’ cash flow constraints, particularly for new ventures. These issues should be considered as part of the Tax White Paper process.

We are disappointing that there is no commentary on the relative capital buffers for mortgages compared with SME lending. There was an opportunity to recommend a tweak, so make SME lending more attractive relative to mortgage lending. Currently many SME’s have real issues getting funding, as highlighted in our recent SME report. The FSI acknowledges “particular sectors of the economy, such as small and medium-sized enterprises (SMEs) or rural businesses, do not have sufficient access to funding” but have not addressed this concern.

FSI – On Financial Advice

The FSI report discusses the alignment of consumer outcomes and financial advice firms, questions “general financial advice” and adviser qualification. The report recommends that the term “general advice” be changed to better reflect what is intended and that the financial adviser or mortgage broker should be required to clearly explain their association with the product issuer. In addition, advisers should be better qualified and cultural misalignment addressed.

The GFC brought to light significant numbers of Australian consumers holding financial products that did not suit their needs and circumstances — in some cases resulting in severe financial loss. Previous collapses involving poor advice, information imbalances and exploitation of consumer behavioural biases have affected more than 80,000 consumers, with losses totalling more than $5 billion, or $4 billion after compensation and liquidator recoveries. The changes outlined in this report should also significantly improve consumer confidence and trust in the financial system.The most significant problems related to shortcomings in disclosure and financial advice, and over-reliance on financial literacy. The changes introduced under the Future of Financial Advice (FOFA) reforms are likely to address some of these shortcomings; however, many products are directly distributed, and issues of adviser competency remain.

The current regulatory framework addresses advice on financial products. The framework makes an important distinction between personal and general advice:
• Personal advice takes account of a person’s needs, objectives or personal circumstances, whereas general advice does not.
• General advice includes guidance, advertising, and promotional and sales material highlighting the potential benefits of financial products. It comes with a disclaimer stating that it does not take a consumer’s personal circumstances into account.

However, consumers may misinterpret or excessively rely on guidance, advertising, and promotional and sales material when it is described as ‘general advice’. The use of the word ‘advice’ may cause consumers to believe the information is tailored to their needs. Behavioural economics literature and ASIC’s financial literacy and consumer research suggests that terminology affects consumer understanding and perceptions. Often consumers do not understand their financial adviser’s or mortgage broker’s association with product issuers. This association might limit the product range an adviser or broker can recommend from. Of recently surveyed consumers, 55 per cent of those receiving financial advice from an entity owned by a large financial institution (but operating under a different brand name) thought the entity was independent.

The Inquiry believes greater transparency regarding the nature of advice and the ownership of advisers would help to build confidence and trust in the financial advice sector. In particular, ‘general advice’ should be replaced with a more appropriate, consumer-tested term to help reduce consumer misinterpretation and excessive reliance on this type of information. Consumer testing will generate some costs for Government, and relabelling will generate transitional costs for industry — although these are expected to be small. The Inquiry believes the benefits to consumers from clearer distinction and the reduced need for warnings outweigh these costs.

Although stakeholders have provided little evidence of differences in the quality of advice from independent or aligned and vertically integrated firms, the Inquiry sees the value to consumers in making ownership and alignment more transparent. In particular, these disclosures should be broader than Financial Services Guide and Credit Guide rules currently require, and could include branded documents or materials. The Inquiry believes the benefits to consumers would outweigh the transitional costs to industry of effecting branding changes.

In addition, the report highlights the need to raise the competency of financial advice providers, and introduce a register of advisers. The register was announced recently but we argued it was not alone sufficient.

The Interim Report observed that affordable, quality financial advice can bring significant benefits for consumers. However, according to the Parliamentary Joint Committee on Corporations and Financial Services (PJCCFS), “the major criticism of the current system is that licensees’ minimum training standards for advisers are too low, particularly given the complexity of many financial products”. This affects confidence and trust in the sector and can prevent consumers from seeking financial advice.
A number of high-profile cases where consumers have suffered significant detriment through receiving poor advice, and a series of ASIC studies, have revealed issues with the quality of advice. For example, ASIC’s report on retirement advice found that only 3 per cent of Statements of Advice were labelled ‘good’, 39 per cent were ‘poor’ and the remaining 58 per cent ‘adequate’. Although these cases and many of these studies occurred before the FOFA reforms to improve remuneration structures, this is not the only issue. Adviser competence has also been a factor in poor consumer outcomes. ASIC’s review of advice on retail structured products found insufficient evidence of a reasonable basis for the advice in approximately half of the files.

Under the current framework, ASIC guidance sets out the minimum knowledge, skills and education for people who provide financial advice to comply with the Corporations Act 2001 and licence conditions. The training standards vary depending on whether the adviser is dealing with Tier 1 or Tier 2 financial products. As a minimum, current education standards are broadly equivalent to a Diploma under the Australian Qualifications Framework for Tier 1 products, and to a Certificate III for Tier 2 products.

Register of advisers
As the PJCCFS stated, “the licensing system does not currently provide a distinction between advisers on the basis of their qualifications, which is unhelpful for consumers when choosing a financial adviser”. ASIC currently has a public record of financial advice licensees and is notified of authorised representatives. However, ASIC has little visibility of employee advisers, or access to the type of information that an enhanced register could hold, such as length of experience and employment history. ASIC argues that transparency about advisers through an enhanced register is an important piece missing from the regulatory framework. Most stakeholders support introducing such an enhanced register.

Conclusion
The benefits of improving the quality of advice are significant. To achieve this, the Inquiry believes that minimum competency standards should be increased and the current Government process to review these standards should be prioritised.
In advance of the completion of the Government process, some adviser firms have recently announced they are increasing their own qualification requirements. However, low minimum competency standards have been a feature of the industry for a substantial length of time, and change is needed across the board. Many stakeholders are highly concerned about the low minimum education standards of financial advisers, with most supporting lifting education requirements to degree level.

Internationally, Singapore and the United Kingdom are seeking to raise minimum competency standards. The Inquiry is of the view that Australia should set high standards in comparison with peer jurisdictions. Although the Inquiry does not recommend a national exam for advisers, this could be considered if issues in adviser competency persist. For individual advisers and firms, the cost of undertaking further and ongoing education would be significant. However, this is a necessary transition to move towards higher standards of competence and would deliver long-term benefits for consumers. The cost would be mitigated by an appropriate transition period. Raising the minimum competency standards may increase the cost of advice for consumers. However, various cost effective market developments are emerging, such as scaled or limited advice and using technology to deliver advice.61 The Inquiry encourages advisers to develop new models for delivering advice more cost effectively to sit alongside existing comprehensive face-to-face advice models.

The requirement for higher education standards may cause some existing advisers to exit the industry and may deter some from entering, potentially causing an ‘advice gap’ for some consumers. Transitional arrangements to give advisers appropriate time to upgrade their qualifications would help manage this risk. Raising standards would also increase confidence and trust in the industry, encouraging more individuals to choose financial advisory services as a career path, and increasing the supply of financial advisers.

The Inquiry has not made a recommendation in relation to mortgage brokers. However, it considers that ASIC should continue to monitor consumer outcomes in this area and the performance of the industry in relation to its obligations under the National Consumer Credit Protection Act 2009. In relation to the register of advisers, the Inquiry supports the establishment of the enhanced register to facilitate consumer access to information about financial advisers’ experience and qualifications and improve transparency and competition. Further consideration could be given to adding other fields, such as determinations by the FOS.62 The register should be designed to take account of possible future developments in automated advice and record the entity responsible for providing such services.

At the heart of the matter is the question of aligning the interests of financial firms and consumers. This is a question of culture.

Recent cases of poor financial services provision raise serious concerns with the culture of firms and their apparent lack of customer focus. Research in 2009 suggested that financial firms may not be implementing systems and procedures within their organisations that promote ethical culture and integrate governance, risk management and compliance frameworks. In 2011–12, approximately 94 per cent of ASIC’s banning orders involved significant integrity issues, where the alleged conduct would breach professional and ethical standards and/or the conduct provisions in the Corporations Act 2001. The remaining 6 per cent of cases involved competency issues. The Inquiry considers that cases of consumer detriment and poor advice reflect organisational cultures that do not focus on consumer interests. Such cultures promote short-term commercial outcomes over longer-term customer relationships. This has contributed to a lack of consumer confidence and trust in the system. In research undertaken by Roy Morgan, only 28 per cent of participants gave financial planners ‘high’ or ‘very high’ ratings for ethics and honesty, and trust in bank managers was held by just 43 per cent of participants. In addition, ASIC found only 33 per cent of stakeholders agreed that financial firms operate with integrity.

Banning power
ASIC has observed phoenix activity in financial firms, where senior people from a financial firm with poor operating practices may establish a new business or move to an alternative firm. Currently, ASIC can prevent a person from providing financial services, but cannot prevent them from managing a financial firm. Nor can ASIC remove individuals involved in managing a firm that may have a culture of non-compliance.

Conclusion
To build confidence and trust in the financial system, financial firms need to be seen to act with greater integrity and accountability. The Inquiry believes changes are required not only to the regulatory regime and supervisory approach, but also to the culture and conduct of financial firms’ management, which needs to focus on consumer interests and outcomes. A change in culture in line with community expectations should promote confidence and trust in the financial system and limit the need for more significant regulation. Raising standards of conduct and levels of professionalism would require both a coordinated industry approach and focus of attention by individual firms. Industry associations could lead this initiative, with stakeholder input from ASIC and consumer organisations. Introducing or enhancing individual firm or industry codes of conduct is one way in which industry could set raised standards and hold themselves accountable. An enhanced banning power should improve professional behaviour, management accountability and the culture of firms, by removing certain individuals from the industry and preventing them from managing a financial firm. This should also include individuals who are licence holders or authorised representatives, or managers of a credit licensee. It should prevent those operating under an Australian Financial Services Licence from moving to operate under a credit licence and vice versa.

The Inquiry notes the FOFA ban on conflicted remuneration and associated measures are relatively new and should bring significant change to the industry and benefits for consumers. However, some incentive-based remuneration models remain, including grandfathered arrangements and other specific exclusions. The Inquiry believes that these instances of conflicted remuneration should be monitored, and Government should intervene if further significant issues are observed. Specific attention is required in the stockbroking sector in the immediate future. Unlike in the life insurance industry, a recent review of practices in stockbroking has not been undertaken. The Inquiry considers that ASIC should review current remuneration practices in stockbroking and advise Government on whether action is needed. The Inquiry believes that better aligning the interests of financial firms with consumer interests, combined with stronger and better resourced regulators with access to higher penalties, should lead to better consumer outcomes.

Given the current state of FOFA, there is an opportunity to get this reform on the right footing based on the recommendations. Most importantly, we believe product sales should be clearly separated from advice. Advice should separated from commissions and payments. Product sales can continue, but separate from advice. We agree that General Advice is not a helpful term.

FSI – Lift Capital Buffers

In today’s FSI report, there is a strong focus on the capital buffers which banks need to hold. We had expected this development.

Australia’s banking system is highly concentrated, with the four major banks using broadly similar business models and having large offshore funding exposures. This concentration exposes each individual bank to similar risks, such that all the major Australian banks may come under financial stress in similar economic and financial circumstances.

Australia’s banks are heavily exposed to developments in the housing market. Since 1997, banks have allocated a greater proportion of their loan books to mortgages, and households’ mortgage indebtedness has risen. A sharp fall in dwelling prices would damage household balance sheets and weigh on consumption and broader economic growth. It would also reduce the quality of the banking sector’s balance sheets and the capacity of banks to extend new credit, which would compromise the speed of a subsequent economic recovery.

A severe disruption via one of these channels would have broad economic and financial consequences for Australia. Indeed, interconnectedness within the financial system and the economy would be likely to propagate distress and heighten other risks and vulnerabilities. Even a modest banking crisis could cost 900,000 jobs.

Whilst Australian banks have strong capital structures, they are not in the top quartile of large internationally active banks. The report highlighted that the top quartile level was increasing as other banks “caught up” and on latest levels the average 9.1 per cent capital levels of the Australian banks was below the median of 10.5 per cent and below the 12.2 per cent required to get into the top quartile. Current global initiatives will raise this further. The FSI said any increases in capital should take the form of common equity capital.

This statement effectively rejects the claims of some submissions arguing the banks were already in top quartile position! The Inquiry believes that top-quartile positioning is the right setting for Australian ADIs.

“ADIs should maintain sufficient loss absorbing and recapitalisation capacity to allow effective resolution while mitigating the risk to taxpayer funds — in line with emerging international practice”

This would require the raising of considerable extra capital, and impact bank profitability and product pricing. Drawing on multiple sources of evidence, the Inquiry calculates that raising capital ratios by one percentage point would, absent the benefits of competition, increase average loan interest rates by less than 10 basis points which could reduce GDP by 0.01-0.1 per cent.

In addition those banks who use the advanced IRB capital calculations should expect their ratios to be lifted higher, reducing the competitive advantage they have experienced recently. The major banks, using their “advanced” modelling systems, can set aside less capital against home loans by generating risk-weights of 18 per cent, compared to 39 per cent for small banks like Suncorp and Bank of Queensland. The recommendation is the major banks should increase their average risk weight to between 25 to 30 per cent. This translates to a one percentage point increase in major bank’s common equity Tier I levels from currency levels. The higher funding costs would be born by shareholders and consumers. As a result, as well as products costing more, we expect this to translate into a more level playing field, allowing players on standard capital ratios to compete more strongly.

A final point. The report recommended an additional ratio measure, banks are subject to a minimum of 3 per cent to 5 per cent “leverage ratio”. This ratio would be something like true value of their equity capital divided by the value of their assets. This ratio should never fall below this level. While the majors would currently not be compliant, if they adjusted their capital as recommended by 1-2 per cent, then they would be compliant with this leverage ratio. This approach nicely skirts around the “risk weighted assets” as calculated by Basel.

For background on capital, you can read my earlier posts.

FSI Report Out

The final FSI report is out, a 350 page document making 44 core recommendations. They received over 6.800 submissions and met more than 50 financial institutions as part of international consultations.

“Australia’s financial system has performed well since the Wallis Inquiry and has many strong characteristics. It also has a number of weaknesses: taxation and regulatory settings distort the flow of funding to the real economy; it remains susceptible to financial shocks; superannuation is not delivering retirement incomes efficiently; unfair consumer outcomes remain prevalent; and policy settings do not focus on the benefits of competition and innovation. As a result, the system is prone to calls for more regulation”.

The Inquiry has made recommendations on five specific themes:
• Strengthen the economy by making the financial system more resilient.
• Lift the value of the superannuation system and retirement incomes.
• Drive economic growth and productivity through settings that promote innovation.
• Enhance confidence and trust by creating an environment in which financial firms treat customers fairly.
• Enhance regulator independence and accountability, and minimise the need for future regulation.

Although the Inquiry considers competition is generally adequate, the high concentration and increasing vertical integration in some parts of the Australian financial system has the potential to limit the benefits of competition in the future and should be proactively monitored over time. The Inquiry’s approach to encouraging competition is to seek to remove impediments to its development. The Inquiry has made recommendations to amend the regulatory system, including: narrowing the differences in risk weights in mortgage lending; considering a competitive mechanism to allocate members to more efficient superannuation funds; and ensuring regulators are more sensitive to the effects of their decisions on competition, international competitiveness and the free flow of capital.

Here is the summary of recommendations by chapter. More commentary to follow, but much is in line with expectations. We are pleased to see comments on “Rename ‘general advice’ and require advisers and mortgage brokers to disclose ownership structures”.

Chapter 1 Resilience.

The Inquiry’s recommendations to improve resilience aim to: 1. Strengthen policy settings that lower the probability of failure, including setting Australian bank capital ratios such that they are unquestionably strong by being in the top quartile of internationally active banks. 2 Reduce the costs of failure, including by ensuring authorised deposit-taking institutions maintain sufficient loss absorbing and recapitalisation capacity to allow effective resolution with limited risk to taxpayer funds — in line with international practice.

Set capital standards such that Australian authorised deposit-taking institution capital ratios are unquestionably strong.
Raise the average internal ratings-based (IRB) mortgage risk weight to narrow the difference between average mortgage risk weights for authorised deposit-taking institutions using IRB risk-weight models and those using standardised risk weights.
Implement a framework for minimum loss absorbing and recapitalisation capacity in line with emerging international practice, sufficient to facilitate the orderly resolution of Australian authorised deposit-taking institutions and minimise taxpayer support.
Develop a reporting template for Australian authorised deposit-taking institution capital ratios that is transparent against the minimum Basel capital framework.
Complete the existing processes for strengthening crisis management powers that have been on hold pending the outcome of the Inquiry.
Maintain the ex post funding structure of the Financial Claims Scheme for authorised deposit-taking institutions.
Introduce a leverage ratio that acts as a backstop to authorised deposit-taking institutions’ risk-weighted capital positions.
Remove the exception to the general prohibition on direct borrowing for limited recourse borrowing arrangements by superannuation funds.

Chapter 2: Superannuation and retirement incomes

The Inquiry’s recommendations to strengthen the superannuation system aim to: 1. Set a clear objective for the superannuation system to provide income in retirement. 2. Improve long-term net returns for members by introducing a formal competitive process to allocate new workforce entrants to high-performing superannuation funds, unless the Stronger Super reforms prove effective. 3 Meet the needs of retirees better by requiring superannuation trustees to pre-select a comprehensive income product in retirement for members to receive their benefits, unless members choose to take their benefits in another way.

Seek broad political agreement for, and enshrine in legislation, the objectives of the superannuation system and report publicly on how policy proposals are consistent with achieving these objectives over the long term.
Introduce a formal competitive process to allocate new default fund members to MySuper products, unless a review by 2020 concludes that the Stronger Super reforms have been effective in significantly improving competition and efficiency in the superannuation system.
Require superannuation trustees to pre-select a comprehensive income product for members’ retirement. The product would commence on the member’s instruction, or the member may choose to take their benefits in another way. Impediments to product development should be removed.
Provide all employees with the ability to choose the fund into which their Superannuation Guarantee contributions are paid.
Mandate a majority of independent directors on the board of corporate trustees of public offer superannuation funds, including an independent chair; align the director penalty regime with managed investment schemes; and strengthen the conflict of interest requirements.

Chapter 3: Innovation

The Inquiry’s recommendations to facilitate innovation aim to: 1 Encourage industry and government to work together to identify innovation opportunities and emerging network benefits where government may need to facilitate industry coordination and action. 2. Strengthen Australia’s digital identity framework through the development of a national strategy for a federated-style model of trusted digital identities. 3. Remove unnecessary regulatory impediments to innovation, particularly in the payments system and in fundraising for small businesses. 4. Enable the development of data-driven business models through holding a Productivity Commission Inquiry into the costs and benefits of increasing access to and improving the use of private and public sector data.

Establish a permanent public–private sector collaborative committee, the ‘Innovation Collaboration’, to facilitate financial system innovation and enable timely and coordinated policy and regulatory responses.
Develop a national strategy for a federated-style model of trusted digital identities.
Enhance graduation of retail payments regulation by clarifying thresholds for regulation by the Australian Securities and Investments Commission and the Australian Prudential Regulation Authority.
Strengthen consumer protection by mandating the ePayments Code. Introduce a separate prudential regime with two tiers for purchased payment facilities.
Improve interchange fee regulation by clarifying thresholds for when they apply, broadening the range of fees and payments they apply to, and lowering interchange fees.
Improve surcharging regulation by expanding its application and ensuring customers using lower-cost payment methods cannot be over-surcharged by allowing more prescriptive limits on surcharging.
Graduate fundraising regulation to facilitate crowdfunding for both debt and equity and, over time, other forms of financing.
Review the costs and benefits of increasing access to and improving the use of data, taking into account community concerns about appropriate privacy protections.
Support industry efforts to expand credit data sharing under the new voluntary comprehensive credit reporting regime. If, over time, participation is inadequate, Government should consider legislating mandatory participation.

Chapter 4: Consumer outcomes

The Inquiry’s recommendations to improve consumer outcomes aim to: 1. Improve the design and distribution of financial products through strengthening product issuer and distributor accountability, and through implementing a new temporary product intervention power for the Australian Securities and Investments Commission (ASIC). 2. Further align the interests of firms and consumers, and improve standards of financial advice, by lifting competency and increasing transparency regarding financial advice. 3. Empower consumers by encouraging industry to harness technology and develop more innovative and useful forms of disclosure.

Introduce a targeted and principles-based product design and distribution obligation.
Introduce a proactive product intervention power that would enhance the regulatory toolkit available where there is risk of significant consumer detriment.
Remove regulatory impediments to innovative product disclosure and communication with consumers, and improve the way risk and fees are communicated to consumers.
Better align the interests of financial firms with those of consumers by raising industry standards, enhancing the power to ban individuals from management and ensuring remuneration structures in life insurance and stockbroking do not affect the quality of financial advice.
Raise the competency of financial advice providers and introduce an enhanced register of advisers.
Improve guidance (including tools and calculators) and disclosure for general insurance, especially in relation to home insurance.

Chapter 5: Regulatory system

The Inquiry’s recommendations to refine Australia’s regulatory system and keep it fit for purpose aim to: 1. Improve the accountability framework governing Australia’s financial sector regulators by establishing a new Financial Regulator Assessment Board to review their performance annually. 2. Ensure Australia’s regulators have the funding, skills and regulatory tools to deliver their mandates effectively. 3. Rebalance the regulatory focus towards competition by including an explicit requirement to consider competition in ASIC’s mandate and conduct three-yearly external reviews of the state of competition. 4. Improve the process for implementing new financial regulations.

Create a new Financial Regulator Assessment Board to advise Government annually on how financial regulators have implemented their mandates. Provide clearer guidance to regulators in Statements of Expectation and increase the use of performance indicators for regulator performance.
Provide regulators with more stable funding by adopting a three-year funding model based on periodic funding reviews, increase their capacity to pay competitive remuneration, boost flexibility in respect of staffing and funding, and require them to undertake periodic capability reviews.
Introduce an industry funding model for the Australian Securities and Investments Commission (ASIC) and provide ASIC with stronger regulatory tools.
Review the state of competition in the sector every three years, improve reporting of how regulators balance competition against their core objectives, identify barriers to cross-border provision of financial services and include consideration of competition in the Australian Securities and Investments Commission’s mandate.
Increase the time available for industry to implement complex regulatory change.
Conduct post-implementation reviews of major regulatory changes more frequently.

Appendix 1: Significant matters

Explore ways to facilitate development of the impact investment market and encourage innovation in funding social service delivery. Provide guidance to superannuation trustees on the appropriateness of impact investment. Support law reform to classify a private ancillary fund as a ‘sophisticated’ or ‘professional’ investor, where the founder of the fund meets those definitions.
Reduce disclosure requirements for large listed corporates issuing ‘simple’ bonds and encourage industry to develop standard terms for ‘simple’ bonds.
Support Government’s process to extend unfair contract term protections to small businesses. Encourage industry to develop standards on the use of non-monetary default covenants.
Clearly differentiate the investment products that finance companies and similar entities offer retail consumers from authorised deposit-taking institution deposits.
Consult on possible amendments to the external administration regime to provide additional flexibility for businesses in financial difficulty.
Publish retirement income projections on member statements from defined contribution superannuation schemes using Australian Securities and Investments Commission (ASIC) regulatory guidance. Facilitate access to consolidated superannuation information from the Australian Taxation Office to use with ASIC’s and superannuation funds’ retirement income projection calculators.
Update the 2009 Cyber Security Strategy to reflect changes in the threat environment, improve cohesion in policy implementation, and progress public–private sector and cross-industry collaboration. Establish a formal framework for cyber security information sharing and response to cyber threats.
Identify, in consultation with the financial sector, and amend priority areas of regulation to be technology neutral. Embed consideration of the principle of technology neutrality into development processes for future regulation. Ensure regulation allows individuals to select alternative methods to access services to maintain fair treatment for all consumer segments.
Rename ‘general advice’ and require advisers and mortgage brokers to disclose ownership structures.
Define bank accounts and life insurance policies as unclaimed monies only if they are inactive for seven years.
Support Government’s review of the Corporations and Markets Advisory Committee’s recommendations on managed investment schemes, giving priority to matters relating to:
• Consumer detriment, including illiquid schemes and freezing of funds.
• Regulatory architecture impeding cross-border transactions and mutual recognition arrangements.
Introduce a mechanism to facilitate the rationalisation of legacy products in the life insurance and managed investments sectors.
Remove market ownership restrictions from the Corporations Act 2001 once the current reforms to cross-border regulation of financial market infrastructure are complete.

The Treasurer was at pains to point out this is a report to Government, for their consideration, not a Government report, allowing substantial wiggle room if required.

FSI Countdown

Sunday is D-day for the FSI inquiry. The Financial System Inquiry will establish a direction for the future of Australia’s financial system. The Inquiry will lay out a ‘blueprint’ for the financial system over the next decade. So in preparation, its worth reflecting on how we got to this point. The earlier Campbell inquiry in 1981 was all about the entry of foreign banks into Australia, deregulation of the financial system and the floating of the Australian dollar. In 1997, the Wallis Inquiry, changed the regulatory environment with APRA looking after prudential regulation and ASIC for consumer protection and business conduct.

Since then the world has changed, with significant industry consolidation, globalisation, the growth of superannuation, new payment systems, and a massive swing towards mortgage lending. In addition the regulatory focus has been on financial system stability, which stood Australia in good stead through the GFC. However, banks are holding less capital today than before the GFC and internationally there is a focus on banks being too big to fail leading to a requirement for new more onerous capital requirements. In Australia we have a cadre of very profitable banks at a competitive advantage to the rest of the market. As a result, it could be argued that consumers and small business customers are not getting the products and services they should, and whilst the banks have inflated their balance sheets with mortgage lending, its not economically productive.

In additional the fast emerging digital landscape has to potential to disrupt products and services across a wide spectrum.

So, the current review was tasked with considering a wide range of issues, including how Australia should funds its growth, local and international competitiveness and the availability of financial services products and capital for users at the right price, quality and safety.

A review panel oversaw the inquiry. It was chaired by the former Commonwealth Bank of Australia chief executive David Murray. He was the inaugural chairman of the Australian government Future Fund board of guardians between 2006 and 2012. Other members include Professor Kevin Davis, Craig Dunn, Carolyn Hewson and Dr Brian McNamee.

There were a vast number of submissions to the inquiry. Many incumbents argued for little change, the regulators pointed to the financial stability exhibited through the GFC (and argued for more regulatory funding), whilst others were more critical, and advocated significant structural change. There is a complex set of interactions in the financial services sector, and many opinions.

In the interim report a number of key issues surfaced. For example, the major banks exposures to the mortgage market could create risks in terms of financial stability in a housing downturn. The recent APRA stress tests made the same point. The big four have significant advantages over smaller players. There were important discussions about the question of banks being too big to fail (meaning they would require public money to bail them out in a down turn). The report also looked at the payments system and the role of emerging technology and superannuation and financial advice were also discussed.

So what might be on the agenda of the final report? Here is my shortlist (against which I will be checking the released documents later).

Capital buffers to be raised to reduce the competitive gradient between larger and small banks, and adjusted also for investment housing lending
Competition rules to be tweaked to reduce the too big to fail problem (probably too hard to break up the existing large integrated financial services players) and to encourage new players
Reduction or removal of credit card surcharging
Changes to financial advice regulation
Leverage rules for Self Managed Super Funds to be trimmed back
Opening up of the payments systems
Use of superannuation funds to more directly power growth
Incentives for lending to SME’s
Changes to the regulatory environment, with a stronger emphasis on consumer protection, to balance financial stability

It is likely that the recommendations contained in the report will go through further iteration before they are implemented. We shall see.