Nuncio D’Angelo of Norton Rose Fulbright takes an in-depth look at the Murray Inquiry, which will establish a future for Australia's financial systems.
"The release of the final report will be of great significance for the financial sector as its recommendations have the potential to significantly affect how business is done in and by Australia, as well as the cost of doing business."
By the time you read this, the Financial System Inquiry (or “Murray Inquiry”, named after chair David Murray) will have issued its final report (according to the terms of reference, the final report must be delivered by the end of November 2014). It is not yet clear if it will be publicly available from the date of issue, or if it will first be handed to the treasurer for consideration before wider distribution.
The Murray Inquiry was established in December 2013 by the treasurer of the newly elected conservative government, to review Australia’s financial system in the aftermath of the 2008 global financial crisis (GFC).
An interim report, handed down in July 2014, contained the committee’s preliminary observations following the first round of submissions and consultations – but it made no firm or formal recommendations. Interested parties were invited to make further submissions to be considered for the final report. By the closing date of 26 August 2014, some 6,500 further submissions were received (on top of almost 300 original submissions).
The committee’s final report will be the first detailed examination of the Australian financial system in 17 years (the last project of this kind resulted in the Wallis Report of 1997). Its recommendations will be used to plan for the future of Australia’s financial system. It is expected to provide insight on the best way for Australia to deal with future crises in the banking and financial sectors, as well as significant local and international changes. Australia’s financial regulatory system has been credited as one of the factors which allowed the country to weather the GFC as well as it did; however, it is acknowledged that the system can and should be improved.
Here are the highlights of the interim report and some contextual commentary.
Interim Report – the Committee’s observations
Australia generally has strong, well-regarded regulators, so the status quo is an appropriate starting point for policy discussion. In particular, the committee has not seen evidence that suggests a need to radically reform the way government intervenes in or regulates the financial system. Regulators’ mandates and powers are generally well defined and clear; however, more could be done to emphasise competition matters. In addition, the Australian Securities and Investments Commission (ASIC), the country’s corporate regulator, has a broad mandate, and the civil and administrative penalties available to it are comparatively low in relation to international standards.
Competition and contestability
Australia’s banking sector is competitive, albeit concentrated, and the application of capital requirements is not competitively neutral. Differences in the structure of payment systems have resulted in systems that perform similar functions being regulated differently, which may not be competitively neutral. Regulation of credit card and debit card payment schemes is required to encourage greater competition.
Funding Australia’s economic activity
Access to foreign funding has enabled Australia to sustain higher growth. The risks associated with foreign funding can be mitigated through the prudent supervisory and regulatory regime.
There are structural impediments for small and medium-sized enterprises to access finance. These impediments include information asymmetries, regulation and taxation.
Superannuation efficiency and policy settings
With its regime of compulsory contributions (9 per cent of employees’ personal income), the Australian superannuation framework is a significant part of the financial system – currently worth almost A$2 trillion by some estimates, making it the fourth-largest pool of superannuation assets in the world. However, there is little evidence of strong fee-based competition in the superannuation sector, and operating costs and fees appear high by international standards, indicating that there is scope for greater efficiencies. Further, if allowed to continue, growth in direct leverage by superannuation funds 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.
Consumer outcomes and conduct regulation
Consumers of financial products and services can be subject to information imbalances and behavioural biases that are detrimental to them. The current disclosure regime produces complex and lengthy documents that often do not enhance consumer understanding.
Improving standards of adviser competence and removing the impact of conflicted remuneration can improve the quality of advice. There is consumer demand for lower-cost scaled advice.
Financial services should not be politicised to the extent that the government sets prices, or mandates non-commercial financial decisions, but if there is a compelling need for government intervention it should be limited to balancing efficiency, stability and fairness.
Technology opportunities and risks
Technology is a major driver of efficiency in the financial system. Government and regulators need to balance these benefits against the risks and facilitate innovation through coordinated action, regulatory flexibility and forward-looking mechanisms.
Access to customer information can improve efficiency, competition and empower consumers. However, a shift to an increasingly online environment heightens cybersecurity risks and the need for digital identity solutions.
Coordination of Australia’s international financial integration could be improved. Developments in the region will require government engagement to facilitate integration with Asia. Domestic regulatory processes could be improved to better accommodate international standards.
Norton Rose Fulbright’s observations
Competition and contestability
The committee considers the Australian banking sector to be competitive, despite its high level of concentration. Factors such as the historically low level of net interest margins and record high levels of customer satisfaction demonstrate the competitiveness of our banking sector, notwithstanding recent consolidation in what was an already concentrated market.
The report notes the government’s role in preventing excessive market power and/or abuse of it by increasing market contestability, although recognising the trade-off between competition and stability. This is consistent with current Australian competition policy. The final report is unlikely to recommend any far-reaching reforms to improve market-based competition.
Stability of the financial system
The report looks at the real cost to the economy of a banking crisis. It recommends that the government reduce the need for intervention and, controversially, allow any failure to be dealt with in the way of ordinary companies – with any losses being borne by creditors and shareholders.
The report favourably views the possibility of implementing the following:
• the ability to impose losses on particular classes creditors, including ‘bail-in’ options such as converting creditors’ debt into equity; and
• a means of ensuring that funding is available to systemic institutions allowing them to sustain critical services, including bridging finance or bail-ins to facilitate an orderly wind-down.
Bank capital and funding
There have been calls from some in the market for banks to hold more common equity tier 1 capital to add a further buffer between shareholders and taxpayers in the event of a collapse. The report recognises the difficulty in ascertaining whether additional capital and liquidity requirements will materially affect banks’ pricing or access to local or offshore funding. Elsewhere in the report, it is noted that capital and liquidity arrangements do impose constraints on banks and that this could limit banks’ ability to finance projects and slow the rate of fixed capital formation. The committee observes that the funding mix for banks has changed as “deposits now represent a larger share of bank funding than they did before the [financial] crisis.”
The report notes that the securitisation is a useful part of the competitiveness of Australia’s home loan market and acknowledges the need for some government support. The recovery in the securitisation market and the increased competition among home loan lenders seems to have led the report’s authors to conclude that price correction rather than market failure has caused changes in the RMBS market. Strikingly, there is very little mention of how securitisation techniques could be used in relation to other assets and why that could inject competitiveness and greater funding diversification in those sectors.
While the report acknowledged that the development of the RMBS market in Australia will largely be led by the private sector, the committee believes governments have a key role in initiating structural reforms such as currency and foreign exchange liberalisation and cross-border dialogue.
The committee has asked for further information on the potential impediments to Australia’s integration with financial markets in Asia, how removal of these would benefit the Australian economy and what future government engagement is needed to facilitate this integration. Consistent with comments in the interim report, the final report is likely to recommend further education and engagement, as well as government-led liberalisation measures to assist Australian companies in taking advantage of projected greater RMBS trade and capital inflows.
Corporate funding generally
The report states that financing conditions for small and medium-sized enterprises (or SMEs) could be improved and recognises that “information asymmetries are the most significant structural factor contributing to the higher cost and lower availability of credit for SMEs and can be a barrier to competition.”
According to the report, submissions have suggested that exceptions to the requirement to prepare a prospectus could be broadened or amended (including by increasing the thresholds for the exemptions for low-value capital raisings such as the “20 in 12” exemption). In our view, this would be a positive measure.
Technology and cybersecurity
The report highlights cybersecurity and technology-related fraud as challenges. The committee looks to US and UK examples for fighting cybercrime as options to be considered here.
While financial institutions retain ultimate responsibility for maintaining the security of their own systems, collaboration with the government can help institutions improve their efforts. US-style reforms on fraud in the private sector and consideration of overseas models targeting cybercrime would be welcomed.
The shortcomings of the mandatory financial services disclosure regime is a recurring theme in the report; ASIC’s call for higher penalties, banning orders and more regulatory intrusion into product development and distribution appears to be gaining traction, given the availability of these regulatory tools to overseas regulators.
The report echoes the global trend of encouraging product issuers to use big data and technology to distribute more suitable financial products, improve financial literacy and develop interactive tools to enable financial advisers and consumers to test the suitability of financial products.
The report recognises the need for a “balanced and effective consumer protection framework” in the financial sector due to product complexity, low levels of consumer financial literacy and engagement, and the significant effects of poor decision-making with respect to financial products and investment.
The report also suggests that disclosure as the primary tool of consumer protection has been inadequate. An innovation suggested by the report involves enhancing ASIC’s powers to permit the regulator to intervene in the market to address specific issues with financial products and to periodically review financial services industry sectors to ensure product’s and governance standards are fair to consumers.
The committee was of the view that regulation of credit card and debit card payment systems was required in order to stimulate competition. The committee is clearly referring to the fact that four party schemes, such as MasterCard and Visa, are currently regulated whereas three party schemes, such as American Express and Diners Club, are not regulated. The report noted that the complex structure of retail payment systems, and the level of public interaction with them, has resulted in the sector’s regulation being fragmented and unnecessarily complex.
The report affirms the important role of funds as backers of infrastructure projects and endorses the view that there is no shortage of private sector capital. Our recent experience advising market participants in highly competitive bids for availability-based PPP concessions, privatisations and even secondary equity transfers also supports that view.
Governments could also consider relaxing the change of control restrictions in project agreements, to more easily facilitate secondary equity transfers, particularly for passive financial investors into post-construction phase projects with long-term operations and maintenance services contractually confirmed.
The report notes that Australia has benefited substantially from international financial integration, and also observes that the world’s economic activity is shifting to the Asian region – presenting significant opportunities and challenges for Australia’s financial system. Importantly, the report supports further financial integration but on the proviso that it does not compromise financial stability and conduct in Australia.
The report identifies two issues concerning corporate governance, namely:
the apparent lack of delineation between the roles of the board and senior management, both within financial institutions and by regulators; and
the “diversity of duties” of governing bodies in different parts of the financial industry.
The committee accepts that the role of boards is not operational and appears to be seeking to protect boards’ governance and strategic roles from encroachment. The US Sarbanes-Oxley Act may provide a useful guide as it places some requirements on management in addition to directors.
The release of the final report will be of great significance for the financial sector as its recommendations have the potential to significantly affect how business is done in and by Australia, as well as the cost of doing business. It should also further enhance confidence in the Australian economy and financial system. Of course, the question then is how many of the recommendations are adopted and implemented – and that is as much a question of politics as it is one of economics.