ASIC funding, resources and powers
The FSI has thrown its support behind an industry funding model for ASIC, a recommendation initially made in the 1997 Wallis Inquiry regarding both ASIC and APRA, but only adopted in relation to APRA.
The FSI’s Final Report recommends that Government continue to set ASIC’s overall funding needs, citing Herbert Smith Freehills’ submission to the Inquiry on ASIC funding. This would be done through three-yearly funding reviews, which would bring additional rigour to the budget process, and improve the efficiency of the regulator.
The Final Report identifies the main benefit of industry funding as the potential to give ASIC more predictable funding, as well as to strengthen engagement between ASIC and the industry on the costs of conduct and market regulation.
The FSI recognises that effective regulation depends on effective human capital, and that more effective regulators are likely to require higher salaries. To facilitate this, the Final Report proposes that ASIC staff are removed from the Public Service Act, and that ASIC and APRA are able to opt out of public sector-wide employment, staffing, and other whole-of-Government policies and procedures that unnecessarily constrain their flexibility to deliver their regulatory mandate.
No doubt this will be music to ASIC’s ears.
The FSI has also heeded ASIC’s call for increased civil and criminal penalties, and for power to seek disgorgement of profits earned as a result of conduct in breach of the Corporations Act. This call was set out in ASIC’s Report 387 – Penalties for corporate wrongdoing.
However, the FSI’s Final Report has not dealt ASIC all the aces. It has also recommended establishing a new Financial Regulator Assessment Board (to replace the existing Financial Sector Advisory Council) which would provide the Government with an annual review of the performance of the financial regulators – ASIC, APRA and the payment system regulation function of the RBA.
The FSI notes that Parliamentary scrutiny tends to be episodic and focus on particular issues or decisions.
This annual assessment would be against the regulators’ statutory mandates, and priorities identified in the annual Statements of Intent each publishes to the Government (in response to the Government’s annual Statement of Expectations). The Inquiry has encouraged both the Government and the regulators to make greater use of the SOEs and SOIs, respectively, as instruments of strategic direction, risk tolerance and performance indication. They may also be used to further another recommendation of the Inquiry – that there be a greater focus on competition in the financial system. Regulators could address the effect on competition of their regulatory conduct. The Final Report has also recommended including a specific requirement to take competition issues into account in ASIC’s statutory mandate.
The annual report would be made public once the Government has had an opportunity to consider a response.
The Assessment Board would be comprised of 5-7 part time members with industry and regulatory experience, with diversity of membership to guard against any particular group or industry view having undue influence.
Bank funding, prudential regulation and disclosure
Australia’s prudential standards have been controversially amended to conform to post-GFC international norms, which some have argued are more stringent than those imposed overseas, and the Final Report has addressed this controversy.
While considering that ‘capital levels at Australia’s major banks … are likely to be above the global median but below the top quartile’, the Final Report has recommended bank capital requirements be set at ‘unquestionably strong’ levels in order to:
- make banks less susceptible to extreme but plausible adverse events,
- create a financial system that is more resilient to shocks and less prone to crises,
- protect the government balance sheet from risks in the financial system, to minimise the burden on taxpayers and the costs to government and taxpayers of the perceived ‘implicit guarantee’ of bank liabilities.
- In recommending ‘unquestionably strong’ capital standards, the first recommendation of the entire document, the Final Report has recommended:
- an increase in the minimum capital required to be held by Australian banks to a level reflecting the top quartile of international comparisons, predominantly in the form of increased common equity tier 1 capital,
- the introduction of a leverage ratio ‘that acts as a backstop to authorised deposit-taking institutions’ risk-weighted capital positions’,
- the development of a loss absorbing and recapitalisation framework for ADIs, including the potential development of debt funding incorporating ‘bail in’ features, to reduce the cost of bank failures by establishing a framework through which failed banks may be more readily recapitalised, and
- the development of a template by APRA to enable comparisons between the capital levels under Australian and international Basel frameworks.
The Inquiry has also recommended that internal ratings-based risk weighting of mortgages be increased to narrow the gap between those weightings and the weightings required under the standardised risk weighting approach. Although this narrowing of the gap is ostensibly driven by competition rather than capital adequacy concerns, the alternative of lowering the risk weighting required under the standardised risk weighting approach was not favoured due to its impact on capital adequacy and inconsistency with the minimum standardised weightings required under the Basel III framework.
Lastly, the Final Report recommended the prospective removal of the ability of superannuation funds to engage in direct borrowing for limited recourse borrowing arrangements.
Consumer outcomes for product issuers
The Final Report considered that the current framework is insufficient to deliver fair treatment to consumers (fair treatment being where financial products and services perform in the way that consumers are led to expect) and identified shortcomings in disclosure and financial advice as being the most significant problems.
The Final Report noted that mandated disclosure is not, of itself, sufficient to allow consumers to make informed decisions and made a number of recommendations, many of which are designed to increase the accountability of issuers and distributors:
Expanding issuers’ and distributors’ accountability and introducing a product intervention power.
- More issuer and distributor accountability: The Final Report recommended that, to promote positive consumer outcomes, product issuers and distributors should take greater responsibility for the design and targeted distribution of products. This was on the basis that this should strengthen consumer confidence and trust in the system and reduce the extent to which consumer behavioural biases and information imbalances are disregarded.
The Final Report recommends the introduction of ‘a principles-based product design and distribution obligation’, which would require product issuers and distributors to consider a range of factors when designing products and distribution strategies. While FOFA has made significant changes to providing personal advice, the Final Report suggests that more is done in the product design phase, particularly for complex products. Existing controls can be scaled up as appropriate for the new standard.
Importantly for issuers, the Final Report did not recommend the introduction of individual appropriateness tests at the point of sale for complex products (an option proposed in the Interim Report and being implemented in other jurisdictions), recognising the significant cost to business of this option.
- New power for ASIC: The Final Report also recommended a new product intervention power for ASIC to enable ASIC to take a more proactive approach to reduce the risk of significant detriment to consumers.
The suggested power is broad (extending to product banning) but is limited to a temporary intervention of 12 months – although that period could be extended by Government if more time was needed either by industry to change its relevant practices or for Government to implement permanent reform.
Also the new power is to be used as a last resort, where there is a risk of significant detriment to a class of consumer. Policy is expected to be issued to provide guidance on the use of the power. Perhaps to allay any concerns given previous adverse regulatory comments in relation to hybrid securities, the Final Report states specifically that the power is not intended to address pricing problems, where consumers may be paying more than expected for a particular product.
Notwithstanding these limitations and that the Final Report recommends ‘[the] regulator … be held to a high level of accountability for its use’, this power could be used where there is no demonstrated or suspected breach of the law, which is a significant departure from the current law and has the potential to create significant uncertainty for industry. In addition the express limits on the power may prove to be cold comfort to issuers or distributors if in practice it can be used in a manner which makes successful issues of products that ASIC deems undesirable simply impracticable, or the Government readily extends a 12 months ban on the basis of ASIC recommendations.
Given the Final Report’s observations that consumer misunderstanding arises more often with complex products it is reasonable to assume that this power will be used more often in the complex products space.
There is some good news for issuers - the Final Report did not recommend the introduction of default products (one option considered in the Interim Report) or prohibiting the distribution of certain classes of products to retail consumers.
Focusing on the interests of consumers.
The Final Report recommended that, to build confidence and trust, industry participants create a culture that focuses on consumer interests.
This includes a recommendation to give ASIC enhanced powers to ban individuals from financial firm management, increasing minimum competency standards for financial advisers and relabelling general advice.
Facilitating innovative forms of disclosure, including promoting technology use.
The Final Report noted that although the disclosure regime has evolved to reduce complexity over the last decade, consumer behavioural biases and commercial disincentives limit its effectiveness. This observation is consistent with ASIC’s observations about behavioural economics.
The Final Report noted that risk and fee disclosure remains variable and consumer understanding is low and suggested promoting the efficient communication of information to consumers in a way that responds to technological advances and changing consumer preferences.
The Final Report also suggested:
- the removal of ‘regulatory impediments to innovative product disclosure and communication with consumers’, and improvement in ‘the way risk and fees are communicated to consumers’,
- aligning the interests of financial services firms and consumers through an increase in industry standards, improved banning powers, and ensuring remuneration structures in life insurance and stockbroking don’t affect the quality of advice,
- raising ‘competency of financial advice providers’ and the introduction of ‘an enhanced register of advisers’, and
- the renaming of general advice to ‘a more appropriate, consumer-tested term’.
Pleasingly, we note that suggestions made by Herbert Smith Freehills, in submissions responding to the Interim Report, for more innovative ways to make disclosure to consumers (by the better utilisation of technology to ensure that clients are aware of the contents of disclosure documents and for ‘facilitative regulation’ in respect of product disclosure by making electronic disclosure the default position) are reflected in the Final Report.
General advice superannuation and life insurance
The following recommendations apply across all financial services sectors (including superannuation and life insurance) and will, if implemented, have a significant impact:
- the recommendation that there be a targeted and principles-based product design and distribution obligations,
- the recommendation that ASIC have a ‘proactive’ product intervention power, and
- the recommendation that the law be amended to remove regulatory impediments to innovative communication of product disclosure information.
These are discussed elsewhere and are not repeated here other than to note the significant impact on product manufacturers liability if the final recommendation is implemented.
Superannuation and retirement incomes
The Report found that the superannuation system is not operationally efficient due to a lack of strong price-based competition and high costs. Given the size and importance of Australia’s superannuation system, the Report makes a number of recommendations aimed at improving the strength, stability and efficiency of the superannuation system.
Some of these recommendations include:
- in relation to superannuation directors who are not subject to civil and criminal penalties for breaching the best interest duty, considering whether there is a case for aligning the penalties with those that apply to managed investment scheme directors,
- improving governance by requiring that superannuation trustee boards to have a majority of independent directors and aligning the director penalty regime with the regime for managed investment schemes,
- that all employees be able to choose the superannuation fund for their Superannuation Guarantee contributions (thereby removing some of the exceptions for awards and enterprise bargaining agreements),
- delivering better member outcomes by introducing a formal competitive process to allocate default fund members to MySuper products,
- greater use of risk pooling to increase retirement incomes generated from accumulated balances – thereby increasing efficiency by taking advantage of the size of the system and its asset pool. In this regard, the Report recommends removing barriers to new product development, providing retirement income projections on member statements and using ‘behavioural biases’ and trustee pre-selection of products to encourage the use of risk pooling products,
- abolishing new limited recourse borrowing, and
- considering whether to align the earnings tax rate across the accumulation and retirement phases.
The Report notes the importance of aligning commercial incentives with consumer outcomes and makes a number of recommendations aimed at improving consumer confidence in life insurance. These include:
- in relation to the directors of life insurance companies who are not subject to civil and criminal penalties for breaching their duties to policy holders, considering whether there is a case for aligning the penalties with those that apply to managed investment scheme directors,
- requiring that an upfront commission for life insurance advice is not greater than ongoing commissions,
- that money payable under a life insurance policy be unclaimed monies only if it has been ‘inactive’ for 7 years, rather than 3 years, and
- the introduction of a mechanism to facilitate the rationalisation of legacy products (products that have become uneconomic or rendered out of date by changes to market structure) in the life insurance and managed investments sectors, to reduce consumer disadvantage.
There is a strong emphasis placed on improving consumer outcomes in financial advice. The Report notes that consumers may misinterpret the distinction between ‘personal advice’ and ‘general advice’ and place an undue reliance on ‘general advice’, due to the use of the word ‘advice’. Accordingly, the Report recommends renaming ‘general advice’ but does not propose any alternative.
The Report also recommends higher minimum standards for those advising on Tier 1 products, including a relevant tertiary degree, competence in specialised areas such as superannuation (where necessary) and ongoing professional development.
Innovation and technological change
The Murray Report highlights the power and value of data to drive new networks of collaboration and alliances in financial services. New players break down market barriers and disrupt traditional players, in turn generating new rounds of innovation and technological change.
This technological revolution gives rise to many public interest concerns, including the need to ensure the security of data, an increase in cyber security risks, privacy challenges and competition issues. The Murray Report has made key recommendations to assist innovation through facilitative regulation designed to promote appropriate collaboration, and which also implements appropriate security measures to protect consumers.
The diagram below summarizes how technology is disrupting our financial services industry and which also sets out the report’s key innovation recommendations.
Please click here to view the diagram.