Key Points:

The Financial System Inquiry says the Australian financial system is operating effectively and not requiring broad systemic change, but has identified some areas needing more attention, particularly capital adequacy and superannuation.

After seven months of deliberations and considering submissions, the Report has identified a series of challenges which the Australian financial sector will need to confront in the future in order to grow, remain productive and continue to meet the Australian public's needs in the wake of a changing financial climate, the Commonwealth Government's Financial System Inquiry (FSI), chaired by former Commonwealth Bank chief executive David Murray, has released its Interim Report.

The FSI was set up in 2013 as part of the Commonwealth Government's deregulation agenda and was asked to report on four key considerations:

  • the efficient allocation of Australian sourced capital to minimise exposure to volatile global markets;
  • balancing competition, innovation and efficiency with stability and consumer protection;
  • the role and impact of new technology, innovation and changing consumer preferences; and
  • international integration, in particular international financial regulation.

The main challenges identified by the Interim Report are:

  • future financial crises;
  • technological advances in financial services;
  • pressure on the budget as a result of Australia's ageing population; and
  • ensuring that higher productivity growth is facilitated through funding the economy more efficiently, finding new business and using new technology.

Overall, while it concludes that the Australian financial system is delivering, it is doing so at a very high cost. The approach going forward will be to determine whether current returns are enough to justify the current costs.

Priority issues identified by the FSI Interim Report

Nine priority issues relating to how well the Australian financial system is prepared to meet the challenges outlined above have also been identified:

  • competition and contestability;
  • funding Australia's economic activity;
  • superannuation efficiency and policy settings;
  • stability and the prudential framework;
  • consumer outcomes and conduct regulation;
  • regulatory architecture;
  • retirement incomes and aging;
  • technology opportunities and risks; and
  • international integration.

The impact of prudential regulation, globalisation and technology on Australian financial services

The Interim Report is the first major review into Australia's financial system in 16 years and while it does not make any recommendations, it does pose some key questions for consideration.

When speaking to the National Press Club on the day of the Report's release, Mr Murray stated that an area of focus had been whether post-financial crisis prudential regulation has gone too far in Australia following the GFC.

Mr Murray hopes to challenge the assumption that the major lenders are too big to fail, and has suggested policies which would reduce the need for government intervention in the banking sector. This includes forcing the major banks to hold larger capital buffers again, leading to debate between banks and regulators as to whether the Big 4 Banks hold enough capital to prevent a repeat of the GFC.

In a post-GFC environment, the Australian Government and political leaders will continue to be under pressure to ensure that taxpayers are not responsible for bailing out struggling financial institutions and instead, leaving this responsibility to shareholders.

Secondly, since the last financial system, a new challenge has emerged to the Australian financial system: the global economy. This is particularly relevant in an environment where so many of the rules governing the Australian financial system are set globally rather than by national regulators.

Finally, another issue which will likely be discussed in the lead-up to the release of the Final Report in November is the impact that technology will continue to have on Australia's financial system. In the short term, technology is likely to improve competitiveness, particularly in the financial services sector by encouraging product issuers to use technology to build new financial products. New technology is likely to also allow financial advisers and consumers greater interaction and ability to test potential new products.

However, one issue which will need to be addressed if the Australian financial system is to utilise the benefits of new technology is cyber security and technology-related fraud. Australia's current Cyber Security Strategy is out of step with other global players including the United States, the United Kingdom, Germany and Japan. One specific model which is being considered is the Financial Services Information Sharing and Analysis Center (FS-ISAC) in the US, which is a collaboration between financial institutions and government.

Superannuation: reform areas identified by the FSI report

As noted above, one key area of focus identified by the FSI was the Australian superannuation sector, suggesting this could be an area where greater efficiencies could be achieved. Three key matters the FSI addressed in the Report were fees charged by superannuation funds, retirement savings risk and borrowing by superannuation funds.

The Report states that Australia's financial system has grown significantly since the Wallis Inquiry was released in the 1990s, largely as a result of the growth in the superannuation sector.

Despite this growth, the FSI observed that superannuation fees remain high, due in part to the Australian superannuation sector having the highest operating costs of any member counties of the Organisation for Economic Cooperation and Development.

While the recent MySuper reforms are tipped to lower superannuation fees, this will nevertheless need to be assessed further in the coming months and years.

The FSI has also questioned the borrowing permission of superannuation funds saying that, the growth in self-managed superannuation funds has advanced the historically limited practice and opened the superannuation system to new vulnerabilities. Though the Report stopped short of suggesting a prohibition on borrowing, it seems that the FSI may be considering this as a possibility.

Lastly the Report suggested that the retirement phase of superannuation remains underdeveloped and does not meet the risk management needs of many retirees. Though there are regulatory and other policy impediments to developing income products that benefit retirees, this remains a key area for improvement.

The most basic question raised by the Report is whether superannuation is doing its job in providing retirement incomes for Australian retirees.

Going forward: submissions sought on the issues in the Interim Report

While the FSI made a series of policy selections for consultation in respect of the Report, these are only draft recommendations and the FSI is now seeking submissions in order to prepare its final report.

For those wishing to make submissions, they can be made online, with the closing date for submissions being 26 August 2014.

The FSI is expected to release its final report in November of this year.