p2014 FSI 01final Report

Financial System Inquiry
Final Report
November 2014
© Commonwealth of Australia 2014
ISBN 978-1-925220-14-8
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Contents
Foreword .................................................................................................................... vii
Background to the Inquiry ................................................................................................vii
Financial System Inquiry Terms of Reference ................................................................ vii
Financial System Inquiry Committee ............................................................................... ix
International Advisory Panel ............................................................................................ xi
Acknowledgements ............................................................................................................ xi
Executive summary ................................................................................................. xiii

Overview and general themes......................................................................................... xiv
Chapter 1: Resilience...........................................................................................................xvii
Chapter 2: Superannuation and retirement incomes ........................................................ xviii
Chapter 3: Innovation .......................................................................................................... xix
Chapter 4: Consumer outcomes ............................................................................................ xx
Chapter 5: Regulatory system ............................................................................................... xx
Appendix 1: Significant matters .......................................................................................... xxi
Appendix 2: Tax summary .................................................................................................. xxi
Recommendations............................................................................................................. xxi
Overview....................................................................................................................... 1
The Australian context ........................................................................................................ 2
Characteristics of a well-functioning financial system ................................................... 3
The Inquiry’s approach to financial system regulation .................................................. 8
Themes of this report ......................................................................................................... 12
Conclusion .......................................................................................................................... 30
Chapter 1: Resilience ................................................................................................ 33

Strength in the financial system ....................................................................................... 34
Recommended actions ...................................................................................................... 35
Principles ............................................................................................................................. 37
Conclusion .......................................................................................................................... 38
Capital levels ...................................................................................................................... 41
Narrow mortgage risk weight differences...................................................................... 60
Loss absorbing and recapitalisation capacity ................................................................. 67
Transparent reporting ....................................................................................................... 76
Crisis management toolkit ................................................................................................ 79
Financial Claims Scheme................................................................................................... 82
Leverage ratio ..................................................................................................................... 84
Direct borrowing by superannuation funds................................................................... 86
Chapter 2: Superannuation and retirement incomes.......................................... 89

Recommended actions ...................................................................................................... 90
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Financial System Inquiry — Interim Report
Principles ............................................................................................................................. 94
Conclusion .......................................................................................................................... 94
Objectives of the superannuation system ....................................................................... 95
Improving efficiency during accumulation .................................................................. 101
The retirement phase of superannuation ...................................................................... 117
Choice of fund .................................................................................................................. 131
Governance of superannuation funds ........................................................................... 133
Taxation of superannuation ............................................................................................ 137
Chapter 3: Innovation ............................................................................................. 143

Recommended actions .................................................................................................... 144
Principles ........................................................................................................................... 146
Conclusion ........................................................................................................................ 146
Collaboration to enable innovation ............................................................................... 147
Digital identity.................................................................................................................. 151
Clearer graduated payments regulation ....................................................................... 161
Interchange fees and customer surcharging................................................................. 168
Crowdfunding .................................................................................................................. 177
Data access and use.......................................................................................................... 181
Comprehensive credit reporting .................................................................................... 190
Chapter 4: Consumer outcomes ............................................................................ 193

Principles ........................................................................................................................... 197
Conclusion ........................................................................................................................ 197
Strengthen product issuer and distributor accountability ......................................... 198
Introduce product intervention power ......................................................................... 206
Facilitate innovative disclosure ...................................................................................... 213
Align the interests of financial firms and consumers.................................................. 217
Raise the competency of advisers .................................................................................. 222
Improve guidance and disclosure in general insurance ............................................. 227
Chapter 5: Regulatory system ............................................................................... 233

Principles ........................................................................................................................... 238
Conclusion ........................................................................................................................ 238
Regulator accountability ................................................................................................. 239
Execution of mandate ...................................................................................................... 246
Strengthening Australian Securities and Investments Commission’s
funding and powers ........................................................................................................ 250
Strengthening the focus on competition in the financial system ............................... 254
Compliance costs and policy processes ........................................................................ 257
Appendix 1: Significant matters ........................................................................... 261

Funding ............................................................................................................................. 261
iv
Contents
Superannuation and retirement incomes ..................................................................... 267

Innovation ......................................................................................................................... 268
Consumer outcomes ........................................................................................................ 271
Regulatory system ........................................................................................................... 273
Appendix 2: Tax summary ..................................................................................... 277
Appendix 3: Small and medium-sized enterprises (SMEs) ............................ 283
Appendix 4: Consultation ...................................................................................... 285

Approach to the Inquiry.................................................................................................. 285
Consultation...................................................................................................................... 285
Submissions to the Inquiry ............................................................................................. 287
Appendix 5: Glossary, acronyms and abbreviations ........................................ 309

Acronyms and abbreviations ......................................................................................... 309
Glossary ............................................................................................................................. 315
v
xxvii
Foreword
Background to the Inquiry
On 20 November 2013, the Treasurer, the Hon. Joe Hockey MP, released a draft terms
of reference for the Financial System Inquiry (the Inquiry) for consultation with
interested stakeholders.
After completing this consultation process on 20 December 2013, the Treasurer

released the final terms of reference and appointed a Committee, independent of
Government, to undertake this task. The members of the Committee are listed on the
following pages.
The Committee was charged with examining how the financial system could be
positioned to best meet Australia’s evolving needs and support Australia’s economic
growth.
On 24 March 2014, the Treasurer appointed an International Advisory Panel

(the Panel) to the Inquiry. The Panel’s role was to provide the Inquiry with an expert
perspective on aspects of the terms of reference, including technological change,
Australia’s global competitiveness and offshore regulatory frameworks. The members
of the Panel are also on the following pages.
Financial System Inquiry Terms of Reference
Objectives
The Inquiry is charged with examining how the financial system could be positioned
to best meet Australia’s evolving needs and support Australia’s economic growth.
Recommendations will be made that foster an efficient, competitive and flexible
financial system, consistent with financial stability, prudence, public confidence and
capacity to meet the needs of users.
Terms of reference
1. The Inquiry will report on the consequences of developments in the Australian
financial system since the 1997 Financial System Inquiry and the global financial
crisis, including implications for:
1. how Australia funds its growth;
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Financial System Inquiry — Final report
Financial System Inquiry Terms of Reference (cont.)

2. domestic competition and international competitiveness; and
3. the current cost, quality, safety and availability of financial services,

products and capital for users.
2. The Inquiry will refresh the philosophy, principles and objectives underpinning
the development of a well-functioning financial system, including:
1. balancing competition, innovation, efficiency, stability and consumer

protection;
2. how financial risk is allocated and systemic risk is managed;
3. assessing the effectiveness and need for financial regulation, including its
impact on costs, flexibility, innovation, industry and among users;
4. the role of Government; and
5. the role, objectives, funding and performance of financial regulators

including an international comparison.
3. The Inquiry will identify and consider the emerging opportunities and
challenges that are likely to drive further change in the global and domestic
financial system, including:
1. the role and impact of new technologies, market innovations and changing
consumer preferences and demography;
2. international integration, including international financial regulation;
3. changes in the way Australia sources and distributes capital, including the
intermediation of savings through banks, non-bank financial institutions,
insurance companies, superannuation funds and capital markets;
4. changing organisational structures in the financial sector;
5. corporate governance structures across the financial system and how they
affect stakeholder interests; and
6. developments in the payment system.
viii
Foreword
Financial System Inquiry Terms of Reference (cont.)

4. The Inquiry will recommend policy options that:
1. promote a competitive and stable financial system that contributes to

Australia’s productivity growth;
2. promote the efficient allocation of capital and cost efficient access and
services for users;
3. meet the needs of users with appropriate financial products and services;
4. create an environment conducive to dynamic and innovative financial

service providers; and
5. relate to other matters that fall within this terms of reference.
5. The Inquiry will take account of the regulation of the general operation of
companies and trusts to the extent this impinges on the efficiency and effective
allocation of capital within the financial system.
6. The Inquiry will examine the taxation of financial arrangements, products or

institutions to the extent these impinge on the efficient and effective allocation of
capital by the financial system, and provide observations that could inform the
Tax White Paper.
7. In reaching its conclusions, the Inquiry will take account of, but not make
recommendations on the objectives and procedures of the Reserve Bank in its
conduct of monetary policy.
8. The Inquiry may invite submissions and seek information from any persons or
bodies.
The Inquiry will consult extensively both domestically and globally. It will publish
an interim report in mid-2014 setting out initial findings and seek public feedback.
A final report is to be provided to the Treasurer by November 2014.
Financial System Inquiry Committee

Mr David Murray AO (Chair)
Mr David Murray AO (Sydney) was most recently the inaugural Chairman of the
Australian Government’s Future Fund Board of Guardians between 2006 and 2012.
Mr Murray was previously the Chief Executive Officer of the Commonwealth Bank of
ix
Australia between 1992 and 2005. In this time, Mr Murray oversaw the transformation
of the Commonwealth Bank from a partly privatised bank to an integrated financial
services company.
In 2001, he was awarded the Centenary Medal for service to Australian society in
banking and corporate governance, and in 2007 he was made an Officer of the Order of
Australia for his service to the finance sector, both domestically and globally, and
service to the community.
Professor Kevin Davis

Professor Kevin Davis (Melbourne) is currently a Professor of Finance at the University
of Melbourne, Research Director at the Australian Centre for Financial Studies and a
Professor of Finance at Monash University. Professor Davis is also a part-time member
of the Australian Competition Tribunal and Co-Chair of the Australia–New Zealand
Shadow Financial Regulatory Committee.
Mr Craig Dunn
Mr Craig Dunn (Sydney) was most recently Chief Executive Officer and Managing
Director of AMP. Mr Dunn led AMP through the global financial crisis and has
extensive experience in the financial sector. He was a member of the Australian
Government’s Financial Sector Advisory Council and the Australian Financial Centre
Forum, and an executive member of the Australia Japan Business Co-operation
Committee. Mr Dunn is a director of the Australian Government’s Financial Literacy
Board.
Ms Carolyn Hewson AO
Ms Carolyn Hewson AO (Adelaide) served as an investment banker at Schroders
Australia for 15 years. Ms Hewson has over 30 years’ experience in the finance sector
and currently serves on the boards of BHP Billiton Ltd and Stockland. Ms Hewson was
made an Officer of the Order of Australia for her services to the YWCA and to
business. Ms Hewson has served on both the boards of Westpac and AMP and retired
from the board of BT Investment Management Ltd and as the Chair of the Westpac
Foundation upon her appointment to the Financial System Inquiry Committee.
Dr Brian McNamee AO
Dr Brian McNamee AO (Melbourne) served as the Chief Executive Officer and
Managing Director of CSL Limited from 1990 to 30 June 2013. During that time, CSL
transitioned from a Government-owned enterprise to a global company with a market
capitalisation of approximately $30 billion. He has extensive experience in the biotech
and global healthcare industries. Dr McNamee was made an Officer of the Order of
Australia for his service to business and commerce.
x
Foreword
International Advisory Panel

Sir Michael Hintze AM
Sir Michael Hintze (London) is the founder and Chief Executive Officer of CQS, a
global multi-strategy asset management firm. Prior to founding CQS, Sir Michael held
senior roles at Credit Suisse First Boston and Goldman Sachs. He was made a Member
of the Order of Australia for his support to the arts, health and education, and
awarded a knighthood for his philanthropic services to the arts in the
United Kingdom.
Dr David Morgan AO
Dr David Morgan (London) is currently the head of private equity group JC Flowers
& Co. in Europe and the Asia-Pacific region. Dr Morgan was previously Chief
Executive Officer of Westpac Banking Corporation and a deputy secretary of the
Australian Treasury, and he has also worked for the International Monetary Fund. He
was made an Officer of the Order of Australia in 2009 for his service to the finance
sector.
Ms Jennifer Nason
Ms Jennifer Nason (New York) is Global Chairman of Technology, Media and Telecom
Investment Banking at JPMorgan Chase & Co. In her 28-year tenure at the bank,
Ms Nason worked around the world on mergers, acquisitions, and debt and equity
financings, and in strategic advisory roles for technology, media and
telecommunications companies.
Mr Andrew Sheng
Mr Andrew Sheng (Hong Kong) is a well-known former central banker and financial
regulator in Asia and a leading commentator on global finance. He is a Distinguished
Fellow and former President of the Fung Global Institute, a Hong Kong–based global
think tank, and previously held senior positions in the Securities and Futures
Commission of Hong Kong, the Hong Kong Monetary Authority and the World Bank.
In 2013, TIME listed Mr Sheng as one of the world’s 100 most influential people.
Acknowledgements
The Committee wishes to thank the large number of stakeholders who freely gave
their time to make submissions, participate in public consultations and meetings with
the Inquiry, or assist with research. The Committee acknowledges the assistance of:
• The public and private sector organisations that provided expertise and resources
to the Secretariat.
xi
• Treasury, the Reserve Bank of Australia, the Australian Prudential Regulation

Authority, the Australian Securities and Investments Commission and the
Australian Taxation Office.
• The large number of international agencies, regulators and financial system

participants that the Committee met with during international consultation.
• Mr Bruce White, the New Zealand observer to the Inquiry.
• The Centre for International Finance and Regulation, and the Australian Centre for
Financial Studies.
• Ms Karen Pryor for editing services.
Finally, the Committee wishes to acknowledge the support provided by all members
of the Secretariat:
John Lonsdale (Head of Secretariat), Mark Adams, Sarah Alland, Geoff Atkins, Debbie
Banerjee, Ian Beckett, Percy Bell, Camille Blackburn, Kylie Bourke, Adam Cagliarini,
Lynda Coker, Jason Collins, Andrew Craston, Kathryn Dolan, George Gardner, Glen
Granger, Jacob Hook, Darren Kennedy, Amanda Kirby, Suh Mian Ng, Brad Parry,
Amber Rowland, Daniel Royal, Luke Spear, Thomas Stapp, Melisande Waterford, Julia
Wells, Vicki Wilkinson, Callan Windsor and Chris Zwolinski.
xii
Executive summary
This report responds to the objective in the Inquiry’s Terms of Reference to best
position Australia’s financial system to meet Australia’s evolving needs and support
economic growth. It offers a blueprint for an efficient and resilient financial system
over the next 10 to 20 years, characterised by the fair treatment of users.
The Inquiry has made 44 recommendations relating to the Australian financial system.
These recommendations reflect the Inquiry’s judgement and are based on evidence
received by the Inquiry. The Inquiry’s test has been one of public interest: the interests
of individuals, businesses, the economy, taxpayers and Government.
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.
To put these issues in context, the Overview first deals with the characteristics of
Australia’s economy. It then describes the characteristics of and prerequisites for a
well-functioning financial system and the Inquiry’s philosophy of financial regulation.
The Inquiry focuses on seven themes in this report (summarised in Guide to the
Financial System Inquiry Final Report). The Overview deals with the general themes of
funding the Australian economy and competition.
The Inquiry has also made recommendations on five specific themes, which comprise
the next chapters of this report:
• 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.
xiii
These recommendations seek to improve efficiency, resilience and fair treatment in the
Australian financial system, allowing it to achieve its potential in supporting economic
growth and enhancing standards of living for current and future generations.
Guide to the Financial System Inquiry Final Report
Overview and general themes

The Inquiry has taken into account important features of Australia’s economy.
Australia has an open, market-based economy and is a net importer of capital. The
Australian economy faces a considerable productivity challenge, and the Australian
population, like many around the world, is ageing. Finally, Australia is in the midst of
one of the most ubiquitous, generally applicable technology changes the world has
ever seen.
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Executive summary
Characteristics of an effective financial system

The financial sector plays a vital role in supporting a vibrant, growing economy that
improves the standard of living for all Australians. The system’s ultimate purpose is to
facilitate sustainable growth in the economy by meeting the financial needs of its users.
The Inquiry believes the financial system will achieve this goal if it operates in a
manner that is:
• Efficient: An efficient system allocates Australia’s scarce financial and other

resources for the greatest possible benefit to our economy, supporting growth,
productivity and prosperity.
• Resilient: The financial system should adjust to changing circumstances while

continuing to provide its core economic functions, even during severe shocks.
Institutions in distress should be resolvable with minimal costs to depositors, policy
holders, taxpayers and the real economy.
• Fair: Fair treatment occurs where participants act with integrity, honesty,
transparency and non-discrimination. A market economy operates more effectively
where participants enter into transactions with confidence they will be treated
fairly.
Confidence and trust in the system are essential ingredients in building an efficient,
resilient and fair financial system that facilitates economic growth and meets the
financial needs of Australians. The Inquiry considers that all financial system
participants have roles and responsibilities in engendering that confidence and trust.
The Inquiry’s approach to financial system regulation

Central to the Inquiry’s philosophy is the principle that the financial system should be
subject and responsive to market forces, including competition.
However, competitive markets need to operate within a strong and effective legal and
policy framework provided by Government. This includes predictable rule of law with
strong property rights; a freely convertible floating currency and free flow of trade,
investment and capital across borders; a strong fiscal position; a sound and
independent monetary policy framework; and an effective, accountable and
transparent government.
The Inquiry’s approach to policy intervention is guided by the public interest. Given
the inevitable trade-offs involved, deciding how and when policy makers should
intervene in the financial system requires considerable judgement. Intervention should
seek to balance efficiency, resilience and fairness in a way that builds participants’
confidence and trust. Intervention should only occur where its benefits to the economy
as a whole outweigh its costs, and should always seek to be proportionate and cost
sensitive.
xv
General themes
The Inquiry identified two general themes where there is significant scope to improve
the functioning of the financial system:
1. Funding the Australian economy.
2. Competition.
Funding the Australian economy

The core function of the Australian financial system is to facilitate the funding of
sustainable economic growth and enhance productivity in the Australian economy.
The Inquiry believes Government’s role in funding markets should generally be
neutral regarding the channel, direction, source and size of the flow of funds.
The Inquiry identified a number of distortions that impede the efficient market
allocation of financial resources, including taxation, information imbalances and
unnecessary regulation. Reducing the distortionary effects of taxation should lead the
system to allocate savings (including foreign savings) more efficiently and price risk
more accurately. The Inquiry has referred the identified tax issues for consideration in
the Tax White Paper.
A number of the Inquiry’s recommendations aim to assist small and medium-sized

enterprises in obtaining better access to funding. To strengthen Australia’s ability to
continue to access funding, both domestically and from offshore sources,
recommendations have been made to improve the resilience of the Australian financial
system. More broadly, given that Australia’s growing superannuation system will
have an increasing influence on future funding flows, the Inquiry believes that the
recommendations it has made to improve the efficiency of the superannuation system
would also enhance financial system funding efficiency.
Competition
Competition and competitive markets are at the heart of the Inquiry’s philosophy for
the financial system. The Inquiry sees them as the primary means of supporting the
system’s efficiency. 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.
xvi
Executive summary
In particular, the state of competition in the financial system should be reviewed every
three years, including assessing changes in barriers to international competition.
Recommendations relating to funding and competition are listed in Table 1.
Table 1: Funding the Australian economy and competition recommendations

Number Description
– Tax observations
18 Crowdfunding
19 Data access and use
20 Comprehensive credit reporting
33 Retail corporate bond market
Competition
Number Description
2 Narrow mortgage risk weight differences
10 Improving efficiency during accumulation
14 Collaboration to enable innovation
15 Digital identity
16 Clearer graduated payments regulation
18 Crowdfunding
27 Regulator accountability
30 Strengthening the focus on competition in the financial system
39 Technology neutrality
42 Managed investment scheme regulation
Chapter 1: Resilience
Historically, Australia has maintained a strong and stable financial system supported
by effective stability settings. However, the Australian financial system has
characteristics that give rise to particular risks, including its high interconnectivity
domestically and with the rest of the world, and its dependence on importing capital.
More can be done to strengthen the resilience of Australia’s financial system to avoid
or limit the costs of future financial crises, which can deeply damage an economy and
have lasting effects on people’s lives.
As the banking sector is at the core of the Australian financial system, its safety is of
paramount importance. Australia should aim to have financial institutions with the
strength to not only withstand plausible shocks but to continue to provide critical
xvii
economic functions, such as credit and payment services, in the face of these shocks.
Adhering to international regulatory norms will help ensure Australian financial
institutions and markets are not disadvantaged in raising funds in international
financial markets.
The Inquiry’s recommendations to improve resilience aim to:
• 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.
• 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.
These recommendations seek to ensure that Australia’s financial system remains

resilient into the future, and that it continues to provide its core economic functions,
even in times of financial stress. These recommendations should also produce
efficiency benefits, including through reducing implicit guarantees and volatility in the
economy and promoting confidence and trust.
Chapter 2: Superannuation and retirement incomes

Australia’s superannuation system is large by international standards and has grown
rapidly since the Wallis Inquiry, primarily as a result of Government policy settings.
An efficient superannuation system is critical to help Australia meet the economic and
fiscal challenges of an ageing population. The system has considerable strengths. It
plays an important role in providing long-term funding for economic activity in
Australia both directly and indirectly through funding financial institutions, and it
contributed to the stability of the financial system and the economy during the global
financial crisis.
However, the superannuation system is not operationally efficient due to a lack of

strong price-based competition. Superannuation assets are not being efficiently
converted into retirement incomes due to a lack of risk pooling and over-reliance on
individual account-based pensions.
The Inquiry’s recommendations to strengthen the superannuation system aim to:
• Set a clear objective for the superannuation system to provide income in retirement.
xviii
Executive summary
• 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.
• 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.
These recommendations seek to improve the outcomes for superannuation fund

members and help Australia to manage the challenges of an ageing population.
Chapter 3: Innovation
Technology-driven innovation is transforming the financial system, as evidenced by
the emergence of new business models and products, and substantial investment in
areas such as mobile banking, cloud computing and payment services.
Although innovation has the potential to deliver significant efficiency benefits and
improve system outcomes, it also brings risks. Consumers, businesses and government
can be adversely affected by new developments, which may also challenge regulatory
frameworks and regulators’ ability to respond.
The Inquiry believes the innovative potential of Australia’s financial system and
broader economy can be supported by taking action to ensure policy settings facilitate
future innovation that benefits consumers, businesses and government.
The Inquiry’s recommendations to facilitate innovation aim to:
• 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.
• Strengthen Australia’s digital identity framework through the development of a

national strategy for a federated-style model of trusted digital identities.
• Remove unnecessary regulatory impediments to innovation, particularly in the

payments system and in fundraising for small businesses.
• 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.
These recommendations will contribute to developing a dynamic, competitive,

growth-oriented and forward-looking financial system for Australia.
xix
Chapter 4: Consumer outcomes

Fundamental to fair treatment is the concept that financial products and services
should perform in the way that consumers expect or are led to believe.
The current framework is not sufficient to deliver fair treatment to consumers. The
most significant problems relate to shortcomings in disclosure and financial advice,
which means some consumers are sold financial products that are not suited to their
needs and circumstances. Although the regime should not be expected to prevent all
consumer losses, self-regulatory and regulatory changes are needed to strengthen
financial firms’ accountability.
The Inquiry’s recommendations to improve consumer outcomes aim to:
• 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).
• Further align the interests of firms and consumers, and improve standards of
financial advice, by lifting competency and increasing transparency regarding
financial advice.
• Empower consumers by encouraging industry to harness technology and develop

more innovative and useful forms of disclosure.
These recommendations seek to strengthen the current framework to promote

consumer trust in the system and fair treatment of consumers.
Chapter 5: Regulatory system

Australia needs strong, independent and accountable regulators to help maintain
confidence and trust in the financial system, thereby attracting investment and
supporting growth. This requires proactive regulators with the right skills, culture,
powers and funding.
Australia’s regulatory architecture does not need major change; however, the Inquiry
has made recommendations to improve the current arrangements. Government
currently lacks a regular process that allows it to assess the overall performance of
financial regulators. Regulators’ funding arrangements and enforcement tools have
some significant weaknesses, particularly in the case of ASIC. In addition, it is not clear
whether adequate consideration is currently given to competition and efficiency in
designing and applying regulation.
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Executive summary
The Inquiry’s recommendations to refine Australia’s regulatory system and keep it

fit for purpose aim to:
• Improve the accountability framework governing Australia’s financial sector

regulators by establishing a new Financial Regulator Assessment Board to review
their performance annually.
• Ensure Australia’s regulators have the funding, skills and regulatory tools to
deliver their mandates effectively.
• 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.
• Improve the process for implementing new financial regulations.
These recommendations seek to make Australia’s financial regulators more effective,

adaptable and accountable.
Appendix 1: Significant matters

In addition to the recommendations in the above areas, the Inquiry has made
13 recommendations relating to other significant matters. These are contained in
Appendix 1: Significant matters.
Appendix 2: Tax summary

A number of tax observations are included in Appendix 2: Tax summary for
consideration by the Tax White Paper.
Recommendations
The Inquiry has made 44 recommendations relating to the Australian financial system.
The nature of some recommendations warrants more in-depth discussion. These
recommendations are shaded darker in the Summary of recommendations by chapter
tables on the following pages. The Inquiry considers that the remaining
recommendations in the body of the report can be made without providing the reader
with the same depth of explanation. Recommendations contained in Appendix 1:
Significant matters are only explained briefly.
xxi
Summary of recommendations by chapter

Chapter 1: Resilience (pages 33–88)
Number Description
1 Capital levels
Set capital standards such that Australian authorised deposit-taking
institution capital ratios are unquestionably strong.
2 Narrow mortgage risk weight differences
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.
3 Loss absorbing and recapitalisation capacity
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.
4 Transparent reporting
Develop a reporting template for Australian authorised deposit-taking
institution capital ratios that is transparent against the minimum Basel
capital framework.
5 Crisis management toolkit
Complete the existing processes for strengthening crisis management
powers that have been on hold pending the outcome of the Inquiry.
6 Financial Claims Scheme
Maintain the ex post funding structure of the Financial Claims Scheme for
authorised deposit-taking institutions.
7 Leverage ratio
Introduce a leverage ratio that acts as a backstop to authorised
deposit-taking institutions’ risk-weighted capital positions.
8 Direct borrowing by superannuation funds
Remove the exception to the general prohibition on direct borrowing for
limited recourse borrowing arrangements by superannuation funds.
xxii
Executive summary
Chapter 2: Superannuation and retirement incomes (pages 89–142)

Number Description
9 Objectives of the superannuation system
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.
10 Improving efficiency during accumulation
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.
11 The retirement phase of superannuation
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.
12 Choice of fund
Provide all employees with the ability to choose the fund into which their
Superannuation Guarantee contributions are paid.
13 Governance of superannuation funds
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.
xxiii
Chapter 3: Innovation (pages 143–192)

Number Description
14 Collaboration to enable innovation
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.
15 Digital identity
Develop a national strategy for a federated-style model of trusted digital
identities.
16 Clearer graduated payments regulation

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.
17 Interchange fees and customer surcharging

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.
18 Crowdfunding
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.
xxiv
Executive summary
Chapter 4: Consumer outcomes (pages 193–232)

Number Description
21 Strengthen product issuer and distributor accountability
Introduce a targeted and principles-based product design and distribution
obligation.
22 Introduce product intervention power

Introduce a proactive product intervention power that would enhance the
regulatory toolkit available where there is risk of significant consumer
detriment.
23 Facilitate innovative disclosure

Remove regulatory impediments to innovative product disclosure and
communication with consumers, and improve the way risk and fees are
communicated to consumers.
24 Align the interests of financial firms and 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.
25 Raise the competency of advisers

Raise the competency of financial advice providers and introduce an
enhanced register of advisers.
26 Improve guidance and disclosure in general insurance

Improve guidance (including tools and calculators) and disclosure for
general insurance, especially in relation to home insurance.
xxv
Chapter 5: Regulatory system (pages 233–260)

Number Description
27 Regulator accountability
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.
28 Execution of mandate
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.
29 Strengthening the Australian Securities and Investments

Commission’s funding and powers
Introduce an industry funding model for the Australian Securities and
Investments Commission (ASIC) and provide ASIC with stronger
regulatory tools.
30 Strengthening the focus on competition in the financial system

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.
31 Compliance costs and policy processes

Increase the time available for industry to implement complex regulatory
change.
Conduct post-implementation reviews of major regulatory changes more
frequently.
xxvi
Executive summary
Appendix 1: Significant matters (pages 261–276)

Number Description
32 Impact investment
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.
33 Retail corporate bond market

Reduce disclosure requirements for large listed corporates issuing ‘simple’
bonds and encourage industry to develop standard terms for ‘simple’
bonds.
34 Unfair contract term provisions

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.
35 Finance companies
Clearly differentiate the investment products that finance companies and
similar entities offer retail consumers from authorised deposit-taking
institution deposits.
36 Corporate administration and bankruptcy

Consult on possible amendments to the external administration regime to
provide additional flexibility for businesses in financial difficulty.
37 Superannuation member engagement

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.
38 Cyber security
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.
xxvii
Appendix 1: Significant matters (pages 261–276) (cont.)

Number Number
39 Technology neutrality
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.
40 Provision of financial advice and mortgage broking

Rename ‘general advice’ and require advisers and mortgage brokers to
disclose ownership structures.
41 Unclaimed monies
Define bank accounts and life insurance policies as unclaimed monies
only if they are inactive for seven years.
42 Managed investment scheme regulation

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.
43 Legacy products
Introduce a mechanism to facilitate the rationalisation of legacy
products in the life insurance and managed investments sectors.
44 Corporations Act 2001 ownership restrictions

Remove market ownership restrictions from the Corporations Act 2001
once the current reforms to cross-border regulation of financial market
infrastructure are complete.
xxviii
Overview
This chapter provides an overview of the Financial System Inquiry’s Final Report. It
sets out the Inquiry’s starting point for considering how the financial system can meet
Australia’s evolving needs and support sustainable economic growth. This includes
outlining the Australian context in which the Inquiry has made its recommendations,
the characteristics of a well-functioning financial system and the Inquiry’s philosophy
of financial regulation. This chapter discusses the two general themes that permeate
much of the Inquiry’s thinking: the effectiveness of the financial system in funding the
economy and the importance of competition in the financial system. It also provides a
brief summary of the five specific themes detailed in the remaining chapters of this
report.
Figure 1: Guide to the Financial System Inquiry Final Report
1
The Australian context

In assessing priority areas of financial sector reform, the Inquiry has taken into account
the following characteristics of the Australian economy:
• Australia is an open market-based economy. The Australian financial system is

predominantly privately owned and operates according to market principles.
• Australia is, and is likely to continue to be, a substantial net importer of capital.
Australia has a relatively small but well-educated and skilled population. It has
significant endowments of natural resources that cannot be fully utilised without
foreign investment. Ongoing access to foreign funding has enabled Australia to
sustain higher growth than it otherwise could. The financial system has an
important role in facilitating funding from, and investing in, offshore capital
markets.
• The structure of the Australian economy will continue to evolve, as seen in the
shift from mining-led investment to broader activities in non-mining sectors. The
financial system plays an important role in assisting the economy as it adapts to
such changes by facilitating the reallocation of financial resources.
• The Australian population, like many around the world, is ageing. This trend is
likely to result in a lower proportion of the population being of working age,
dampening long-term economic growth and placing greater fiscal pressures on
governments. In this environment, a well-functioning superannuation system will
be important in alleviating these pressures and ensuring good outcomes for
retirees.
• The Australian economy faces a considerable productivity challenge. Compared

with the last decade, productivity growth will need to be stronger to maintain
Australia’s living standards, as our terms of trade continue their expected decline
and the population ages. The financial system plays an important role in facilitating
productivity growth by funding the economy more efficiently, including funding
new businesses and using new technology.
• With the advent of digital technology, Australia is in the midst of one of the most
ubiquitous, generally applicable technology changes the world has seen. Its effect
has been, and continues to be, revolutionary as innovative business models insert
new competitive tensions into a variety of industries. For the financial system,
technology-driven innovation will continue to change the financial products offered
to consumers and the very nature of financial intermediation.
2
Overview
• Australian financial system assets have grown from the equivalent of around two
years’ worth of nominal gross domestic product (GDP) in 1997 to more than three
years’ worth of nominal GDP. 1 Compared to international peers, Australia has a
relatively large financial system. 2 In particular, superannuation assets are expected
to continue to grow and increasingly influence funding flows in the economy.
• Some sectors of the Australian financial system are concentrated. In particular, the
banking sector is concentrated, with the four major banks being the largest players
in many aspects of the financial system and having significant market influence.
Such concentration creates risks to both the stability and degree of competition in
the Australian financial system.
Characteristics of a well-functioning financial system

The financial system plays a vital role in supporting sustainable economic growth and
meeting the financial needs of Australians. It does this by facilitating funding, liquidity
and price discovery, while also providing effective risk management, payment and
some monitoring services.
The Inquiry believes the financial system achieves this most effectively when it
operates in an efficient and resilient manner and treats participants fairly. This occurs
when participants fulfil their roles and responsibilities in a way that engenders
confidence and trust in the system.
The financial industry makes a considerable contribution to employment and

economic output in Australia. However, the Inquiry believes the focus of financial
system policy should be primarily on the degree of efficiency, resilience and fairness
the system achieves in facilitating economic activity, rather than on its size or direct
contribution (such as through wages and profits) to the economy.
1 Reserve Bank of Australia (RBA) 2014, First round submission to the Financial System
Inquiry, page 15.
2 Note: This comparison is based on the share of gross value-added terms. Reserve Bank of
Australia (RBA) 2014, First round submission to the Financial System Inquiry, pages 17-18.
3
Efficiency
An efficient financial system is fundamental to supporting Australia’s growth and
productivity. An efficient system allocates Australia’s scarce financial and other
resources for the greatest possible benefit to our economy, promoting a higher and
more sustainable rate of productivity, and economic growth. The Inquiry is concerned
with three distinct, but interrelated, forms of efficiency:
• Operational efficiency — where financial products and services are delivered in a

way that minimises costs and maximises value. This largely depends on how
effectively firms deploy labour, capital and technology, and the regulations with
which firms comply. Strong competition, both from new entrants and incumbents,
encourages firms to innovate and increase operational efficiency to survive and
prosper. This can be seen in the ongoing industry focus on deploying new
technologies in the Australian financial system to improve the quality and reduce
the cost of products and services. Good policy-making can also assist operational
efficiency by providing a stable regulatory environment and well-designed
regulation that takes into account its likely effect on industry.
• Allocative efficiency — where the financial system allocates financial resources to

the most productive and valuable use. Central to achieving allocative efficiency is
the ability of prices to adjust freely to give participants information about the value
and risk of various financial products and services. Prices help allocate financial
resources to productive uses. Prices also help allocate risks to those most willing
and able to bear them, such as through insurance or derivative contracts. For prices
to play this role, market participants require access to comprehensive information
about the risks and expected returns of financial products. Allocative efficiency can
be hampered by ineffective disclosure, government guarantees (explicit or implicit)
and tax policies that distort price signals.
• Dynamic efficiency — where the financial system delivers price signals that induce
the optimal balance between consumption and saving (deferred consumption). At
times, policy intervention may be required to overcome behavioural biases that
impede an economy’s ability to allocate resources with dynamic efficiency. For
example, Australia’s compulsory superannuation system was introduced, in part,
to overcome the tendency of individuals to underestimate the value of deferred
consumption for long periods, such as for retirement.
Resilience
Resilience refers to the financial system’s capacity to adjust to both the normal business
cycle and a severe economic shock. A resilient system does not preclude failure, nor
necessarily imply price stability. Rather, a resilient system can adjust to changing
circumstances while continuing to provide core economic functions, even during
severe but plausible shocks. In a resilient system, individual institutions in distress
4
Overview
should be resolvable with minimal costs to depositors, policy holders, taxpayers and
the real economy.
Occasional episodes of financial instability are inherent in a market economy and are
typically associated with asset price volatility, high levels of leverage, under-pricing of
risks and mismatches between assets and liabilities. History suggests that events of
instability will continue to occur, but their timing, severity and causes cannot be
reliably predicted.
Although Australia’s experience of the global financial crisis (GFC) was not as acute as
that of other countries — in part because of a strong Commonwealth fiscal position,
effective monetary policy, ongoing demand for commodity exports and a prudent and
well-managed financial system — Australia has not always been so well placed. Land
and property speculation in the 1880s and 1890s led to an economy-wide depression,
with real per capita GDP falling 20 per cent and around half of the Australian trading
banks closing. 3 During the 1930s depression, a number of financial institutions faced
depositor runs. 4 In the late 1980s and early 1990s, an unsustainable boom, primarily in
the commercial property sector, combined with poor lending practices and associated
loan defaults, resulted in aggregate bank losses equivalent to one-third of
shareholders’ funds. 5 This led to depositor runs on some institutions and was a
contributing factor in Australia’s recession at that time.
Severe financial shocks have broad negative consequences, both for individuals and
for the general economy. Depositors, policy holders, creditors and shareholders of
affected institutions can lose money. Credit and risk management services may be
scaled back. In extreme circumstances, payments mechanisms may break down.
Confidence in the financial system can evaporate, causing contagion to spread from
distressed institutions to the rest of the system. General economic growth slows,
unemployment rises and standards of living fall.
Australia’s use of offshore funding, while beneficial to economic growth, makes the
country vulnerable to sudden changes in international investor sentiment. Because of
this, it is critical that the Australian financial system is resilient. As the cost of offshore
borrowing is linked to the nation’s credit rating, it is also critical that both federal and
state governments maintain strong fiscal positions.
3 Maddock, R 2014, ‘Capital markets’ in Ville, S and Withers, G (eds), The Cambridge economic
history of Australia, Cambridge University Press, page 274.
4 Fisher, C and Kent, C 1999, Two depressions, one banking collapse, Research discussion paper,
1999-06, Reserve Bank of Australia, Sydney, pages 13–14.
5 Gizycki, M and Lowe, P 2000, ‘The Australian Financial System in the 1990s’, paper
presented at The Australian Economy in the 1990s conference held by the Reserve Bank of
Australia, Sydney, 24–25 July, page 181.
5
Fair treatment
Fair treatment occurs where participants act with integrity, honesty, transparency and
non-discrimination. A market economy operates more effectively where participants
enter into transactions with confidence that they will be treated fairly.
Fair treatment does not involve shielding consumers from responsibility for their
financial decisions, including for losses and gains from market movements. Some
investor losses are an inevitable feature of a well-functioning market economy, which
allows risk-taking in search of a return.
Behavioural biases and information imbalances 6 can be detrimental to both financial

system participants and system efficiency. Participants, including consumers, have a
responsibility to accept the outcomes of their financial decisions, but financial firms
should have regard to these information imbalances in treating their customers fairly.
Financial firms need to place a high degree of importance on treating customers fairly.
This includes providing consumers with clear information about risks; competent,
good-quality financial advice that takes account of their circumstances; and access to
timely and low-cost alternative dispute resolution and an effective judicial system.
Roles and responsibilities of participants

Confidence and trust are essential ingredients in building an efficient, resilient and fair
financial system that facilitates economic growth and meets the financial needs of
Australians. However, confidence and trust cannot be prescribed in legislation. Rather,
the Inquiry expects participants to fulfil the following roles and responsibilities in a
way that engenders confidence and trust:
• Consumers are generally best placed to make financial decisions that meet their
financial needs and have a responsibility to accept the outcomes of those decisions
when they have been treated fairly.
• Businesses, 7 both small and large, should be able to access funding and take
productive risks to reap commercial rewards. The outcomes from these ventures
should be shared according to well-defined and enforceable contractual terms.
Businesses should not be prevented from failing, nor guaranteed access to private
financial services on non market based terms.
6 In economic terms, ‘information asymmetries’. These occur when two parties entering into a
transaction do not have the same level of information, placing one at an advantage over the
other.
7 This includes financial firms.
6
Overview
• Financial firms (banks, insurers, financial advisers, superannuation trustees,

responsible entities, lenders, brokers etc.) should act in the interests of their legal
beneficiaries. Financial firms should earn the confidence and trust of customers by
complying with their legal obligations and considering community expectations,
thus limiting or avoiding the need for more prescriptive or interventionist
regulation.
• Regulators are responsible for discharging their mandate and exercising their
judgement to the standards of the civil service. To be effective, regulators should be
independent and accountable, and have access to the appropriate regulatory tools
and resources.
• Governments are responsible for setting policy that enables the financial system to
facilitate sustainable growth and meet the financial needs of Australians, while
minimising risk to taxpayers’ funds. Governments have an obligation to act in the
long-term national interest, rather than using the financial system for short-term
political gain. 8
Culture of financial firms

Since the GFC, a persistent theme of international political and regulatory discourse
has been the breakdown in financial firms’ behaviour in failing to balance risk and
reward appropriately and in treating their customers unfairly. Without a culture
supporting appropriate risk-taking and the fair treatment of consumers, financial firms
will continue to fall short of community expectations. This may lead to ongoing
political pressure for additional financial system regulation and the undermining of
confidence and trust in the financial system.
An organisation’s culture reflects its accumulated knowledge, beliefs and values in a

way that sets norms for the behaviour of its employees and their decision making.
Organisational objectives, business strategies and systems all influence employees’
behaviour, which reflects on an organisation’s culture. Leaders and their governing
bodies determine organisational culture through their own conduct and design of
objectives, strategies and systems. This creates competitive advantage.
The Inquiry considers that industry should raise awareness of the consequences of its
culture and professional standards, recognising that, responsibility for culture in the
financial system ultimately rests with individual firms and the industry as a whole.
Culture is a set of beliefs and values that should not be prescribed in legislation. To
expect regulators to create the ‘right’ culture within firms by using prescriptive rules is
likely to lead to over-regulation, unnecessary compliance cost and a lessoning of
8 For a discussion of the potential for financial system policy to be influenced by political
interests, see, for example, Calomiris, C and Haber, S 2014, Fragile by Design: Political Origins
of Banking Crises and Scarce Credit, Princeton University Press, Princeton.
7
competition. The responsibility for setting organisational culture rightly rests with its
leadership.
The Inquiry’s approach to financial system regulation

The starting point for the Inquiry’s approach to examining the role of Government in
the financial system is the Wallis Inquiry’s philosophy of regulation. 9 Insights
provided by academic research and practical experience since then have advanced the
Inquiry’s understanding of the financial system. Critically, this new understanding has
reduced the Inquiry’s confidence in the inherent efficiency and stability of financial
markets 10 and increased its understanding of the financial system as a complex,
adaptive network. 11 Box 1: Implications of developments since the Wallis Inquiry
summarises the implications of some developments since the Wallis Inquiry.
Box 1: Implications of developments since the Wallis Inquiry

Developments since the Wallis Inquiry Lessons for this Inquiry
The GFC has again demonstrated that Australia remains susceptible to financial
financial systems are prone to crises, including from the dislocation of
instability and that the resulting international markets. A resilient system
financial failure can have a significant is required to bolster stability, prevent an
cost to taxpayers, economic output and increase in moral hazard and reduce risk
employment. to taxpayers.
The Australian financial system is part Policy making should be coordinated,

of a global economy increasingly more accountable and better
influenced by Asia. It is affected by the implemented to deal with changes in
increasing scope and complexity of global regulation and in the financial
cross-border financial regulation as well systems of our major trading partners.
as other broader economic changes.
9 Commonwealth of Australia 1997, Financial System Inquiry Final Report, Canberra, Chapter 5
— Philosophy of Financial Regulation.
10 A recent survey of some of this research is provided by Brunnermeier, M, Eisenbach, T and
Sannikov, Y 2013, ‘Macroeconomics with Financial Frictions: A Survey’, in Acemoglu, D,
Arellano, M and Dekel, E (eds.) 2013, Advances in Economics and Econometrics, Tenth World
Congress of the Econometric Society, Volume II: Applied Economics, Cambridge University Press,
New York, pages 4–94. See also Allen, F, Babus, A, Carletti, E 2009, ‘Financial Crises: Theory
and Evidence‘, Annual Review of Financial Economics, volume 1, pages 97–116.
11 See, for example, Haldane, A 2009 Rethinking the financial network, speech to the Financial
Student Association Amsterdam, 28 April.
8
Overview
Box 1: Implications of developments since the Wallis Inquiry (cont.)

Developments since the Wallis Inquiry Lessons for this Inquiry
Behavioural biases undermine the Although disclosure remains a valuable
assumption that individuals are tool to improve consumer outcomes, it
‘rational’. They limit the efficacy of should not be relied on in isolation.
disclosure as a regulatory tool and can
lead to sub-optimal outcomes for
consumers. 12
Rapid technological innovation brings Policy settings should facilitate

opportunities to improve user outcomes innovation and accommodate market
and system efficiency, but also raises developments where these improve
new risks and challenges. system efficiency and user outcomes.
General acceptance that, in a severe To avoid moral hazard, regulatory

financial crisis, governments (and settings should reduce the likelihood of
taxpayers) may play a role in protecting Government support being required.
the real economy. However, Government should maintain
a strong fiscal position with the capacity
to provide this support in extreme
circumstances.
The central role of market forces

Central to the Inquiry’s philosophy is that the financial system should be subject, and
responsive, to market forces, including competition. This is based on the Inquiry’s
view that the private sector is best placed to make decisions affecting the efficient
allocation of resources.
Competition remains the cornerstone of a well-functioning financial system and is

generally preferred to government intervention. 13 Competition drives efficient
outcomes for price, quality and innovation. However, the Inquiry recognises that
competition alone does not always deliver the best balance between efficiency,
resilience and fair treatment.
12 See, for example, Kahneman, D 2011, Thinking Fast and Slow, Penguin Books Ltd, London.
13 Intervention is defined as including regulation, legislation, guidance, general supervision
and enforcement.
9
Government prerequisites
Competitive markets need to operate within a strong and effective legal and policy
framework provided by government. The characteristics required for the financial
system to contribute effectively to sustainable economic growth are:
• Predictable rule of law with strong property rights, providing certainty of contract;
protection from fraudulent, predatory and anti-competitive behaviour; and access
to redress.
• Freely convertible floating currency and general free flow of trade, investment and
capital across borders.
• Strong fiscal position.
• Sound monetary policy framework, including an independent central bank.
• Effective, accountable and transparent government.
Although these conditions are regarded as generally being met in Australia,

Government should not underestimate their importance, and policy should be directed
at their maintenance.
Sector-specific regulation in the financial system

The Inquiry believes the financial system requires sector-specific regulation, in
addition to the above legal and policy prerequisites, for two reasons:
1. More so than other sectors, the financial system has the ability to create or
amplify economic shocks because of its use of leverage, its complexity and its
interconnectedness with the rest of the economy.
2. The significant harm to consumers that may result from complex financial
decisions, or from dishonest and predatory practices, requires specialist
regulation to promote fair treatment.
Sector-specific regulation is not unique to the financial system. Characteristics such as

the high potential for harm and complexity result in specialist regulation in other
industries, including aviation and pharmaceuticals. However, the Inquiry considers
the potential effect on living standards or economic growth from mismanaging risk in
the financial system requires more specialised regulatory oversight than that provided
under general economy-wide trading rules.
10
Overview
Framework for policy intervention

The Inquiry’s approach to policy intervention is guided by the public interest. Given
the inevitable trade-offs involved, deciding how and when to intervene in the financial
system requires considerable judgement by policy makers.
Intervention should seek to balance efficiency, resilience and fairness in a way that
builds participants’ confidence and trust. Intervention should only occur where its
benefits to the economy as a whole outweigh its costs. Intervention should always seek
to be proportionate and cost sensitive. However, in many cases, the assessment of costs
and benefits will not be clear-cut and will require policy makers to exercise judgement
— as has been the case for many matters considered by this Inquiry. 14
Impediments to efficient market operations, such as information imbalances and

principal agent conflicts, should be minimised. 15 The Inquiry expects policy makers to
set regulatory frameworks that encourage private sector competition and innovation
by applying regulation on a functional basis, graduating regulatory obligations and
assisting industry to overcome collective action problems. 16,17
A resilient financial system allows financial failure but manages it in a way that limits
the cost to the general economy and taxpayers. The Inquiry believes policy makers
should seek to minimise the chance of systemic crises, but have the right tools to
manage such events when they do occur. As a last resort, Government should have the
fiscal capacity to support the economy if required.
To encourage the fair treatment of participants in the financial system, policy makers
should establish frameworks that ensure the orderly conduct of financial markets and
minimise incidences of consumers buying financial products and services that do not
meet their needs.
The Inquiry’s philosophy places great responsibility on policy makers, particularly

regulators, to make decisions that best balance the desired outcomes of efficiency,
resilience and fair treatment. Principles-based decisions will often depend on
regulators’ professional judgement. Central to this approach is the need for
appropriately skilled, effective regulators that are both independent and highly
accountable for discharging their mandates.
14 Policy makers should use evidence-based approaches in policy analysis, including trials or
pilots when feasible.
15 Principal agent conflicts occur if an agent (for example, a company executive) pursues their
own self-interest rather than those of the principal (for example, a shareholder) who has
provided them with resources and delegated responsibility to them for making decisions.
16 Functional regulation involves regulating similar economic functions in a similar way.
17 Graduated regulation involves providing lower-intensity regulation for businesses that pose
lower risks to the system.
11
Box 2: General principles for policy makers
Determining when to intervene

• Intervention should be considered where it would improve the efficiency,
resilience or fairness of the financial system, but only introduced if its benefit is
judged to outweigh the costs to the economy as a whole.
• Unless there is a clear public interest, policy makers should give competitive
markets the opportunity to adjust to market signals and allow established legal
remedies to be enforced rather than pre-emptively regulating.
Delivering efficiency
• Policy makers should seek to remove distortions to the efficient allocation of
funds and risks in the economy, and reduce unnecessary regulatory burdens.
• Policy makers should seek to encourage competition by removing unnecessary

barriers to domestic and international competition.
• Policy settings should seek to encourage innovation by being technologically and

competitively neutral in design.
Delivering resilience
• Private sector risk-taking should be supported, allowing both success and failure.
• Policy makers should seek to prevent a build-up of systemic risk. They should
have systems in place to manage failing financial institutions in an orderly
manner that protects the financial system’s critical functions and maintains
financial stability while minimising risk to taxpayers.
Delivering fair treatment

• Consumers should generally bear responsibility for their financial decisions, but
should be able to expect financial products and services to perform in the way
they are led to believe they will.
• Policy makers should be aware of, and design regulatory frameworks that take
into account, behavioural biases.
Themes of this report

Australia’s financial system has performed well since the Wallis Inquiry. Australia has
a competitive financial system with sophisticated capital markets and firms that are
quick to adopt new technologies that reduce costs or provide improved products and
services.
12
Overview
Although Australia was not immune to the effects of the GFC, the financial system and
institutional framework held up well compared with many financial systems
elsewhere in the world. In particular, Australia’s regulatory frameworks proved robust
during this period.
However, the Inquiry’s assessment is that Australia’s financial system is at risk of

falling short of its potential to operate in a manner characterised by efficiency,
resilience and fair treatment. This assessment led the Inquiry to focus on the seven
themes in this report (summarised in Figure 1: Guide to the Financial System Inquiry Final
Report).
The first general theme, the funding of the Australian economy, refers to the core
function of the financial system. A number of important opportunities for
improvement in funding relate to tax. While taxation is outside the terms of reference
of this Inquiry, a number of observations on tax are summarised in
Appendix 2: Tax summary.
The second general theme, competition, underpins a well-functioning financial system

and is integral to a number of recommendations of this report.
The Inquiry has also made recommendations within five specific themes, each of
which is covered in an individual chapter:
• Strengthen the economy by making the financial system more resilient

(Chapter 1: Resilience).
• Lift the value of the superannuation system and retirement incomes

(Chapter 2: Superannuation and retirement incomes).
• Drive economic growth and productivity through settings that promote innovation
(Chapter 3: Innovation).
• Enhance confidence and trust by creating an environment in which financial firms

treat customers fairly (Chapter 4: Consumer outcomes).
• Enhance the independence and accountability of regulators and minimise the need
for future regulatory intervention (Chapter 5: Regulatory system).
In addition, a number of other recommendations are summarised in

Appendix 1: Significant matters.

The core function of the Australian financial system is to facilitate the funding of
sustainable economic growth and enhance productivity in the Australian economy.
This is the starting point for considering whether Australia’s current financial system
13
is fit for purpose, which greatly influences the Inquiry’s view on specific
recommendations within this report.
As outlined in the Interim Report, it is difficult to assess and quantify the most efficient
allocation of funding for the Australian economy. 18 In the view of the Inquiry, the
framework for the issuance and trading of debt and equity in Australia is operating
reasonably well. Australia has a well-functioning equity market, a sophisticated
wholesale financial market, and a privately owned banking and insurance system that
provides a range of competitive retail products and services. However, some funding
markets in Australia, including the corporate bond and venture capital markets,
appear underdeveloped compared with those of some international peers.
The Inquiry has taken a principles-based approach to funding policy. The Inquiry
believes government’s role in funding markets should generally be neutral on the
channel, direction, source and size of the flow of funds. Financial instruments, markets
and forms of intermediation should develop, evolve and operate in ways that best
reflect investor and borrower preferences and technological developments. Outside an
extreme financial shock, there is generally little benefit in policy makers attempting to
improve efficiency by insulating the economy from market forces. Instead, the
Inquiry’s approach has been to seek to identify and remove distortions to the
inefficient allocation of resources.
The Inquiry has heard four main concerns in relation to the flow of funding in the
Australian economy. First, that some funding markets, including the corporate bond
and venture capital markets, are too small. Second, that particular sectors of the
economy, such as small and medium-sized enterprises (SMEs) or rural businesses, do
not have sufficient access to funding. Third, that the major banks may face a ‘funding
gap’ that would restrict economic growth in the future. Finally, stakeholder input and
Inquiry research indicate significant potential tax distortions.
Regarding the relative size of various funding markets, the Inquiry’s approach is to
seek to remove unnecessary regulatory settings that distort the flow of funds favouring
the use of one market over another. In the case of the domestic corporate bond market,
these include both tax and regulatory settings such as excessive disclosure
requirements. The Inquiry does not believe mandating or subsidising a particular
market in an attempt to increase its size (whether it be corporate bond, securitisation or
venture capital markets) is an effective strategy in the long term. Instead, the size of a
funding market should reflect market forces.
Some submissions also called on Government to influence the allocation of resources

towards particular sectors of the economy perceived to have insufficient access to
funding. For example, several submissions call on Government to encourage the
18 Commonwealth of Australia 2014, Financial System Inquiry Interim Report, page 2-44.
14
Overview
investment of superannuation assets in infrastructure or to establish a

Government-owned bank to direct funding to particular causes, such as rural
businesses. The Inquiry does not support such approaches — to maximise the
efficiency of the financial system policy makers should not set out to favour one
particular funding destination over another.
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. Appendix 3: Small and medium sized enterprises (SMEs) summarises the
Inquiry’s recommendations relating to SMEs.
As discussed in the Interim Report, some submissions also argued that the major
banks face a ‘funding gap’. 19 These submissions suggest that in some circumstances
banks would be unable to fund higher credit growth with new deposits, placing
economic growth at risk. The Inquiry acknowledges that the ability of Australian
banks to fund themselves is critical to their stability and is of great importance to the
broader economy. However, on consideration of the relevant evidence and arguments,
the Inquiry has concluded that Australia is not at risk from an emerging ‘funding gap’
for the following reasons:
• To the extent that some banks cannot source sufficient funding on commercially
attractive terms to meet demand, market mechanisms such as the price of credit
will attract alternative providers of funds, for example superannuation funds and
other investors lending directly, greater prevalence of market-based financing or
peer-to-peer lending.
• Such market mechanisms are also likely to increase the attractiveness of deposits as
an investment vehicle under a high credit-growth scenario, thus increasing the
supply of funding available to the banks (as occurred in Australia in the period
following the GFC). 20
The Inquiry takes a neutral approach to the mechanism through which Australia
sources its funding, including funding from offshore markets. The flow of funds
should be subject to market forces and be free to evolve to meet user demands and
market conditions.
The funding-related issue that concerns the Inquiry most is that of distortions to the
market allocation of resources, including through taxation, information imbalances
19 Commonwealth of Australia 2014, Financial System Inquiry Interim Report, page 2-78.
20 For a description of the interaction between the provision of credit and holding of deposits
by banks, refer to McLeay M, Radia A and Thomas R, 2014 ‘Money creation in the modern
economy’ Bank of England Quarterly Bulletin Quarter 1, pages 14–27.
15
and unnecessary regulation. 21 If unaddressed, such distortions are likely to lead to

lower productivity and lower longer-term living standards than otherwise would be
the case.
A significant number of the distortions identified are tax-related, as summarised in

Box 3: Major tax distortions. Reducing the distortionary effects of these taxes should lead
the system to allocate savings (including foreign savings) more efficiently and price
risk more accurately. This would increase aggregate productivity and limit the
build-up of systemic vulnerabilities.
Throughout this report, the Inquiry has made a number of recommendations relating
to funding:
• The Tax White Paper should consider the reform of tax settings that distort the flow
of funds (see Box 3: Major tax distortions).
• Obstacles to the growth of the corporate bond market should be addressed,

including regulatory barriers and tax distortions, particularly the non-neutral
treatment of savings vehicles (see Appendix 2: Tax summary and Recommendation 33:
Retail corporate bond market).
• Reforms should be made to remove obstacles to SME financing, including

facilitating crowdfunding and reducing information imbalances (see Appendix 3:
Small and medium sized enterprises (SMEs)).
• To strengthen Australia’s ability to continue to access funding, both domestically

and from offshore sources, recommendations have been made to improve the
resilience of the Australian financial system (see Chapter 1: Resilience).
• A more efficient superannuation system should result in more funds for investment
as well as more effective investment decisions and more efficient allocations of
funds (see Chapter 2: Superannuation and retirement incomes).
21 Refer to Chapter 1: Resilience for a discussion on distortions related to perceptions of implicit

guarantees.
16
Overview
Box 3: Major tax distortions

A more neutral tax treatment of savings vehicles would reduce distortions in the
composition of household balance sheets and the broader flow of funds in the
economy. Across savings vehicles, after-tax returns differ markedly. For example,
interest income is relatively heavily taxed. 22 To the extent that distortions direct
savings to less productive investments, a more neutral treatment would increase
productivity.
For assets that generate capital gains, the tax treatment encourages leveraged
investment, which is a potential source of financial system instability. Investors are
attracted by the asymmetry in the tax treatment of expenses and capital gains,
where individuals can deduct the full interest costs of borrowing (and other
expenses) from taxable income, but only half of their long-term capital gains are
taxed. The tax treatment of investor housing, in particular, tends to encourage
leveraged and speculative investment in housing.
The implications of dividend imputation are less clear. The introduction of
imputation reduced firms’ cost of equity; however, the effectiveness of imputation
in lowering the cost of capital arguably has declined as the economy has become
more open. The tax benefits of imputation may encourage domestic investors to
invest in domestic firms with domestically-focused investments, which would limit
opportunities and increase risk from less diversified portfolios. To the extent that
imputation distorts the allocation of funding, a lower company tax rate would be
likely to reduce those distortions. A lower company tax rate would also enhance
Australia’s attractiveness as a place to invest, which would increase Australia’s
productivity and living standards.
Reducing the uncertainty and scope of taxes on cross-border flows would improve
Australian entities’ access to offshore savings. Access to offshore funding markets
provides Australian entities with cheaper funds than otherwise would be the case.
Having access to more diverse sources of funding reduces the risk from dislocation
in one or more funding markets. That said, the complex, ad-hoc tax treatment of
cross-border transactions reflects, in part, Government’s desire to maintain the
integrity of the tax base — from profit shifting and other tax avoidance strategies —
in the face of continued financial innovation and internationalisation.
22 Commonwealth of Australia 2014, Financial System Inquiry Interim Report, Canberra,

page 2-49.
17
Box 3: Major tax distortions (cont.)

For non-residents, repatriated income from Australian investments is subject to a
regime of withholding taxes. The application and rate of withholding tax varies
with respect to a host of factors, including the type of funding, the country of the
foreign entity and the relationship between the domestic and foreign entity.
Withholding tax increases the required rate of return for non-residents, which
reduces the attractiveness of Australia as an investment destination. In cases where
the non-resident can pass on the cost, the cost of funding is raised in Australia.
Refer to Appendix 2: Tax summary for additional information on the Inquiry’s
observations related to tax.
Competition
The Inquiry believes competition and competitive markets to be at the heart of its
philosophy and sees them as the primary means of improving the system’s efficiency.
This section builds on the discussion in the Interim Report of the competitive strength
in various sectors of the Australian financial system. 23 It summarises the Inquiry’s
recommendations regarding amendments to current competitive regulatory settings
and strengthening competition in the future. These recommendations are spread
across a range of chapters in this report.
Competition in the financial system is generally adequate at present. The Inquiry’s

approach to encouraging competition is to remove impediments to its development.
The Inquiry recommends making the following adjustments to current regulatory
settings:
• Narrowing the differences in risk weights between authorised deposit-taking

institutions (ADIs) using internal ratings-based models and those using
standardised models in mortgage lending (see Recommendation 2: Narrow
mortgage risk weight differences).
• Introducing a competitive process to allocate new default fund members to

high-performing superannuation funds, unless the Stronger Super reforms prove
effective (see Recommendation 10: Improving efficiency during accumulation).
• Refining the payments regulation framework (see Recommendation 16:

Clearer graduated payments regulation).

Chapter 2.
18
Overview
• Supporting innovation and new entrants (see recommendations 14: Collaboration to

enable innovation, 15: Digital identity, 18: Crowdfunding, 19: Data access and use,
20: Comprehensive credit reporting, 39: Technology neutrality and 30: Strengthening the
focus on competition in the financial system).
In addition, the Inquiry notes that perceptions of implicit guarantees in the banking
system can distort competition by providing a funding advantage to those banks
believed to most benefit from such guarantees. Recommendations that increase the
resilience of the banking sector, especially of the largest banks, will reduce these
perceptions over time and help contribute to restoring a more competitive
environment. 24
Notwithstanding the above recommendations to amend current regulatory settings,

high concentration and trends towards increasing vertical integration in some sectors
of the financial system have the potential to limit the benefits of competition in the
future.
The Inquiry acknowledges that no single solution will guarantee the ‘right’ level of
competition in the future — competition is a dynamic concept, changing over time.
Instead, policy makers should be proactive in reviewing levels of competitiveness and
removing barriers to the emergence of disruptive competitors, including both
international entrants and domestic innovators. 25 In particular, the state of competition
in the financial system should be reviewed every three years, including assessing
changes in barriers to international competition (see Recommendation 30: Strengthening
the focus on competition in the financial system).
Conduct and prudential regulators have a natural tendency to prioritise fairness or

stability over competition and long-term efficiency. The long-term benefits of
competition can be potentially difficult to identify or value, while the short-term costs
of instability or unfair outcomes are immediately visible to regulators, governments
and the general public. Therefore, the Inquiry has made a number of recommendations
to ensure regulators are more sensitive to the effects their decisions have on
competition:
• A Financial Regulator Assessment Board should be established to advise

Government, including on how regulators consider competition issues in designing
and implementing regulation (see Recommendation 27: Regulator accountability).
24 This approach has been recognised by the Financial Stability Board. See Financial Stability
Board (FSB) 2014, Adequacy of loss-absorbing capacity of global systemically important banks in
resolution, Basel, page 6.
25 The Inquiry supports the approach outlined in the draft report of the Competition Policy
Review, suggesting a new Australian Council for Competition Policy be empowered to carry
out market studies of competition in particular sectors. See Commonwealth of Australia
2014, Competition Policy Review — Draft Report, Canberra, Recommendation 39, page 57.
19
• An explicit requirement to consider competition should be included in the

Australian Securities and Investments Commission’s (ASIC) mandate
(see Recommendation 30: Strengthening the focus on competition in the financial system).
• Regulators should more clearly explain in their annual reports how they have
considered the effect of their decisions on competition and compliance costs
(see Recommendation 27: Regulator accountability).
As discussed in the Interim Report, the Inquiry supports the implementation of the
Council of Financial Regulators (CFR) recommendations on strengthening the financial
market infrastructure (FMI) framework and Government’s review of the market
licensing framework. 26 This would create a framework under which competition and
international financial integration in FMI could be increased.
As outlined in Box 4: International competitiveness, unnecessary barriers to international

competitiveness and market access into Australia should be front of mind in designing
and applying Australia’s regulatory frameworks. The free flow of capital in and out of
Australia significantly benefits competition and those who use Australia’s financial
system. For example, borrowers can lower their funding costs by directly accessing
international bond markets, or they can borrow from Australian intermediaries that
have lowered their funding costs by accessing less expensive foreign sources of capital.
Box 4: International competitiveness

Australia has relatively open financial markets: foreign financial services providers
can generally provide retail services on the same terms as domestic competitors.
Many wholesale markets are open to foreign providers, such as foreign ADI
branches, without the need to comply with specific domestic regulatory frameworks
— strengthening competition.
But Australia’s financial sector is less open and internationally integrated than it
could be now — and than it will need to be in the future. 27 More needs to be done to
remove impediments to cross-border competition and other barriers to the free flow
of capital across borders, such as tax impediments.

page 2-37.
27 For a discussion of international integration of the Australian financial system, refer to
Commonwealth of Australia 2014, Financial System Inquiry Interim Report, Canberra,
Chapter 10.
20
Overview
Box 4: International competitiveness (cont.)

Developments and opportunities in Asia make change imperative. Financial system
liberalisation and integration in our region creates an opportunity to mobilise
surplus savings more efficiently and channel it to investment opportunities,
supporting economic development and trade.
Where possible, policy makers should avoid adopting unique Australian

regulatory approaches that are inconsistent with international practice. They should
also remove impediments to recognising foreign frameworks for domestic purposes
(either unilaterally or mutually). The Inquiry recommends:
• Government and regulators should identify rules and procedures that create
barriers to competition and consider whether these can be modified or removed.
(see Recommendation 30: Strengthening the focus on competition in the financial
system).
• Government should also consider developing a mechanism to enable Australian

fund managers to use collective investment vehicles that are more common
overseas, such as a corporate vehicle (see Recommendation 42: Managed investment
scheme regulation).
Government and regulators should develop and implement regulatory frameworks

in ways that do not impose unnecessary costs on Australian firms operating
offshore but support improved access to offshore markets. 28
Tax impediments to the free flow of capital add to the cost of doing business in
Australia. They limit the capacity for Australia’s financial system to exploit new and
developing product areas, such as those for the Renminbi market, which would
diversify financial solutions available in Australia.
Resilience
Australia weathered the GFC well relative to many international peers. However, it
would be imprudent to assume the conditions that cushioned Australia during the
crisis will exist when future shocks occur. Australia should heed the lessons learnt by
other countries during the GFC. As a capital-importing country exposed to fluctuating
terms of trade and characterised by a concentrated banking system, Australia needs to
be better positioned than most.
28 A recent example is the financial services component of the China-Australia Free Trade
Agreement, Department of Foreign Affairs and Trade 2014, China-Australia Free Trade
Agreement — Key Outcomes, Canberra, viewed 19 November,
<http://www.dfat.gov.au/fta/chafta/fact-sheets/key-outcomes.html>.
21
Australia will experience future financial crises. However, their timing and sources are
difficult to predict. As outlined in Box 5: Systemic and housing risk in Australia, in some
circumstances, the Australian financial system is vulnerable to a number of sources of
risk that could severely damage both the economy and individuals’ financial
circumstances.
Box 5: Systemic and housing risk in Australia

A number of characteristics of the Australian economy and financial system present
sources of potential systemic risk: 29
• As a large capital importer, Australia is susceptible to the dislocation of

international funding markets or a sudden change in international sentiment
towards Australia, which would reduce access to, and increase the cost of,
foreign funding.
• As an open economy, Australia is exposed to shocks in the economies of our

major trading partners and subject to volatility in commodity prices.
• Australia’s banking system is highly concentrated, with the four major banks
using broadly similar business models and having large offshore funding
exposures. 30 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. 31 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.
29 A disruption to the financial system could be considered systemic if it was so widespread or

severe that it caused material damage to the economy.
30 International Monetary Fund (IMF) 2012, Australia: Financial System Stability Assessment, IMF,
Washington, page 10.
page 2-56.
22
Overview
Given Australia’s concentrated financial system, high household leverage and

relatively high house prices, the Inquiry is particularly concerned about the banking
system’s exposure to housing. Despite housing risk being generally well understood
by both regulators and the financial industry, the Inquiry has specifically considered
this risk when making its recommendations.
More can be done to strengthen the resilience of Australia’s financial system. Although
no system can ever be ‘bullet proof’, Australia should aim to cultivate financial
institutions with the strength not only to withstand plausible shocks but to continue to
provide critical economic functions, such as credit and payment services, in the face of
these shocks.
A number of aspects are critical to this strength, including an institution’s capital

levels, liquidity, asset quality, business model and governance, and Australia’s
sovereign credit rating. Of these, capital levels are particularly important, as they
provide a safety buffer to absorb losses regardless of the source.
The Inquiry proposes a package of recommendations to enhance resilience in

Australia’s financial system. This package would make institutions less susceptible to
shocks and the system less prone to crises. It would reduce the costs of crises when
they do happen and improve the allocative efficiency of the system generally by
reducing perceptions of an implicit guarantee. The package aims to minimise the cost
to taxpayers, Government and the broader economy from risks in the financial system.
In doing so, the package seeks to balance trade-offs between system safety and
competitiveness where they are in conflict, and aspires to have competitively neutral
regulatory settings where possible.
The Inquiry has primarily focused on reforms to two aspects of Australia’s financial
stability framework:
• ADI capital levels should be raised to ensure they are unquestionably strong.
Evidence from banks, regulators and others suggests that Australian banks are not
in the top quartile of large internationally active banks. Regulatory changes in other
countries may further weaken the relative position of Australian banks. The Inquiry
believes that top-quartile positioning is the right setting for Australian ADIs
(see Recommendation 1: Capital levels).
• 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. Regulators’ toolkits are critical and should be
enhanced to prevent distress and to resolve failing financial institutions (see
Recommendation 3: Loss absorbing and recapitalisation capacity and Recommendation 5:
Crisis management toolkit).
In the Inquiry’s view, raising capital requirements for ADIs would provide a net
benefit to the economy. It would assist to avoid or reduce the severe and prolonged
23
costs of future crises, including high levels of unemployment. The cost of raising
capital would be reduced by competition in the market, including the effect of the
recommendations in this report. 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. 32
Making the system more resilient also has efficiency benefits. Large or frequent
financial crises create volatility and uncertainty that impede the efficient allocation of
resources and harm dynamic efficiency by discouraging investment. In the resulting
long periods of high unemployment, productive resources are under-utilised.
In addition, if implemented, this package of reforms should prevent the need for
further structural reform in the industry, such as ring-fencing certain operations of the
major banks. The Inquiry also believes that introducing the proposed reforms would
reduce the need to pre-fund the Financial Claims Scheme (see Recommendation 6:
Financial Claims Scheme).
Although stability settings aim to minimise the economic cost of financial institutions
failing, it is not possible — or efficient — to eliminate failure altogether. Government
must ensure its financial position remains sufficient to support the financial system in
a future crisis. Macro-economic conditions can deteriorate rapidly in a crisis, and
Government needs to remain alert to this. Maintaining a AAA credit rating would give
Government the flexibility necessary to support the economy (although not necessarily
the failed institutions) in such circumstances.
The GFC highlighted the benefits of Australia’s largely unleveraged superannuation

sector. The absence of borrowing enabled the superannuation sector to have a
stabilising influence on the financial system and the economy during the crisis.
Restricting leverage in the sector will be important for mitigating future risks (see
Recommendation 8: Direct borrowing by superannuation funds).
Superannuation and retirement incomes

Superannuation is now the second largest asset for many Australians. Its growing
importance underlines the need for a regulatory approach that puts individual
members at the very centre of the system — benefiting both individual Australians and
the economy as a whole.
32 For details of this estimate, please see Chapter 1: Resilience. This is a conservative estimate that
does not account for a number of important benefits, including reducing perceptions of an
implicit guarantee, or factors that mitigate the cost, such as the effect of competition and
monetary policy settings.
24
Overview
An efficient superannuation system is critical to help Australia meet the economic and
fiscal challenges of an ageing population. While its importance for retirees and, to a
lesser extent, taxpayers is self-evident, superannuation efficiency is also vital to
sustaining long-term economic growth, given the system’s increasing importance in
funding Australia’s prosperity.
Australia’s superannuation system has considerable strengths. However, the system

lacks efficiency in a number of areas.
The lack of clarity around the ultimate objective of superannuation policy contributes
to ad hoc short-term policy making, which imposes unnecessary costs on
superannuation funds and members, reduces long-term confidence in the system and
impedes efficiency. The Inquiry believes the purpose of the superannuation system is
to provide an individual with an income in retirement (see Recommendation 9:
Objectives of the superannuation system).
At retirement, superannuation assets are not being efficiently converted into

retirement incomes. This contributes to a significantly lower standard of living for
some Australians in retirement and during their working life. Efficiency can be
improved by removing barriers to product development and encouraging the take-up
of pooled longevity products by requiring superannuation trustees to pre-select a
comprehensive income product in retirement, while maintaining member choice
(see Recommendation 11: The retirement phase of superannuation).
Economic growth will benefit if the growing number of retirees are able to sustain
higher levels of consumption. The superannuation system is not operationally efficient
due to a lack of strong price-based competition. As a result, the benefits of scale are not
being fully realised. Although it is too early to assess the effectiveness of the Stronger
Super reforms, the Inquiry has some reservations about whether MySuper will be
effective in driving greater competition in the default superannuation market.
Unless the Stronger Super reforms prove effective, the Inquiry recommends
introducing a competitive process to allocate new default fund members to
high-performing superannuation funds. This would improve the competitive
dynamics of the sector, reduce costs for funds and reduce compliance costs for
employers (see Recommendation 10: Improving efficiency during accumulation).
25
The superannuation recommendations in this report have the potential to increase

retirement incomes for an average male wage earner by around 25 to 40 per cent
(excluding the Age Pension). 33 While these estimates are illustrative and based on
models that cannot fully reflect the unique circumstances of different individuals, the
Inquiry is confident that significant increases in retirement incomes can be achieved.
To protect the best interests of members the Inquiry has also made recommendations
to improve the governance of superannuation funds (see Recommendation 13:
Governance of superannuation funds) and remove restrictions on some employees
choosing the fund that receives their Superannuation Guarantee contributions (see
Recommendation 12: Choice of fund).
Innovation
For the financial system, technology-driven innovation is transformative.
Opportunities for innovation are abundant as, fundamentally, the system revolves
around recording, analysing and interpreting transactions, and managing associated
information flows. With no physical products to manage, these processes readily lend
themselves to improvements via digital technologies.
In Australia, the effect has been significant, particularly as Australian consumers are
fast adopters of technology compared to consumers in many other countries.
The Inquiry cannot be certain of how future developments in technology will affect the
financial system. Innovation is by its nature evolving and dynamic, and primarily
driven by private sector commercial incentives and customer expectations. Instead, the
Inquiry has focused on ensuring policy settings accommodate technological change to
facilitate a dynamic, competitive, growth-oriented and forward-looking financial
system.
33 Estimates prepared by the Australian Government Actuary for the Inquiry, using input from
Treasury models. Over 10 percentage points of the estimated increase in retirement income
reflects the benefits of lower superannuation fees and savings from maintaining only a single
superannuation account over a person’s working life. The remaining portion (and range)
reflects the use of a comprehensive income product in retirement; in particular, different
combinations of an account-based pension and either a deferred life annuity or group self
annuitisation product. The estimates are also sensitive to assumptions regarding the level of
contributions, time in the workforce and the drawdown rate for the account-based pension.
The major driver of the increase in retirement income is the benefit of pooling in retirement,
which comes at a cost of smaller bequests from superannuation and reduced flexibility. For
further details, see Chapter 2: Superannuation and retirement incomes.
26
Overview
The Inquiry has focused on reforms to Australia’s innovation architecture. It

recommends:
• Government should review the costs and benefits of increasing access to, and
improving the use of, data. As increasing amounts of data are collected and more
sophisticated analytical techniques emerge, data can be used to develop alternative
business models, products and services that improve user outcomes and system
efficiency (see Recommendation 19: Data access and use).
• A national strategy for a federated-style model of trusted digital identities should

be developed to set a framework and common standards to support the
development of a competitive market in identity services that enhances consumer
choice, privacy and security, and balances these objectives with financial system
efficiency (see Recommendation 15: Digital identity).
• Government and regulators should remove unnecessary impediments to

innovation by applying graduated functional frameworks in a range of areas,
including the payments system. The Inquiry supports simplifying and clarifying
payments regulation to facilitate innovation; lowering interchange fees to
reduce costs for merchants and prices for customers; and preventing merchants
from over-surcharging customers paying with debit and credit cards (see
Recommendation 16: Clearer graduated payments regulation and Recommendation 17:
Interchange fees and customer surcharging).
• Graduating the regulation of market-based financing will increase opportunities for

small businesses to seek finance from the general public. The Inquiry supports
facilitating crowdfunding and other innovative sources of finance (see
Recommendation 18: Crowdfunding).
The Inquiry’s recommendations seek to provide more facilitative settings that enable
financial firms to innovate — increasing competitive tension, delivering greater
efficiency and enhancing user outcomes.
Consumer outcomes
To build confidence and trust, and avoid over-regulation, the financial system should
be characterised by fair treatment.
In terms of fair treatment for consumers, the current framework is not sufficient. 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. 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.
27
Consumers should have the freedom to take financial risks and bear the consequences
of these risks. However, the Inquiry is concerned that consumers are taking risks they
might not have taken if they were well informed or better advised.
The Inquiry deliberated on a spectrum of approaches, from regulating core product

features to introducing appropriateness and suitability tests for complex products,
which are features of some international jurisdictions. The Inquiry has developed an
approach that streamlines and complements the current framework and strengthens
the accountability of product issuers and distributors. The Inquiry recommends the
following package of reforms:
• The design and distribution of products should be strengthened through improved

product issuer and distributor accountability, and the creation of a new product
intervention power to allow ASIC to take a more proactive approach in reducing
the risk of significant detriment to consumers (see Recommendation 21: Strengthen
product issuer and distributor accountability and Recommendation 22: Introduce product
intervention power).
• Standards of financial advice should be improved by lifting adviser competency

(see Recommendation 25: Raise the competency of advisers), better aligning the interests
of firms and consumers and enhancing banning powers (see Recommendation 24:
Align the interests of financial firms and consumers).
• Regulatory impediments to industry use of technology should be removed (see

Recommendation 39: Technology neutrality) and more innovative forms of disclosure
developed (see Recommendation 23: Facilitate innovative disclosure).
The Inquiry expects these changes will reduce the likelihood of future losses similar to
those experienced in recent financial investment collapses. 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. 34 The
changes outlined in this report should also significantly improve consumer confidence
and trust in the financial system.
The Inquiry considers that the additional regulatory elements of the package will
rebuild consumer confidence and trust in the financial system in the long term, and
should help to limit the need for more interventionist regulation in the future. For
reputable firms with a strong customer focus, the Inquiry expects that costs involved in
changing practices in response to the recommendations will be low. The Inquiry notes
34 This estimate includes losses involving Storm Financial, Opes Prime, Westpoint, Great
Southern, Timbercorp and Banksia Securities.
28
Overview
that success will require a greater level of regulator judgement, necessitating

high-quality, accountable regulators with adequate funding.
The Inquiry also supports continuing industry and government efforts to increase
financial inclusion and financial literacy to improve customer outcomes.
Regulatory system
The roles and performance of financial system regulators have an important effect on
system efficiency. Strong, independent and accountable regulators assist in
maintaining confidence and trust in the financial system.
The Inquiry considers that Australia’s current regulatory architecture does not need
major change. Although minor refinements are necessary, the roles of the three major
financial regulators — the Reserve Bank of Australia, the Australian Prudential
Regulation Authority (APRA) and ASIC — remain appropriate.
The Inquiry’s philosophy places a high level of trust in regulators to make judgements
that balance the efficient, stable and fair operation of the financial system. While
acknowledging that regulators often have a difficult task, there is room for
improvement. In particular, the current arrangements lack a systematic mechanism for
Government to assess regulators’ performance relative to their mandate. Instead,
scrutiny tends to be episodic and focused on particular issues or decisions. A new
Financial Regulator Assessment Board should be established to conduct annual
performance reviews of regulators and provide advice to Government (see
Recommendation 27: Regulator accountability).
Regulators also need to have the funding, expertise and regulatory tools to deliver on
their mandates effectively. APRA and ASIC would benefit from more funding
certainty, more operational flexibility and a greater ability to compete with industry
for staff (see Recommendation 28: Execution of mandate). ASIC should be able to recover
the costs of its regulatory functions from industry, and its powers need strengthening
in some areas (Recommendation 29: Strengthening Australian Securities and Investments
Commission’s funding and powers).
Regulators should also undertake periodic, forward-looking capability reviews to

ensure they are fit for purpose and have the capability to address future regulatory
challenges.
Levels of financial regulation

Internationally, the pace of change in financial system regulation has surged since the
GFC, with some of these regulatory changes yet to be fully agreed and implemented.
As a capital-importing country, Australia has had little choice but to introduce many of
these changes. This is on top of a range of fundamental changes in the domestic
regulatory framework in the last decade, such as the Stronger Super, FOFA and
national consumer credit reforms.
29
The Inquiry commissioned Ernst & Young (EY) to assess the cost effectiveness of
certain regulatory changes implemented in the last decade. 35 Although the assessment
highlighted broad agreement with the policy that led to the intervention, it also
highlighted shortcomings in how policy makers and regulators approach regulatory
design and implementation. These included gaps in consultation processes and
optimistic time frames for implementation.
The Inquiry is very conscious that unnecessary and inappropriate regulation has the
potential to reduce the financial system’s efficiency. It therefore supports ongoing
Government efforts to review and remove unnecessary regulation in the financial
system and has not sought to duplicate this process. 36 The Inquiry makes
recommendations to remove unnecessary regulation or improve regulatory processes
(see Recommendation 31: Compliance costs and policy processes and Recommendation 39:
Technology neutrality).
That said, the Inquiry recognises that many of its recommendations involve new
regulation or changes to existing regulation. The Inquiry considers that these
recommendations will both strengthen the financial system now and prevent excessive
regulatory responses in the longer term. A more competitive and innovative financial
system with minimal distortions will improve allocative efficiency and drive
sustainable growth. A more resilient financial system will manage future financial
shocks at a lower cost to the taxpayer and the real economy. A fairer financial system
will avoid the need for more interventionist regulation in the future. In particular, the
Inquiry is seeking to avoid rushed regulatory reactions motivated primarily by the
political environment.
Of course, this Inquiry cannot guarantee that there will not be further unnecessary or
poorly designed regulation in the future. The quality of new regulation will depend on
the actions of industry, regulators and governments.
Conclusion
The Inquiry believes that, if implemented and enforced, the recommendations in this
report should provide a robust framework to strengthen the financial system, and
position it to meet Australia’s evolving needs and support sustainable economic
growth.
35 Refer to Chapter 5: Regulatory system for further information on this research.

36 The Commonwealth’s whole-of-Government deregulation agenda is outlined in Department
of the Prime Minister and Cabinet 2014, Whole of Government deregulation agenda,
Commonwealth of Australia, viewed 14 November 2014,
<https://www.dpmc.gov.au/deregulation/whole_govt_agenda.cfm>.
30
Overview
The Inquiry recognises it has not addressed all issues put before it by interested
parties. The Final Report, by necessity, prioritises those issues the Inquiry considers
most important in setting a blueprint for the Australian financial system.
The issues examined and recommendations made by the Inquiry involve matters of
judgement. Importantly, the Inquiry’s test in these judgements has been one of public
interest: the interests of individuals, businesses, the economy, taxpayers and
Government. Some recommendations are likely to have a private cost for stakeholders.
These costs have been explicitly taken into account in the Inquiry’s deliberations. After
carefully considering the evidence provided, the Inquiry’s judgment is that the benefit
to the public interest from these recommendations outweighs their associated costs.
The net result of these recommendations would be to:
• Encourage an efficient financial system to allocate Australia’s scarce financial and

other resources for the greatest possible benefit to the economy, promoting higher
and more sustainable productivity and economic growth.
• Promote competition in the financial system, both now and into the future.
• Strengthen the resilience of the financial system, improving its capacity to adjust to
both the normal business cycle as well as a severe economic shock.
• Lift the value of Australia’s superannuation system and retirement incomes both
for individuals and the economy.
• Drive economic growth and productivity by establishing policy settings that

promote an innovative and dynamic financial system.
• Enhance the confidence and trust that users of financial products and services have
in the financial system by creating a regulatory environment in which financial
firms treat their customers fairly.
• Provide financial regulators with the right tools to achieve their mandates, while
ensuring they are held accountable.
Such outcomes will improve efficiency, resilience and fair treatment in the Australian
financial system, allowing it to achieve its potential in supporting economic growth
and enhancing standards of living for current and future generations.
31
Australia’s financial sector is not invulnerable to risks to stability, and the costs of
crises can be wide-ranging and severe. Financial crises can deeply damage an economy
and have a lasting impact on people’s lives. Although Australia was not as acutely
affected by the global financial crisis (GFC) as some countries, international experience
suggests the average financial crisis could see 900,000 additional Australians out of
work as well as substantially reduce the wealth of a generation. 1 Financial crises tend
to be protracted, with unemployment remaining high for years. The average total cost
of a crisis is around 63 per cent of annual gross domestic product (GDP), and the cost
of a severe crisis is around 158 per cent of annual GDP ($950 billion to $2.4 trillion in
2013 terms). 2
More can be done to strengthen Australia’s economy and financial system by

preventing and mitigating these costs. Although no system can ever be ‘bulletproof’,
Australia should aim to cultivate financial institutions with the strength to not only
withstand plausible shocks, but also to continue to provide critical economic functions,
such as credit and payment services, in the face of these shocks. Australia also needs a
system that minimises the costs to individuals, the economy and taxpayers when
financial failure does occur. The world has learnt valuable lessons from the GFC, and
Australia should look to benefit from this experience.
A more resilient financial system also has efficiency benefits. Large or frequent
financial crises create volatility and uncertainty, which impede the efficient allocation
of resources and harm dynamic efficiency by discouraging investment. In addition, the
long periods of high unemployment following crises reflect under-utilised resources.
Government actions required to stabilise financial sectors both overseas and in

Australia during the GFC reinforced perceptions that some institutions are implicitly
guaranteed. The private sector accrued gains from financial activities in the run-up to
the GFC, but losses and risk were shared with taxpayers when failures occurred or
were threatened. These implicit guarantees create market distortions, altering the
risk-reward equation and conferring a funding cost advantage on financial institutions
perceived as guaranteed.
Removing perceptions of these guarantees will reduce Government’s contingent

liability and improve the efficiency of the financial system and economy. This chapter
1 Reinhart, C and Rogoff, K 2009, This time is different: eight centuries of financial folly, Princeton
University Press, Princeton, page 224. The authors find that the average financial crisis
increases unemployment by seven percentage points, which is almost 900,000 people as at
October 2014.
2 Basel Committee on Banking Supervision 2010, An assessment of the long-term economic impact
of stronger capital and liquidity requirements, Bank for International Settlements, Basel, page 10.
33
recommends steps to minimise these perceptions in Australia. These steps will

strengthen the resilience of banks and enhance resolution arrangements that minimise
the need for taxpayer support. In the Inquiry’s view, the alternative option of charging
for such guarantees is not appropriate for Australia as it does not reduce the
contingent liability of Government.
Strength in the financial system

The Australian financial system has characteristics that give rise to particular risks. The
financial system is complex and highly interconnected with the rest of the world.
Australia is a capital-importing nation with a significant component of domestic
investment funded by foreign savings channelled through the banking system. The use
of foreign investment, which the Inquiry expects to continue, has been advantageous
for Australia, enabling higher investment and growth than would otherwise have been
possible. Yet it also brings risks, such as vulnerability to a loss of foreign investor
confidence, which may lead to increased costs and a sharp contraction in funds
available for investment.
As the banking sector is at the core of the Australian financial system, its stability is of
paramount importance. The sector is responsible for the majority of intermediation
between savers and investors, and is highly interconnected with the rest of the
financial system. In addition, the banking sector is concentrated, with the four major
banks being the largest players in virtually all respects. This concentration, combined
with the predominance of similar business models focused on housing lending,
exacerbates the risk that a problem at one institution could cause issues for the sector
and financial system as a whole. To prevent further concentration, the longstanding
‘Four Pillars’ policy, which precludes mergers between the four major banks, should
be preserved as outlined in the Interim Report.
The importance of the banking sector means that it must be unquestionably strong to
meet the needs of Australia. A number of aspects are critical to this strength, including
an institution’s capital levels, liquidity, asset quality, business model and governance,
and Australia’s sovereign credit rating. Australian authorised deposit-taking
institutions (ADIs) are generally well placed in these respects, with strengthened
capital and liquidity requirements, low loan losses, a business model focused on
domestic and commercial banking, sound governance and a AAA-rated Government.
Of these, capital levels are particularly important, as they provide a safety buffer to
absorb losses no matter what their source. In the Inquiry’s view, although Australian
ADIs are generally well capitalised, further strengthening would assist in ensuring
capital levels are, and are seen to be, unquestionably strong. Liquidity is also very
important and must be readily available. Given the considerable strengthening of
regulatory liquidity requirements underway — the effects of which have yet to be seen
— the Inquiry has not made recommendations in this area.
34
Australia’s stability framework promotes strength in these aspects through:
1. Active supervision by APRA — a vital component that must remain strong. It

is particularly useful for assessing the qualitative aspects of an institution’s
strength, including through the Australian Prudential Regulation Authority’s
(APRA) use of its Probability and Impact Rating System (PAIRS) risk
assessment model. 3
2. Prudential requirements — providing qualitative and quantitative measures,

including ensuring adequate minimum capital and liquidity buffers for ADIs.
3. Systems for dealing with financial institution distress — where the strength
of an institution proves to be insufficient, a robust framework for effectively
resolving the failed institution is critical to minimise harm to the economy.
A robust stability framework provides a stable foundation for the financial system.
Currently, financial system stability in Australia is underpinned by the continued
strong financial performance of the banking system. 4 Further, many of the reforms
made to the Australian banking sector following the GFC have now settled.
Strengthening necessary areas of the financial system at a measured pace now, rather
than later, will cost less than actions to reinforce the system at a time when it is weak
or where change must occur quickly. Reforms during good times also dampen
pro-cyclicality in the financial system.
Determining the appropriate strength of stability settings is necessarily a matter of

judgement. The Inquiry’s test has been one of public interest: the interests of
individuals, businesses, the economy, taxpayers and Government. The Inquiry
believes that, on the basis of public interest, the benefits of the recommended measures
outweigh the associated costs. The GFC demonstrated that risks are real and the cost of
complacency is very high.
Recommended actions
The Inquiry’s recommendations are designed to enhance the resilience of the
Australian financial system, which underpins the strength and efficiency of the
economy. The recommendations seek to make institutions less susceptible to shocks
and the system less prone to crises, reducing the costs of crises when they do happen,
and supporting trust and confidence in the system. They aim to minimise the use of
taxpayer funds, protect the broader economy from risks in the financial sector and
minimise perceptions of an implicit guarantee and the associated market distortions.
3 Australian Prudential Regulation Authority (APRA), APRA Probability and Impact Rating
System, viewed 11 November 2014,
<http://www.apra.gov.au/AboutAPRA/Pages/PAIRS-1206-HTML.aspx>.
4 Reserve Bank of Australia (RBA) 2014, Financial Stability Review, September 2014, RBA,
Sydney, page 1.
35
The recommendations seek to strike a balance between system stability and

competitiveness, and, where possible, aspire for competitively neutral regulatory
settings. In many cases there is little trade-off, as greater stability promotes trust and
confidence in the financial system and enhances resilience and long-term allocative
and dynamic efficiency.
This chapter describes eight recommendations to strengthen stability settings,

applying across a number of sectors.
Banking: these recommendations broadly have two objectives:
• Reducing the probability of failure. Evidence from ADIs, regulators and others
suggests that Australian banks’ capital ratios are not in the top quartile of
internationally active banks when it comes to capital strength. The Inquiry believes
it is in Australia’s interest that they are. To this end, ADI capital levels should be
raised. In achieving this, the transparency of existing capital settings and the
competitive neutrality of the system for determining risk weights should also be
improved. The risk-weighted approach to capital requirements should be
supplemented with a leverage ratio that protects against potential weaknesses in
the risk-weighting system.
• Minimising the costs of failure. The toolkits available to regulators to prevent

distress and resolve failing financial institutions are critical and should be
enhanced. ADIs should also maintain sufficient loss absorbing and recapitalisation
capacity to allow effective resolution with minimal risk to taxpayer funds, in line
with emerging international practice. As this area is complex and evolving,
Australia should take a cautious approach in developing requirements for such
capacity.
These recommendations, which reduce the probability of failure and minimise the cost
of failure when it does occur, are complementary and should not be seen as substitutes
for each other. Several of the recommendations focus on an ADI’s liability structure:
the mix of different types of debt and equity instruments used to fund the institution.
Box 6: ADI liability structures and prudential requirements explains the main categories of
instruments and the role these play.
Insurance: Significant reforms took place following the collapse of HIH Insurance
Limited (HIH) in 2001, with ongoing subsequent improvements, including a
comprehensive review of capital standards in recent years. The regulatory framework
continues to change, with health insurers shortly moving to prudential supervision
under APRA. Some of the proposals in Recommendation 5: Crisis management toolkit
relate to insurance. Beyond these, the Inquiry has not seen a compelling case for
further changing stability settings in insurance at this stage. However, as noted in
Chapter 4: Consumer outcomes, Government is facilitating greater competition in the
North Queensland market by clarifying restrictions on the use of Unauthorised
36
Financial Insurers (UFIs). Should the use of UFIs became widespread, the stability
implications should be revisited.
Superannuation: The GFC highlighted the benefits of Australia’s largely unleveraged

superannuation sector. The absence of borrowing enabled the superannuation sector to
have a stabilising influence on the financial system and the economy during the GFC.
Continuing to restrict leverage in the sector will be important for mitigating future
risks. The Inquiry recommends limiting borrowing in superannuation funds.
Financial market infrastructure (FMI): Substantial reforms have taken place since the
GFC, such as making greater use of FMI for over-the-counter trading derivatives
transactions. The Inquiry supports reforms to FMI regulation to strengthen the
resolution framework and preserve critical functions in a crisis.
Shadow banking: Australia currently has a small shadow banking sector, which is
reviewed annually by the Council of Financial Regulators (CFR). Although the Inquiry
is making no direct recommendations to address shadow banking, it is aware that
measures to enhance resilience in the banking sector could encourage some activities
to move outside the prudential regulation perimeter. This risk is being actively
monitored globally. 5 In Australia, the CFR should continue to monitor risks in the
shadow banking sector to enable prompt responses to notable changes.
More generally, the Inquiry notes that considerable work is continuing in the
international arena to enhance financial system stability and that, where possible,
Australia should align itself with international developments. Domestically, the CFR
agencies continue to work on planning and pre-positioning to ensure they are ready to
respond to any emerging threats to stability. The Inquiry is supportive of this work.
Finally, the Financial Claims Scheme (FCS) is a fundamental component in protecting

depositors in the system, providing a guarantee on deposits of up to $250,000 per
account holder per institution. This is supported by Australia’s system of depositor
preference, which further protects depositors from loss. The Inquiry recommends
maintaining the current ex post funding model for the FCS, while noting that the cap
of $250,000 is relatively high compared to other countries.
Principles
In making the recommendations in this chapter, the Inquiry has been guided by the
following principles:
• Responsibility for sound governance, robust risk management and adequate

financial soundness rests primarily with a financial institution’s management and
5 Financial Stability Board (FSB) 2014, Global shadow banking monitoring report 2014, FSB, Basel.
37
its board. Financial institutions have a responsibility to operate with integrity to

build and protect trust and confidence in the financial system.
• Instability in the financial system imposes large costs on individuals, the economy,
Government and taxpayers. Minimising the risk of instability, or its impact where
unavoidable, is a worthwhile investment. The wellbeing of the Australian
community depends on the financial system being able to continue to provide its
core economic functions, even in times of financial stress.
• Government should not generally guarantee the ongoing solvency and operations
of individual financial institutions. However, there may be instances — particularly
where system-wide failure is threatened — where public sector support of the basic
functions of the financial system is warranted, such as liquidity support by the
Reserve Bank of Australia (RBA). In determining whether to intervene in the event
of a failure, Government should be guided by the anticipated effect of failure on the
wider economy and seek to minimise taxpayer exposure.
• System stability should be promoted while giving due regard to the importance of
balancing potential reductions in competition and efficiency. Where possible,
regulation should be risk-based, as this helps ensure measures taken to establish
stability are applied efficiently. Financial regulation should aim to be competitively
neutral and not favour one type or class of institution over others, unless there is a
sound public policy reason. An approach that combines strong regulatory and
supervisory frameworks and market-based disciplines will deliver the best balance
between financial stability and economic efficiency.
• In implementing regulation, Australia should build on global frameworks while

reflecting features of the Australian system.
• The CFR has a shared responsibility for the stability of the financial system and
monitoring systemic risks, while the member regulators retain ultimate
responsibility and accountability for their respective mandates.
Conclusion
The Inquiry believes that implementing these recommendations, and continuing to
develop policy based on these principles, will assist in ensuring Australia’s financial
system remains strong and stable into the future and continues to provide its core
economic functions — even in times of financial stress.
The recommendations increase the system’s resilience to institutional failure and, in

doing so, reduce the likelihood of future crises. They aim to protect taxpayers and the
Government balance sheet, help maintain investor confidence and increase efficiency
in the economy. Where crises are unavoidable, the recommendations are designed to
lessen their impact, minimising the need for taxpayer funds to be put at risk to support
the financial sector and reducing the cost of a future crisis to the broader economy.
38
Box 6: ADI liability structures and prudential requirements

This box outlines the main components of an ADI’s liability structure. It describes
the relationship of this structure with capital requirements, and loss absorbing and
recapitalisation capacity.
Figure 3: ADI liability structure and prudential requirements
RWA: risk-weighted assets.

D-SIB: domestic systemically important bank.
CET1: common equity tier 1.
The liability structure is the mix of debt and equity instruments that the ADI uses to
fund its activities, shown in the centre of Figure 3. Each category in the liability
structure represents a layer in the creditor hierarchy. The top layer will be the first to
absorb a loss. Once a layer has been depleted, further losses are applied to the next
layer and so on. This means that the liability categories closest to the top of the
structure are also the riskiest for investors and attract correspondingly higher rates
of return. The corollary is that these instruments are also the most expensive sources
of funding for the ADI.
39
Box 6: ADI liability structures and prudential requirements (cont.)

Historically, prudential requirements have been placed on the top layers of ADIs’
liability structures to reduce the probability of failure — shown on the left-hand
side of Figure 3. This includes capital requirements that mandate a minimum
portion of the ADI’s funding be in the form of certain regulatory capital. This
chapter includes recommendations to strengthen these requirements, which include:
• Buffers: It’s generally expected that an ADI’s capital level will be above the level
specified by the buffers, but it can fall below this level if necessary. When it falls
below, restrictions are placed on dividends and bonus payments.
• Hard minimums: ADI capital levels must be maintained above specified hard
minimums. An ADI would likely be declared non-viable if capital dropped
below these levels.
More recently, international standard-setting bodies have worked on separate

requirements to minimise the cost of failures. Although no such requirements are
currently in place in Australia, the right-hand side of Figure 3 shows the capacity for
different instruments in the liability structure to perform this function. This chapter
includes a recommendation to introduce a framework for loss absorbing and
recapitalisation capacity. This aims to ensure that, where an ADI fails, its liability
structure enhances the ability to feasibly impose losses on creditors and recapitalise
the institution, minimising the need for taxpayer-funded bail-out.
Measures to address the goals of reducing the probability of failure and minimising
the cost of failure when it does occur are complementary, and meeting one objective
should not be seen as a substitute for meeting the other.
This chapter makes extensive reference to the different types of regulatory capital
included in the Basel framework:
• Common Equity Tier 1 (CET1) capital comprises ‘tangible’ equity such as
shareholders’ common equity. It is the primary defence against insolvency and
bank failure.
• Additional Tier 1 (AT1) capital primarily refers to other forms of equity capital,
such as preference shares, as well as some kinds of debt instruments with similar
characteristics. Under the Basel framework, AT1 capital must be available to
absorb the losses of a troubled institution before it becomes non-viable.
• Tier 2 capital includes subordinated debt that has a ‘bail-in’ clause, meaning it
can be converted to equity or written off should a set trigger condition be met.
40
Capital levels
Recommendation 1
Set capital standards such that Australian authorised deposit-taking institution capital
ratios are unquestionably strong.
Description
APRA should raise capital requirements for Australian ADIs to make ADI capital
ratios unquestionably strong. A baseline target in the top quartile of internationally
active banks is recommended. This principle should apply to all ADIs but is of
particular importance for ADIs that pose systemic risks or access international funding
markets.
The target would be aided by adopting Recommendation 4: Transparent reporting, which

aims to improve the international comparability of Australian ADI capital ratios.
The Inquiry’s judgement is that, although Australian ADIs are generally well
capitalised, further strengthening the banking sector would deliver significant benefits
to the economy at a small cost. Evidence available to the Inquiry suggests that the
largest Australian banks are not currently in the top quartile of internationally active
banks. Australian ADIs should therefore be required to have higher capital levels.
The quantum of any change should take account of the effect of other
recommendations, particularly Recommendation 2: Narrow mortgage risk weight
differences, which aims to improve competitive neutrality of regulatory settings.
Objectives
• Make banks less susceptible to extreme but plausible adverse events — such as
asset price collapses — unexpected loan losses or offshore funding shocks, to
reduce the likelihood of bank failures and promote trust and confidence in the
banking sector.
• Create a financial system that is more resilient to shocks and thus less prone to
crises, which can have devastating and long-lasting effects on the economy and
society.
• Protect the Government balance sheet from risks in the financial system, to
minimise the burden on taxpayers.
• Reduce perceptions of an implicit Government guarantee for ADIs and the

associated economic inefficiency.
41
Discussion
Problems the recommendation seeks to address
Importance of capital in the banking sector
Capital, particularly equity capital, is an essential element in both actual and perceived
financial soundness, acting as a shock absorber for unexpected losses. Once equity has
been exhausted, a bank is generally non-viable — and could well have been before that
point. Equity capital is therefore an important determinant of how likely a bank is to
fail. Capital is also a safety buffer for creditors, as it is typically exhausted before the
bank defaults on its obligations. By making creditor funds relatively safer, high levels
of capital assist to maintain confidence in a bank, even in times of market stress.
Making banks safer and enhancing investor confidence both contribute to reducing the
likelihood of a financial crisis. Shocks will always buffet the financial system, whether
they are generated domestically or overseas. Capital is one of the best protections
against those shocks generating a crisis.
Although banks choose capital at levels that account for their own specific risks, this
does not account for the risks the banking system poses to the broader economy.
Risks and costs of financial crises

Australia’s financial system is a vital part of the economy, providing avenues for
saving, investment and funding growth. However, it also poses risks that must be
managed. This includes minimising the likelihood of future financial crises, which can
have significant costs for individuals, the economy, Government and taxpayers.
Australia should not underestimate the risks of financial crises

Australia’s resilience during the GFC partly reflected the strength of the financial
sector, the quality of its regulatory framework and supervision, and Government’s
assistance to the financial sector. However, many other important factors were also at
play, including macro-economic policy, a strong Government balance sheet and
Chinese resource demand. Given these supporting factors may not be present in the
next crisis, Australia should not become complacent about the risks of financial crises
as a result of its GFC experience. Australia is not immune to financial crises.
Australia can draw lessons from other countries’ GFC experiences, which highlighted
that financial systems are vulnerable to low-probability, high-impact ‘tail events’,
which can be caused by large external shocks or be generated domestically. An asset
value shock of similar magnitude to those experienced by overseas banks during the
GFC would cause Australian banks significant distress.
For example, the major banks currently have a leverage ratio of around 4–4½ per cent
based on the ratio of Tier 1 capital to exposures, including off-balance sheet. An overall
asset value shock of this size, which was within the range of shocks experienced
42
overseas during the GFC, would be sufficient to render Australia’s major banks
insolvent in the absence of further capital raising. In reality, a bank is non-viable well
before insolvency, so even a smaller shock could pose a significant threat. Following its
recent stress-test of the industry, APRA concluded, “… there remains more to do to
confidently deliver strength in adversity”. 6
Financial crises have large costs

The costs of financial crises are high, and their effects broad-ranging. Financial crises:
• Significantly constrain households’ and businesses’ access to credit, inhibiting the

ability to invest, buy a home or grow a business.
• Potentially affect confidence in banks, which in turn may impact confidence in the
operation of the payments system.
• Are historically associated with an average rise in unemployment of seven

percentage points, which in 2014 would be almost 900,000 additional Australian
workers. 7 Recovery from financial crises can be protracted, with high
unemployment continuing for a long period.
• Can result in large contractions in trade credit and make it more difficult for
businesses, including small businesses, to access financing.
• Can substantially reduce the wealth and savings of a generation, particularly for
those with lower initial wealth. This may particularly harm those people who rely
most on savings, such as those in or close to retirement.
• Create large falls in GDP. International estimates of the GDP cost of a crisis are
19–158 per cent of one year’s GDP — which for Australia would have equated to
$300 billion to $2.4 trillion in 2013 — with a median of around 63 per cent of GDP
($950 billion). 8
• Erode a government’s fiscal position. The need to directly support the financial
system, along with the deteriorating budget position due to the associated
recession, causes a substantial increase in net government debt. According to
International Monetary Fund (IMF) data, general government net debt between
2007 and 2013 as a share of 2013 GDP rose by around 40 percentage points in the
6 Byres, W 2014, Seeking strength in adversity: lessons from APRA’s 2014 stress test on Australia’s
largest banks, AB+F Randstad Leaders Lecture Series, 7 November, Sydney.
University Press, Princeton, page 224.
43
United States, 50 percentage points in the United Kingdom, 55 percentage points in

Portugal and more than 80 percentage points in Ireland. 9
The Australian Federal Government is currently one of the strongest rated sovereigns
in the world, with a AAA equivalent credit rating from all the major credit rating
agencies. Significant deterioration in the fiscal position as a result of a financial crisis
would be expected to threaten this rating. A reduction in Government’s credit rating is
likely to lead to the banks’ credit ratings being downgraded, increasing funding costs.
As well as affecting the financial sector directly, a downgrade of the sovereign credit
rating would raise Government’s borrowing costs and damage Australia’s reputation
as a safe investment destination, ultimately harming the broader economy — including
by raising borrowing costs for households and businesses.
Characteristics of Australia’s banking system create additional systemic risks

Historically, Australia’s growth has been assisted by the banks’ role as a conduit for
foreign savings to fund domestic investment — a trend the Inquiry expects to
continue. However, the benefits of offshore funding come with the risk that foreign
investors will stop lending to an Australian bank.
The Inquiry recognises that Australian banks have built a reputation for prudent risk
management, with low levels of proprietary trading and sound management.
However, maintaining foreign investor confidence in the strength of the Australian
banking system is paramount for maintaining the banks’ access to foreign funding.
This goes beyond the strength of any individual bank, as Australia is a small part of
the global financial system and investors may view Australian banks as a group. Many
jurisdictions are still increasing capital levels to implement Basel III, a process largely
complete in Australia. Over time, the relative strength of Australian ADI capital ratios
may therefore decline as banks in other jurisdictions continue to increase capital.
Australia’s highly concentrated banking sector, at the core of its financial system, poses
a further risk. The majority of Australian banks pursue similar business models, with
broadly similar balance sheet compositions that can be expected to have a high
correlation during a crisis. The major banks form part of the largest Australian
financial groups and are highly interconnected with the financial sector. Hence,
disruption to the functioning of one major bank could be expected to impose
significant costs on the economy, particularly if it resulted in contagion to other
Australian financial institutions.
9 International Monetary Fund (IMF), World Economic Outlook Database October 2014, IMF,
viewed 11 November 2014,
<http://www.imf.org/external/pubs/ft/weo/2014/02/weodata/index.aspx>.
44
Implicit guarantee
Actions taken by governments both in Australia and overseas to support their financial
sectors during the GFC have reinforced perceptions of an implicit guarantee. Implicit
guarantees arise when creditors believe that, if a bank were to fail, the government
would step in to rescue the institution.
Implicit guarantees reduce banks’ funding costs by moving risk from private investors
onto the Government balance sheet — a contingent liability for Government. As a
result, the creditor takes no (or a reduced) loss, making it less risky to invest in the
institution. Creditors will therefore accept a lower interest rate, which lowers funding
costs for the bank and provides a competitive advantage to those institutions most
affected.
Empirical studies have found that Australian ADIs, especially the largest ADIs, benefit
from an implicit guarantee. 10 This is also evident in the credit ratings of the major
Australian banks, which all receive a two-notch credit rating uplift from credit rating
agencies Standard & Poor’s and Moody’s due to expectations of Government support.
Implicit guarantees create inefficiencies by:
• Providing a funding cost advantage for banks over other corporations.
• Giving large banks an advantage over smaller banks.
• Weakening the market discipline provided by creditors.
• Potentially creating moral hazard that encourages inefficiently high risk taking. 11
Rationale
The Inquiry considers that these factors provide a compelling case for ensuring
Australian ADIs have unquestionably strong capital ratios. The Inquiry’s judgement,
based on the available evidence, is that the CET1 capital ratio of Australia’s major
banks is currently not in the top quartile of internationally active banks, although it is
likely to be above the median. 12 Although this position does not suggest capital levels
at Australian ADIs are weak, it also does not suggest they are unquestionably strong.
Perceptions of an implicit guarantee introduce a range of damaging distortions into the

financial sector that reduce efficiency. They also transfer risk from the banking sector
10 For example, International Monetary Fund (IMF) 2012, Australia: Financial System Stability
Assessment, IMF Country Report No. 12/308, IMF, Washington, DC.
11 International Monetary Fund (IMF) 2014, Global Financial Stability Report April 2014, IMF,
Washington, DC; Independent Commission on Banking 2011, Final Report, Independent
Commission on Banking, London, page 101.
12 On a broader measure of capital, which includes CET1, Additional Tier 1 and Tier 2 capital,
Australian major banks are ranked lower reflecting their proportionally greater use of CET1.
45
to taxpayers. In the Inquiry’s view, such factors make it appropriate to take steps to
minimise implicit guarantees.
Raising capital requirements means that a larger share of bank funding would be in
the form of equity — which is not perceived to have a guarantee — rather than debt. In
addition, the perceived value of the guarantee for remaining debt would be lessened,
as the ADI is safer and there is less chance the guarantee will be called upon. This
reduces the implicit guarantee, in conjunction with Recommendation 3: Loss absorbing
and recapitalisation capacity and Recommendation 5: Crisis management toolkit, which
strengthen credible options to resolve an ADI with minimal recourse to public finds.
Options considered
1. Recommended: Set capital standards such that Australian ADI capital ratios
are unquestionably strong.
2. Make no changes to capital ratio requirements.
Option costs and benefits

Summary of stakeholder submissions
Submissions from ADIs do not generally support increases to capital requirements —
especially equity requirements — for a number of reasons.
They argue that increased capital, particularly equity, is unnecessary. As outlined in

the Australian Bankers’ Association’s (ABA) second round submission (discussed later
in this chapter), the Australian banks consider themselves to be highly capitalised
relative to global peers. They argue that they are among the best capitalised banks in
the world and are around or above the 75th percentile of capital ratios globally. 13
The banks submit that their absolute (not only relative) capital position is very strong.
Several banks note that internal stress tests show their capital position is sufficient to
absorb large economic shocks, and APRA’s stress-testing has not led the regulator to
raise capital requirements. 14
Despite the banks’ submissions, the Inquiry notes that Standard & Poor’s classifies the
major bank capital ratios as ‘adequate’ but not ‘strong’ or ‘very strong’. 15
Several of the major banks point to the need to consider capital within the context of
broader settings for financial stability in Australia. They argue that these broader
13 Australian Bankers’ Association 2014, Second round submission to the Financial System
Inquiry, page 36.
14 For example, Westpac 2014, Second round submission to the Financial System Inquiry,
page 71.
15 Standard & Poor’s 2014, The Top 100 Rated Banks: Will 2014 Mark A Turning Point in Capital
Cushioning?, Standard & Poor’s.
46
settings and conditions make Australia a safe environment, reducing or negating the
need for additional equity. 16 Such conditions include conservative prudential
regulation, which is stricter in a number of aspects than in other countries, and
intensive and effective supervision from APRA.
The banks also point out that equity is their most expensive source of funding and that
this cost will be passed on (at least in part) to consumers, ultimately slowing credit and
GDP growth. They note that other forms of regulatory capital, such as Tier 2 capital,
would provide protection from losses at a lower cost. The banks did not provide
estimates of the extent to which competitive pressure would limit any rise in loan
interest rates, but they did note that the sector is highly competitive.
Some smaller ADIs suggest that it would be appropriate to impose an additional

capital requirement on those banks APRA designates as domestic systemically
important banks (D-SIBs), to offset funding advantages from perceptions of an implicit
guarantee. They argue that offsetting the funding cost advantage of the implicit
guarantee would improve competitive neutrality in the banking sector. 17
APRA considers Australian banks to be well capitalised, but acknowledges that

overseas jurisdictions are continuing to increase capital requirements for their
domestic banks. APRA’s preliminary view is that the major banks’ CET1 ratios are
likely positioned broadly in the middle of the second highest quartile of internationally
active banks, which is consistent with the Inquiry’s findings.
In its submission and subsequent discussions, APRA notes that stress-testing is a

useful tool for assessing the riskiness of banks and their capital position. However,
APRA cautions against relying on stress-testing too heavily to determine exact capital
levels, given the margin for error in such exercises. 18 It notes that many banks are still
developing and improving their stress-test modelling as well as the critical data that
underpins the models.
In addition, stress-testing exercises do not typically take into account more complex
feedback loops and amplification mechanisms that can develop in practice. For
example, banks are likely to respond to stress by cutting lending growth, which in turn
may amplify stress and restrict economic recovery. Losses may also be more
concentrated at one institution or a handful of institutions than can be assumed in the
stress test. Even though a given institution may survive the average industry loss, it
may be less resilient to a concentrated loss. As APRA notes in its most recent stress
test, “… even though CET1 requirements were not breached, it is unlikely that
16 ANZ 2014, Second round submission to the Financial System Inquiry, page 4.
17 Customer Owned Banking Association 2014, Second round submission to the Financial
System Inquiry, page 15.
18 Australian Prudential Regulation Authority 2014, Second round submission to the Financial
47
Australia would have the fully-functioning banking system it would like in such an
environment”. 19
A number of analysts, think tanks and academics argue that, although equity funding
may be expensive for the banks, increasing it does not impose large costs on the
economy overall in terms of higher loan interest rates or lower GDP growth. 20 They
view greater use of equity funding as cheap insurance against the risks to which
banking can expose depositors, Government, taxpayers and the broader economy.
Capital levels at the major banks

In the Inquiry’s judgement, capital levels at Australia’s major banks — as measured by
CET1 capital — are likely to be above the global median but below the top quartile.
The Inquiry has not sought to determine the exact capital position of Australian banks
on a consistent basis compared with banks in other countries. It is a very complex area,
given the varied national discretions taken by different countries, including Australia.
This is a task for APRA, taking into account the recommendations in this report.
However, the Inquiry has sought to determine a plausible range for the current capital
ratios of Australian banks for comparison with the current global distribution.
Based on the evidence available for the purposes of comparing with the global
distribution, a plausible range for current Australian major bank CET1 capital ratios is
10.0–11.6 per cent (Figure 4: Adjusted average Australian major bank CET1 capital ratios).
The lower bound is derived from the latest Basel Committee on Banking Supervision
(BCBS) data, adjusted upwards by 0.8 percentage points to account for risk-weighted
asset calculation differences based on APRA’s RCAP (Regulatory Consistency
Assessment Program) data. 21,22 The upper bound derives from a report submitted by
the ABA which calculates capital ratios based on the Basel minimum requirements. 23
20 For example, Admati, A and Hellwig, M 2013, The Bankers’ New Clothes, Princeton University
Press, Princeton. At the extreme, some academics argue that changes in capital levels will not
affect bank funding costs at all under certain conditions.
21 Australian major banks’ position is contained in a non-public BCBS report and was provided
to the Inquiry by APRA. The adjustment for risk-weighting calculation differences are in
Australian Prudential Regulation Authority 2014, First round submission to the Financial
system Inquiry, page 81.
22 Using the estimates from the ABA report, excluding those related to capital definitions
(which the BCBS data adjusts for), the lower bound on the range would be 10.5 per cent.
23 Australian Bankers’ Association (ABA) 2014, Second round submission to the Financial
System Inquiry, Appendix A: International comparability of capital ratios of Australia’s major
banks. The ABA report was commissioned from PricewaterhouseCoopers. It uses bank data
for March and June 2014, while the BCBS global distribution is as at December 2013. Between
December 2013 and March/June 2014 the major banks increased CET1 capital ratios by an
average of around 0.5 percentage points. A stricter comparison of the major banks to the
global distribution could take this into account and suggest an upper bound of only
11.1 per cent.
48
Figure 4: Adjusted average Australian major bank CET1 capital ratios

Based on December 2013 global distribution
Sources: Australian Bankers’ Association 2014, Second round submission to the Financial System Inquiry,
Appendix A: International comparability of capital ratios of Australia’s major banks; Australian Prudential
Regulation Authority 2014, First round submission to the Financial System Inquiry, page 81; Basel
Committee on Banking Supervision 2014, Basel III monitoring report September 2014, Bank for International
Settlement, Basel; Inquiry calculations.
As Figure 4 shows, the available evidence suggests the major banks are not in the top
quartile of CET1 capital ratios globally.
This view is supported by APRA’s assessment that the largest Australian banks are
broadly in the middle of the second-top quartile of their peers for CET1 capital ratios. 24
The Inquiry’s conclusion updates the observation in the Interim Report that Australia’s
major banks were around the middle of the pack globally. That observation was based
on data from the BCBS, which remains the most comprehensive data available for
comparing capital levels across jurisdictions. However, although the BCBS data
account for national differences in how capital is defined, they do not adjust for
national differences in the way risk-weighted assets are calculated. Adjusting for this
would move the Australian banks higher in the global distribution.
BCBS reported capital levels

Nonetheless, the BCBS provides the only available information about the distribution
of global capital ratios, offering a useful context against which to compare Australian
bank capital. The latest release, from December 2013, shows the CET1 capital global
median and 75th percentile both increased to 10.5 per cent and 12.2 per cent
respectively over the prior six months. 25 In that time, the adjusted Australian major
bank CET1 capital ratios reported by the BCBS increased by a lesser amount, to
9.2 per cent on average. This highlights that many countries are still ‘catching up’ with
25 Basel Committee on Banking Supervision 2014, Basel III Monitoring Report, September 2014,
Bank for International Settlement, Basel.
49
their implementation of Basel III relative to Australia and, in a number of cases, are
introducing stricter requirements than exist locally. It can be expected that the global
distribution of capital levels will therefore continue to rise for some time yet.
ABA reported capital levels

The ABA submitted a report that endeavoured to adjust Australia’s major bank capital
ratios for differences between the Australian framework and estimates against the
Basel framework and against international practice. Against the Basel framework, the
ABA report assessed the average CET1 capital ratio across the major banks to be
around 11.6 per cent as at August 2014. This approach considered similar items to
those in APRA’s submission, although the ABA’s estimated value within categories
was higher in a number of cases. 26 In the Inquiry’s view, this estimate forms a
plausible upper bound on the range of adjusted Australian major bank capital ratios.
Against its measure of international practice, the ABA report estimated a higher
average CET1 capital ratio of 12.7 per cent. On this basis, it concluded that the major
Australian banks were at or above the 75th percentile of identified international peers
in terms of CET1 capital. Although this material was useful for considering the relative
strength of Australian bank capital, its accuracy was limited by issues such as:
• The restricted number of comparison countries and banks — it used 52 banks,

compared to 102 in the BCBS report.
• Minimal or no adjustment to foreign bank capital ratios to ensure they were on the
same basis as the ABA-adjusted Australian bank capital ratios, which is crucial
since the report directly compares these ratios.
• Attempting to adjust some items to ‘international practice’ where credible

benchmarks are not available, rather than to the minimums set out in the Basel
framework, where benchmarks are clearer.
There is no benchmark of international practice: all jurisdictions have implemented the

Basel framework in a different manner, reflecting their domestic circumstances. As a
result, it is highly complex to compare even two jurisdictions, let alone to compare all
jurisdictions. This is reflected in Recommendation 4: Transparent reporting, which
recommends using the Basel framework since a broader benchmark does not exist. In
the Inquiry’s view, the ABA’s adjustments that go beyond comparisons to minimums
in the Basel framework are not a plausible basis for international comparison.
Benefits of higher capital

Higher capital provides insurance against the large losses that can be caused by
financial crises through reducing the likelihood of such crises. It achieves this by
26 APRA’s approach is outlined in APRA 2014, First round submission to the Financial System
Inquiry, page 81.
50
making individual financial institutions safer and by promoting greater investor

confidence in the system. It also reduces distortions caused by perceptions of an
implicit Government guarantee. The benefits of increasing capital are not linear;
however, the incremental benefit will decrease as the starting level of capital rises.
All financial crises are different, and the exact benefits of avoiding any particular crisis
are therefore difficult to predict. Figures for the ‘average’ experience of a crisis should
not be taken as precise estimates, but instead as indicative of the likely experience,
noting that the actual magnitude can be much more severe.
Despite this limitation, a safer banking system that is less prone to crises provides large
benefits, which accrue to individuals, the economy, Government and taxpayers.
Benefits to individuals
Financial crises are costly to individuals, both through the direct effects of financial
institution failure and falls in asset prices, and as a result of the large recessions that
typically accompany such crises.
Research on the ‘average’ financial crisis finds that the unemployment rate typically
rises by around seven percentage points — over three times the increase in Australia
during the GFC. 27 The associated economic weakness lasts around four years on
average, meaning that high unemployment can be protracted. The effect is often
greatest for younger generations, particularly those trying to enter the workforce for
the first time.
Financial crises can substantially reduce the savings of an entire generation. In relative
terms, the largest effect tends to be concentrated on those people with lower initial
levels of wealth. This can have a lasting effect on society, particularly on those who are
in retirement, or about to retire, and who have limited capacity to rebuild lost savings.
Benefits to the economy

In its review of 21 empirical studies, the BCBS found the median estimate of the cost of
a crisis in terms of cumulative foregone output due to the economic downturn is
63 per cent of one year’s GDP. 28 The estimate range is 19–158 per cent of one year’s
GDP, with the BCBS noting that the maximum cost of a crisis tends to be three to five
times the average cost. Haldane estimated that the cost of the GFC, a particularly
severe crisis, could be at least 90 per cent of 2009 world GDP. 29 More recently, the
University Press, Princeton.
29 Haldane, A 2010, The $100 billion dollar question, speech at the Institute of Regulation & Risk
North Asia, 30 March, Hong Kong, Table 1, page 16.
51
Dallas Federal Reserve estimated the cost of the GFC to the United States economy at
US$6–US$14 trillion (40–90 per cent of annual GDP). 30
The BCBS also estimates that financial crises occur, on average, every 20–25 years in a
given country, implying a 4–5 per cent chance of a financial crisis in any given year.
However, across the world, crises occur somewhere with much greater frequency, and
these crises typically have spill-over effects for other countries.
Combined with this estimated probability, the median cost of a financial crisis suggests
an annual expected loss of around 2½–3 per cent of GDP. In dollar terms, based on
2013 nominal GDP, this translates to an expected cost to the Australian economy of
$40–$50 billion per year. If this estimate was instead based on the top of the BCBS’s
range for the cost of a crisis, this figure would rise to $100–$120 billion per year.
Given these large potential costs, even a small reduction in the probability or cost of a
crisis would yield significant benefits.
The Inquiry notes that the estimated benefit of avoiding crises will tend to understate
the true benefit to the Australian economy, since it does not account for:
• Reduced perceptions of implicit guarantees. Weaker perceptions of an implicit

guarantee reduce Government’s contingent liability and create fewer distortions to
competition and efficiency in the financial system and broader economy. In
addition, because ADIs are safer, any remaining perceptions of guarantee would be
reduced.
• An economy with fewer crises is less likely to be volatile, which has welfare
benefits and promotes long-term trust and confidence to support investment in the
economy. In contrast, volatility undermines long-term confidence and the ability of
individuals, businesses and Government to plan for the future, impairing allocative
and dynamic efficiency.
Benefits to Government and taxpayers

Reducing the likelihood of financial crises would protect Government and taxpayers
from the costs of giving direct support to the financial sector. It would also help
prevent the deterioration of the fiscal position due to the deep recession typically
associated with financial crises.
The GFC clearly demonstrated the damage that can be done to governments’ fiscal
position and the associated increase in net government debt. Chart 1 shows the change
in general government net debt for a number of countries between 2007 and 2013, as a
share of GDP. This captures the crisis period and the protracted recession that
30 Atkinson, T, Luttrell, D and Rosenblum, H 2013, How bad was it? The costs and consequences of
the 2007–09 financial crisis, Federal Reserve Bank of Dallas Staff Papers No. 20, Federal
Reserve Bank of Dallas, Dallas, page 1.
52
followed in many economies. In parts of Europe, the recession and associated fiscal
costs continue more than six years after the crisis began.
Chart 1: Change in general government net debt, 2007–2013

Per cent of 2013 GDP
Per cent Per cent

90 90
80 80
70 70
60 60
50 50
40 40
30 30
20 20
10 10
0 0
Source: International Monetary Fund (IMF), World Economic Outlook Database October 2014, IMF, viewed
11 November 2014, <http://www.imf.org/external/pubs/ft/weo/2014/02/weodata/index.aspx>.
The GFC and the associated economic downturn left the Australian federal and state
governments with notably higher net debt, which has yet to peak, despite Australia’s
less acute experience of the GFC. The Inquiry understands there is limited room before
Australia’s AAA credit rating is threatened. Estimates suggest this would occur as
Commonwealth and state debt levels approached around a 30 per cent net debt level. 31
Another financial crisis like the GFC could put Australia’s AAA credit rating in
jeopardy, with likely knock-on effects for the credit ratings of Australian ADIs. This
would make it more difficult for banks to access offshore funding markets, and would
raise their funding costs.
Cost of higher capital

Overall, the expected cost of increasing capital requirements is small. The Inquiry
estimates that a one percentage point increase in capital requirements would increase
31 Standard & Poor’s 2014, Ratings on Australia affirmed at ‘AAA/A-1+’ on monetary and fiscal
flexibility; outlook remains stable, media release, 29 July.
53
the average interest rate on a loan by less than 10 basis points. 32 This is the figure if the
full cost is passed on to consumers with no offset in interest rates by the RBA.
However, in a competitive market, the actual change in lending interest rates would be
lower and the RBA may lower the cash rate if conditions warrant. The Inquiry asked
APRA to review its approach to generating these estimates, and APRA confirmed this
approach was reasonable and consistent with other studies.
The Inquiry’s estimated effect on loan interest rates is roughly in the middle of the
range found in a number of studies. The surveyed studies find increases in loan prices
for a one percentage point increase in capital ratio are 1–22 basis points. 33 The studies
include:
• APRA’s regulatory impact statement for the introduction of Basel III, which
estimates a 5 basis points interest rate increase on a loan with a 50 per cent risk
weight. 34
• A recent Bank for International Settlements (BIS) study on the impact of Basel III,
which found a 12 basis points increase in loan prices per percentage point increase
in capital, falling to around 8 basis points if only considering the advanced
countries. 35
This low cost reflects that changing capital requirements only affect a small portion of
the funding of a loan. For example, a one percentage point rise in capital requirements
affects the funding cost of less than 0.5 per cent of the average loan. 36 That is, the
funding cost on 99.5 per cent of the loan does not increase, and the incremental cost of
equity over debt is only felt on the remaining 0.5 per cent. 37 Changing the cost of this
small slice of a loan’s funding therefore has a correspondingly small effect on the
average funding cost.
RBA staff research suggests that an interest rate increase of this magnitude would
reduce real GDP by less than 0.1 percentage points, while other studies suggest the
32 The precise quantum of additional capital necessary to place Australian ADIs in the top
quartile of global peers is left to APRA to determine — the one percentage point increase
here is for indicative purposes only.
33 See, for example, Barrell, R, Davis, E, Fic, T, Holland, D, Kirby, S and Liadze, I 2009, Optimal
regulation of bank capital and liquidity: how to calibrate new international standards, Financial
Services Authority Occasional Paper 38, London; Elliott, D 2009, Quantifying the effects on
lending of increasing capital requirements, Center for Financial Stability; Kashyap, A, Hanson, S
and Stein, J 2011, ‘A macroprudential approach to financial regulation’, Journal of Economic
Perspectives, vol 25, no. 1; Miles, D, Yang, J, Marcheggiano, G 2011, Optimal bank capital, MPC
Unit Discussion Paper No. 31., Bank of England, London.
34 Australian Prudential Regulation Authority (APRA) 2012, Implementing Basel III capital
reforms in Australia, APRA, Sydney, page 15.
35 Cohen, B and Scatigna, M 2014, Bank and capital requirements: channels of adjustment, Bank for
International Settlements, Basel, page 17.
36 The proportion of funding affected for a given loan is the change in capital requirement
multiplied by the risk weight on that loan. The average risk weight of the major banks is
currently less than 45 per cent.
37 Because higher capital makes the ADI safer, the funding cost of the 99.5 per cent of the loan
may actually decrease to the extent that the risk premium demanded by debt and equity
holders falls.
54
effect could be even lower. 38 In addition, the effect on growth would likely be taken
into account in macro-economic policy settings since the RBA considers actual lending
rates when determining the cash rate. 39
The Inquiry’s estimate is consistent with a range of empirical studies that have
estimated the effect of capital requirement changes on the economy (Table 2: Effect on
GDP of a one percentage point rise in capital ratio). Studies examining the effect on GDP
estimate that a one percentage point increase in capital ratios would potentially
decrease annual GDP by 0.01–0.1 per cent ($150 million to $1.5 billion in terms of 2013
GDP) per year.
Table 2: Effect on GDP of a one percentage point rise in capital ratio*

Study Effect on GDP** Notes
Miles et al (2011) 1–5bps Effect on level of GDP
BIS (2010) 3bps Estimated lower growth during transition to higher capital.
After implementation period, GDP recovers to trend.
BCBS (2010) 9bps Effect on level of GDP
Barrell et al (2009) 10bps Effect on level of GDP
Riksbank (2011) 6–16bps For low and high social cost of capital respectively
*Capital ratio measured as equity to risk-weighted assets.
**Note that definitions of capital vary across studies.
Sources: Miles, D, Yang, J, Marcheggiano, G 2011, Optimal bank capital, MPC Unit Discussion Paper
No. 31., Bank of England, London; Macroeconomic Assessment Group 2010, Assessing the macroeconomic
impact of the transition to stronger capital and liquidity requirements, Bank for International Settlement,
Basel; Basel Committee on Banking Supervision (BCBS) 2010, An assessment of the long-term economic
impact of strong capital and liquidity requirements, Bank for International Settlement, Basel, page 25;
Barrell, R, Davis, E, Fic, T, Holland, D, Kirby, S and Liadze, I 2009, Optimal regulation of bank capital and
liquidity: how to calibrate new international standards, Financial Services Authority Occasional Paper 38,
London; Sveriges Riksbank 2011, Appropriate capital ratio in major Swedish banks — an economic analysis,
Sveriges Riksbank, Stockholm, page 31.
Reducing perceptions of an implicit Government guarantee reduces Government’s
contingent liability. This benefit is not factored into the cost estimates above. The
United Kingdom’s Independent Commission on Banking report estimated that around
half the cost of its proposal to increase capital was offset by a reduction in the implicit
guarantee. 40
38 Lawson, J and Rees, D 2008, A sectoral model of the Australian economy, Reserve Bank of
Australia Research Discussion Paper 2008-01, estimates that an unexpected 25 basis points
increase in the cash rate reduces real GDP below its baseline by just more than 0.2 percentage
points. A smaller estimate is provided in Jääskelä, J and Nimark, K 2008, A medium-scale open
economy model of Australia, Reserve Bank of Australia Research Discussion Paper 2008-07 and
Dungey, M and Pagan, A 2009, Extending a SVAR Model of the Australian Economy, Economic
Record, vol. 85 no. 268.
39 For example, Battellino, R 2009, Some comments on bank funding, remarks to 22nd Australasian
Finance and Banking Conference, 16 December, Sydney; Hansard 2009, Reference: Reserve
Bank of Australia annual report 2008, House of Representatives Standing Committee on
Economics, 20 February, Canberra.
40 Independent Commission on Banking 2011, Final Report, Independent Commission on
Banking, London, page 141.
55
Box 7: The cost of raising capital requirements

To examine the potential effect on loan prices, this box provides a stylised example
of a one percentage point increase in capital requirements. For simplicity, it does not
account for a number of complications such as tax.
The effect on pricing is primarily driven by the proportion of funding that changes
from debt to equity, the cost of the debt funding that is being replaced, and the cost
of the new equity funding in terms of shareholder-required return on equity (ROE).
In Figure 5, a bank has a $100 portfolio of loans (the asset), which is funded by a
mixture of debt and equity (the liabilities).
Figure 5: Example of raising capital requirements
Originally, the bank has a capital ratio of 8 per cent, with an average risk weight of
50 per cent. The bank therefore:
• Has $50 in risk-weighted assets ($100 x 50 per cent risk weight).
• Uses $4 of equity funding ($50 x 8 per cent capital requirement) and $96 of debt
funding.
• Has a weighted average funding cost of 4.15 per cent given a cost of equity
(target ROE) of 15 per cent, and an interest rate on debt funding of 3.7 per cent.
56
Box 7: The cost of raising capital requirements (cont.)

Increasing the capital ratio by one percentage point requires an additional $0.50 of
equity funding ($100 x 1 percentage point capital increase x 50 per cent risk weight).
The additional cost is the cost of the new equity less the cost of the debt it replaces
(15 per cent — 3.7 per cent) x $0.50, or $0.06. To retain the same ROE, the bank
charges an additional 6 basis points on the loan.
However, with greater equity, the bank would be safer so the risk premium built
into both the cost of debt and investors’ required ROE should fall. In addition,
competition may limit the extent to which the bank decides to increase prices for
customers. These factors would reduce the increase in loan price.
This is an indicative example that illustrates how capital increases affect pricing.
Although the identified price increase should not be interpreted as a precise change
that would occur, it gives the Inquiry confidence that the change in loan pricing due
to a one percentage point rise in capital ratios would be less than 10 basis points.
Conclusion
The Inquiry’s judgement is that, although Australian ADIs are generally well
capitalised, strengthening the banking sector would deliver a net benefit to taxpayers
and the broader economy. Evidence available to the Inquiry suggests the largest
Australian banks are not currently in the top quartile of internationally active banks.
Australian ADIs should therefore be required to have higher capital levels.
Unquestionably strong capital positions would deliver benefits by providing greater

insurance against future financial crises and the associated harm to individuals, the
economy, Government and taxpayers. Moreover, the cost of strong capital positions—
the ‘insurance premium’ to reduce the risk of financial crises — is low. This cost would
be reduced by competition in the market, including the effect of the recommendations
in this report. The Inquiry estimates that a one percentage point increase in capital
ratios would, absent the benefits of competition, increase lending interest rates by less
than 10 basis points, which could reduce GDP by 0.01–0.1 per cent.
Although the benefits of higher capital are inherently difficult to quantify in a single
number, to provide a net benefit to the economy, an additional percentage point of
capital would only need to reduce the probability or severity of a crisis by 1 in 25 to
1 in 30. 41
In addition, the RBA sets monetary policy, taking into account actual lending rates,
and — to the extent that higher capital would affect GDP or inflation — can change the
41 As the expected average effect of a crisis is 2½–3 per cent of GDP per year, to justify a cost of
capital of 0.1 per cent of GDP would require a reduction of 1 in 25 (0.1/2.5) to 1 in 30 (0.1/3)
in the probability or severity of the crisis.
57
cash rate to at least partially offset the cost. 42 Weighed against the risk of widespread
unemployment, many households losing their savings, several years of economic
recession and a large deterioration in the fiscal position, the Inquiry views this as a
small cost.
The Inquiry recognises that the benefits of additional capital are likely to diminish the
higher the starting level is. For example, moving from 2 per cent to 3 per cent capital is
likely to have a larger effect on stability than going from 15 per cent to 16 per cent and,
at some point, adding additional capital will not provide sufficient benefit to justify the
added cost. However, in the Inquiry’s judgement, capital levels at Australian ADIs are
below this point and there are clear benefits to additional capital.
Implementation considerations
Determining the appropriate level of capital to ensure Australian ADI capital ratios are
unquestionably strong necessarily involves judgement. In the Inquiry’s view, if
requirements are set such that ADI capital ratios are positioned in the top quartile of
internationally active banks, this will achieve the goal of ensuring they are, and are
perceived to be, unquestionably strong.
The optimal level of capital

A body of empirical work estimates the ‘optimal’ bank equity ratio for specific
countries; that is, the level at which the net benefit to the economy is maximised. To
the Inquiry’s knowledge, such a study has not been undertaken for Australia. Studies
from other countries typically find the optimal level of equity capital ratios is
10–20 per cent of risk-weighted assets. 43
Current minimum CET1 requirements for Australian banks, including CET1 buffers,
are 8 per cent for D-SIBs and 7 per cent for others. Even after adjusting these to account
for differences to the Basel framework — as outlined above — Australia’s
requirements are at the lower end of the range of international estimates of the capital
ratio that maximises net benefits to the economy.
42 For example, Battellino, R 2009, Some comments on bank funding, remarks to 22nd Australasian
Finance and Banking Conference, 16 December, Sydney; Hansard 2009, Reference: Reserve
Bank of Australia annual report 2008, House of Representatives Standing Committee on
Economics, 20 February, Canberra.
43 See Miles, D, Yang, J, Marcheggiano, G 2011, Optimal bank capital, MPC Unit Discussion
Paper No. 31., , Bank of England, London; Basel Committee on Banking Supervision 2010,
An assessment of the long-term economic impact of strong capital and liquidity requirements, Bank
for International Settlements, Basel; Barrell, R, Davis, E, Fic, T, Holland, D, Kirby, S and
Liadze, I 2009, Optimal regulation of bank capital and liquidity: how to calibrate new international
standards, Financial Services Authority Occasional Paper 38, London; Sveriges Riksbank 2011,
Appropriate capital ratio in major Swedish banks— an economic analysis, Sveriges Riksbank,
Stockholm; Independent Commission on Banking 2011, Final Report, Independent
Commission on Banking, London.
58
Of course, each system is different and there is no guarantee that what is appropriate
for another country will be right for Australia. However, considering Australia’s
characteristics and circumstances, the ranges found in these studies support the idea
that higher bank capital ratios would have a net benefit in Australia.
Further details
Unquestionably strong levels of capital would be beneficial for all ADIs. It may be
argued that only the largest, most systemically important ADIs should be held to such
a standard. However, in the Inquiry’s view, the failure of an ADI would have adverse
consequences for its customers and the economy, and has the potential to undermine
confidence and trust in the system. As such, the Inquiry judges that this standard
should apply to all ADIs. In addition, holding different parts of the banking system to
substantially different standards would introduce an unwelcome distortion to the
competitive neutrality of regulatory settings.
The Inquiry recommends that increases in capital ratios from current levels should
primarily take the form of increases in CET1, as the highest quality form of capital
providing the greatest level of protection against a bank failing. However, APRA
should use its discretion regarding whether part of such change should be through
Tier 1 capital or total capital requirements. Appropriate transition periods should be
used to limit the costs of transitioning to higher capital.
In implementing this requirement, the interaction between this recommendation and

the effects of Recommendation 2: Narrow mortgage risk weight differences should be taken
into account. In addition, the Inquiry notes a higher capital base for all ADIs may
reduce the need for future changes to the D-SIB buffer.
59
Narrow mortgage risk weight differences
Recommendation 2
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.
Description
APRA should adjust the requirements for calculating risk weights for housing loans to
narrow the difference between average IRB and standardised risk weights. This should
be achieved in a manner that retains an incentive for banks to improve risk
management capacity. It should also appropriately recognise the differences in the
risks captured by IRB and standardised risk weights.
In making these changes, the adjusted framework should remain compliant with the
Basel framework and remain risk sensitive.
Objectives
• Improve the competitive neutrality of capital regulation by limiting distortions
caused by the differential regulatory treatment of different classes of ADI.
• Retain an incentive for ADIs to improve risk management capacity.
Discussion
Problem the recommendation seeks to address
Australia’s current capital framework for ADIs includes two approaches to
determining risk weights for the purpose of calculating capital ratios.
• Standardised approach: This is the default approach, where ‘standardised ADIs’

use a common set of risk weights that seek to reflect general risks of different broad
asset classes. These risk weights are not tailored to a specific ADI and are set at a
conservative level to ensure standardised ADIs are adequately capitalised.
• IRB approach: Accredited ADIs (IRB banks) use their own internal models to
determine risk weights for credit exposures. These risk weights are tailored to the
internally assessed risks of the asset and institution, and are more granular than
standardised risk weights. Achieving IRB accreditation requires a strong and
sophisticated risk management framework and capacity. To date, APRA has only
accredited the four major banks and Macquarie Bank to use IRB models.
60
Prior to Basel II being introduced in 2008, all ADIs were required to operate with the
same risk-weight model, which resulted in the same capital for a given asset, including
loans. Since the IRB approach was introduced, the divergence in mortgage risk weights
between the two approaches has widened, as IRB banks have refined their models and
adjusted their balance sheets in light of modelled risks. The average mortgage risk
weight for an ADI using the standardised model is currently 39 per cent — more than
twice the size of the average mortgage risk weight for banks using IRB models, which
is 18 per cent. 44
IRB risk weights are lower for many reasons, including because this method reflects a
more refined calculation of the risks at IRB banks. However, the Inquiry notes that the
principle of holding capital relative to risk should apply, not only within an institution,
but also across institutions. In the Inquiry’s view, the relative riskiness of mortgages
between IRB and standardised banks does not justify one type of institution being
required to hold twice as much capital for mortgages than another. This conclusion is
supported by the findings of APRA’s recent stress test, which found regulatory capital
for housing was more sufficient for standardised banks than IRB banks. 45
The gap between average IRB and standardised mortgage risk weights means IRB
banks can use a much smaller portion of equity funding for mortgages than
standardised banks. Because equity is a more expensive funding source than debt, this
translates into a funding cost advantage for IRB banks’ mortgage businesses to the
extent that the riskiness of mortgage portfolios is similar across banks.
Given that mortgages make up a significant portion of the assets of almost all
Australian ADIs, competitive distortions in this area could have a large effect on their
relative competitiveness. This may include inducing smaller ADIs to focus on
higher-risk borrowers. Restricting the relative competitiveness of smaller ADIs will
harm competition in the long run.
Rationale
The Inquiry considers that, absent other policy objectives, competitive neutrality is an
important regulatory principle. In the case of risk weights, two policy objectives justify
a difference in risk weights between IRB banks and standardised ADIs:
1. To encourage improved risk management capacity at ADIs. Achieving IRB

accreditation can result in lower risk weights and a related reduction in
funding costs. This is an incentive for banks to develop further risk
management capacity to achieve accreditation.
45 “Regulatory capital for housing held by standardised banks was (just) sufficient to cover the
losses incurred during the stress period; that was not the case for IRB banks”, Byres, W 2014,
Seeking strength in adversity: lessons from APRA’s 2014 stress test on Australia’s largest banks,
AB+F Randstad Leaders Lecture Series, 7 November, Sydney.
61
2. To conform with the principle that capital should be commensurate with

risk. This enhances efficiency and gives ADIs incentives to align risk and
capital. Where an institution can model its risks to an acceptable standard,
estimates from these models should reflect the actual risk of a portfolio and
more accurately align risk and capital (the IRB approach). Where that
capability does not exist, a benchmark risk weight provides a conservative
measure to ensure the ADI is appropriately capitalised (the standardised
approach).
The Inquiry accepts both policy objectives and believes they provide a reason for some
difference in risk weights. It also notes a natural gap between risk weights under the
two systems, reflecting that, unlike IRB risk weights, standardised risk weights take
account of more than credit risk. However, in the Inquiry’s view, none of these provide
a sufficient rationale for the magnitude of the differences that have developed between
IRB and standardised mortgage risk weights.
The Inquiry believes the incentive to improve risk management capacity can be
maintained with a narrower difference between mortgage risk weights. In
implementing this recommendation, APRA should preserve appropriate risk
incentives and take into account differences in the broader frameworks for IRB and
standardised ADIs.
This recommendation addresses appropriate competitive neutrality of the

risk-weighting framework. Larger ADIs may have a number of other advantages, such
as economies of scale, more sophisticated business models, and a greater ability to
diversify assets and manage risk. These are part of the market process; the Inquiry is
not suggesting these are a problem.
Options considered
The Inquiry considered two options to narrow the difference between standardised
and IRB mortgage risk weights:
1. Recommended: Raise average IRB mortgage risk weights.
2. Lower standardised mortgage risk weights. In submissions, some ADIs argue

that a mortgage risk weight of around 20 per cent would be appropriate. 46

Raise average IRB mortgage risk weights
ADIs that use the standardised risk-weight model strongly support narrowing the
difference between IRB and standardised mortgage risk weights. These ADIs argue
46 For example, Suncorp Bank 2014, First round submission to the Financial System Inquiry,
page 6.
62
they are at a considerable competitive disadvantage. In some cases, these ADIs

contend that, without change, they will be forced out of the market — materially
lessening competition. Although ADIs using the standardised model generally
advocate for lowering standardised mortgage risk weights, many indicate that raising
IRB risk weights would also address the problem. 47 This includes some smaller banks
that have spent significant resources on IRB capacity but have not yet achieved IRB
accreditation.
In general, the major banks advocate for smaller ADIs to be supported in achieving
IRB accreditation, rather than making changes to risk weights. They are particularly
opposed to raising IRB risk weights, arguing that changes to the IRB model could
move the resulting risk weights away from the underlying principle that risk weights
should reflect the actual risk of the portfolio. They also note differences in risk between
mortgage portfolios at the major banks and some other ADIs. In discussions, some
major banks indicated they had no strong objections to reducing standardised risk
weights for mortgages.
One major bank submits that the effective difference between the credit risk portion of
mortgage risk weights under the IRB and standardised models is small (in the order of
seven percentage points), since reported standardised risk weights captured more than
credit risk. 48 Although the Inquiry accepts the broader point that IRB and standardised
risk weights capture different things, its judgement is that the gap is not likely to be as
small as suggested by the bank’s analysis. For example, that estimate adjusts for the
D-SIB buffer, which is unrelated to risk weight models and not applied to all IRB
banks. However, in implementing this recommendation, APRA should consider
factors which generate a gap between standardised and IRB risk weights.
In discussions, one major bank argued that raising IRB risk weights would have effects
beyond the mortgage market. In particular, it may induce them to reduce other types
of lending, such as business lending, to offset overall increases in funding costs. While
each institution will make its own lending decisions, many factors other than mortgage
risk weights will affect the type of lending banks undertake, including the level of
demand for overall credit, the strength of returns for the banks, the rate of capital
generation and competition in the sector.
If this recommendation is adopted, APRA has indicated its strong preference is to

narrow mortgage risk weights by raising IRB risk weights. 49 This reflects the need to
maintain appropriate prudential capital settings, particularly for Australian ADIs’
47 Customer Owned Banking Association 2014, Second round submission to the Financial
48 National Australia Bank 2014, Second round submission to the Financial System Inquiry,
page 11.
63
largest exposure class, and that lowering standardised risk weights below 35 per cent
would not be permitted under the Basel framework.
Stakeholder’s raised a number of concerns with the risk-weight approach to

calculating capital ratios. The Basel Committee is already reviewing parts of the
standardised and IRB framework. These measures include reducing the modelling
choices in the IRB framework when determining estimates of credit, market and
operational risk-weighted assets. 50 This work is not due to be completed until the end
of 2015 but may result in increases in some areas.
This recommendation does not seek to eliminate entirely the difference in risk weights
between the IRB and standardised models. It recognises that the current system
provides incentives for ADIs to improve their risk management capabilities and that
the IRB approach seeks to better align capital with risk.
Other countries have also placed restrictions on IRB mortgage risk weights through a
number of means. For example, Sweden, Hong Kong and the United Kingdom have all
used or proposed a mortgage risk-weight floor of 15–25 per cent. New Zealand has
made a number of changes to the Basel-specified parameters for IRB models. Norway
will introduce a 20 per cent floor on the loss given default parameter, which is the
same as the current practice in Australia.
In addition to assisting with regulatory competitive neutrality, increasing IRB risk

weights has two further benefits:
1. It would reduce the likelihood of the IRB approach underestimating risk, or

being subject to model risk or outright manipulation. 51 A minimum average
risk weight prevents very low risk weights being assigned in a manner that
may not reflect the true risk of an asset. The Inquiry notes that models based
on individual borrower characteristics rarely capture the systemic risk that can
become the primary risk driver at the portfolio level.
2. It would increase the capital IRB banks require, increasing their resilience.
The principal cost of raising the average IRB mortgage risk weights is that greater use
of equity, which is typically more expensive than debt, would raise the average cost of
funding for IRB banks. The cost of meeting higher average mortgage risk weights is
expected to be small. The required quantum of capital to achieve an average risk
weight of 25–30 per cent would be roughly equivalent to a one percentage point
increase in major banks’ CET1 capital ratios from current levels. This corresponds with
a small funding cost increase for the major banks. Competition will limit the extent to
50 Basel Committee on Banking Supervision 2014, Reducing excessive variability in banks’

regulatory capital ratios: a report to the G20, Bank for International Settlements, Basel.
51 Byres, W 2012, Regulatory reforms — incentives matter (can we make bankers more like pilots?),
remarks to the Bank of Portugal conference on Global Risk Management: Governance and
Control, 24 October, Lisbon.
64
which this cost is passed on to consumers, and shareholders will likely bear some of
the cost in the form of a lower ROE. This in turn should be at least partially offset by
lower required returns due to the banks being less likely to fail.
Lowering standardised mortgage risk weights

The alternative option of lowering standardised mortgage risk weights to be closer to
their IRB equivalents would have a similar primary benefit to the recommended
option. It would promote competition and improve the future viability of smaller
ADIs. In addition, as ADIs using standardised risk weights would need less equity
funding, the costs identified above would run in the opposite direction, possibly
giving those ADIs a funding cost reduction.
However, this option suffers from several drawbacks relative to raising IRB risk
weights:
• It is non-compliant with the Basel framework.
• It would mean standardised ADIs use less equity and other regulatory capital
funding, which could weaken their prudential position, making these ADIs less
resilient and increasing their probability of failure.
• It would reduce the incentive to improve risk management practices and create an
incentive for standardised ADIs to increase mortgage lending as a share of their
balance sheet.
Conclusion
The costs to the economy of making the regulatory approach for mortgage risk weights
more competitively neutral are modest. The Inquiry judges that these are outweighed
by the long-term competition benefits of assisting to maintain a diversity of ADIs into
the future.
The Inquiry judges the option of lowering standardised mortgage risk weights to be
substantially inferior to the recommended option of raising IRB mortgage risk weights.
The recommended option is predicated on the existing Basel framework, which the
Inquiry understands is currently under review. The intention is to narrow the
difference between IRB banks and standardised average mortgage risk weights. If the
existing Basel framework alters, this should be taken into account.
The Inquiry considers a range between 25 and 30 per cent to be appropriate, to be

decided on by APRA in targeting an average IRB mortgage risk weight. This is based
on international experience and the current average IRB and standardised mortgage
risk weights of 18 per cent and 39 per cent respectively.
65
The risk weight gap could be narrowed in a variety of ways. In determining the
approach, APRA should seek to maintain as much risk sensitivity in the capital
framework as possible and recognise lenders mortgage insurance where appropriate.
This recommendation is focused on mortgage portfolios, given the importance of this

market for Australian ADIs. APRA could also investigate whether similar issues exist
in other portfolios.
The recommendation should be considered in conjunction with others in this report; in

particular, Recommendation 1: Capital levels and Recommendation 4: Transparent reporting
in relation to Australian ADIs’ capital position and transparency of the capital
framework.
To promote incentives for ADIs to develop IRB capacity, APRA could also consider
how to make the accreditation process less resource intensive without compromising
the (necessarily) very high standards that must be met. APRA has already indicated it
is willing to explore a proposal to decouple the need to achieve internal model
accreditation for both financial and non-financial risks simultaneously. That is, an ADI
may be accredited for regulatory capital models for credit and market risks without
having been accredited to model operational risk. The Inquiry supports exploring such
initiatives.
Some ADIs will not use the IRB approach, because it may not be cost effective for
smaller institutions. As such, the gap between IRB and standardised mortgage risk
weights should be closed to improve competitive neutrality, regardless of any
assistance provided to help with IRB accreditation.
66
Loss absorbing and recapitalisation capacity
Recommendation 3
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.
Description
APRA should develop a loss absorbing and recapitalisation framework aligned with
international standards: it should not generally seek to move outside international
frameworks or ahead of global peers unless there are specific domestic circumstances
to warrant this.
This framework should provide sufficient loss absorbing and recapitalisation capacity
to facilitate the orderly resolution of ADIs. It should minimise negative effects on
financial stability, ensure the continuity of critical functions and minimise the use of
taxpayer funds.
Total loss absorbing and recapitalisation capacity should consist of an ADI’s equity as
well as debt instruments on which losses can credibly be imposed in a resolution. This
includes debt instruments that can be converted to equity or written off where
specified triggers are met to recapitalise the ADI or its critical functions.
The Inquiry supports pursing such a framework, but cautions Australia to tread
carefully in its development and implementation as this area is complex and evolving.
The Inquiry recommends that the framework follow these guiding principles:
• Clearly set out the instruments eligible for inclusion in a loss absorbing and
recapitalisation capacity requirement.
• Ensure clarity of the creditor hierarchy with clear layers of subordination between
classes.
• Ensure clarity of the mechanisms and triggers under which creditors will absorb
losses.
• Seek to ensure eligible instruments can be exposed to loss without adverse

consequences for financial stability, including being held by investors who can
credibly be exposed to loss.
The Inquiry intends that this framework would only include specific liabilities and not
deposits. Deposits are protected by a guarantee under the FCS of up to $250,000 per
67
account holder per ADI and by depositor preference. In Australia, deposits are not and
should not be subject to bail-in.
In considering eligible instruments, the benefit of the lower cost of less subordinated
instruments, such as a new layer between Tier 2 and senior unsecured debt in the
creditor hierarchy, should be weighed against the ability to credibly write off or
convert the instrument without causing financial instability. The clearer the
mechanisms and triggers under which creditors will absorb losses are in advance, the
more likely it is that this can be achieved. To this end, where losses are to be imposed
through instruments being converted to equity or written off, issuing new contractual
instruments has substantive advantages over broad statutory bail-in powers.
Objectives
• Ensure Australian ADIs have sufficient loss absorbing and recapitalisation capacity
in resolution to make it feasible to implement an orderly resolution.
• Reduce perceptions that some banks are subject to an implicit Government

guarantee to lessen market distortions created by this perception and improve
competition in the banking sector.
Discussion
In a stable system, if financial institutions fail, they do so in an orderly fashion, without
excessively disrupting the financial system, without interrupting the critical economic
functions these institutions provide or exposing taxpayers to loss. 52
The Inquiry believes three aspects of Australia’s framework for the orderly resolution
of ADIs could be strengthened:
1. Effective crisis management powers for authorities. Recommendation 5: Crisis

management toolkit addresses this aspect.
2. Effective pre-positioning and planning for the use of those powers. The
Inquiry supports further work by authorities on this aspect.
3. Sufficient loss absorbing and recapitalisation capacity, which is addressed by

this recommendation.
Currently, Australia does not have requirements for loss absorbing and
recapitalisation capacity. Introducing a loss absorbing and recapitalisation capacity
52 Bank of England 2014, The Bank of England’s approach to resolution, Bank of England, London,
page 7.
68
framework creates credible alternatives to using taxpayer funds to resolve a bank and
reduces perceptions of an implicit guarantee.
This is a focus of ongoing international policy work building on the experience of

many national governments during the GFC, where significant taxpayer funds were
put at risk to assist troubled banks as no other credible options were available to
support financial stability. In many cases, even capital instrument investors were
bailed out, despite these instruments being intended to absorb losses. As a core part of
the G20 agenda to end the problems associated with some institutions being perceived
as ‘too-big-to-fail’, the Financial Stability Board (FSB) is consulting on an international
framework for loss absorbing and recapitalisation capacity for global systemically
important banks (G-SIBs). 53 Indications are that many countries will also adopt these
standards for D-SIBs. As a small, open, capital-importing economy, Australia cannot
stand outside international practice.
An orderly resolution can be achieved with Government support, but this puts
taxpayer funds at risk and protects bank creditors from loss. If Australia introduces a
framework requiring banks to have sufficient loss absorbing and recapitalisation
capacity, losses or recapitalisation costs are more likely to be borne by a failed bank’s
shareholders and creditors rather than taxpayers.
Further, if the market believes that Government support is the only viable option, this
creates the perception of an implicit guarantee and the potential for associated
distortions. The Australian Government support provided during the GFC, although
not at the same level as in some other jurisdictions, has reinforced perceptions of an
implicit guarantee for some banks in Australia.
Perceptions of implicit guarantees have costs, creating a contingent liability for the
Government and distortions in the market. They reduce market discipline and
potentially confer funding advantages on the banks involved. Credit rating agencies
explicitly factor in rating upgrades for banks they perceive to benefit from
Government support, directly benefiting these banks. 54 Reducing perceptions of
implicit guarantees in Australia could therefore improve efficiency and competition in
the banking sector.
Rationale
Australia’s prudential framework is not, and should not be, premised on the
assumption that ADIs will never fail, nor that unsecured bank creditors will never be
exposed to loss. Inevitably, failures can and will occur, the system will be exposed to
crises and, at times, unsecured bank creditors will be exposed to loss.
53 Financial Stability Board (FSB) 2014, Adequacy of loss absorbing capacity of global systemically
important banks in resolution, FSB, Basel.
54 For example, see Standard & Poor’s 2013, Australia’s developing crisis-management framework
for banks could moderate the Government support factored into ratings, Standard & Poor’s.
69
A loss absorbing and recapitalisation capacity framework would help to implement an

orderly resolution of a distressed ADI with minimum use of taxpayer funds. This
would reduce perceptions of an implicit Government guarantee, thereby reducing the
contingent liability of the Government and the associated market inefficiencies.
Options considered
The Inquiry considered two options:
1. Recommended: Implement a framework for minimum loss absorbing and

recapitalisation capacity in line with emerging international practice, sufficient
to facilitate the orderly resolution of Australian ADIs and minimise taxpayer
support.
2. Make no change to current arrangements.

The banking sector disputes the need for additional loss absorbing and recapitalisation
capacity. However, banks generally acknowledge that such a framework is inevitable
given the work underway to develop a set of international standards.
In this context, most of the major banks argue strongly that senior unsecured debt
should not be subject to bail-in. They contend that, were such a bail-in ever used, it
could have a significant destabilising effect on the financial system. To this point, they
note that senior unsecured debt is a vital funding source and that a loss of investor
confidence in that market could be damaging. Instead, banks prefer a loss absorbing
and recapitalisation capacity requirement in the form of existing Tier 1 or Tier 2
capital, or a new layer of loss absorbing debt distinct from regular senior unsecured
debt.
The banks also warn that a loss absorbing and recapitalisation framework would
introduce costs, as bail-in debt would have higher spreads than existing debt,
reflecting the additional risk. This could be exacerbated if the demand for these bail-in
instruments is limited and spreads increased further to encourage greater holdings.
Banks submit that changes in funding costs would be passed on to consumers, at least
in part, which would raise the cost of credit and potentially affect GDP growth.
APRA notes that the global debate is moving beyond how to reduce the probability of
bank failure, which is addressed by capital requirements, and now focusing on how to
reduce the cost of failure. This will result in a global loss absorbing and recapitalisation
capacity framework for G-SIBs to remove perceptions that such institutions are
too-big-to-fail. Although Australia has no G-SIBs, when seeking funding in wholesale
markets, the internationally active Australian banks must compete against banks that
meet these global requirements. These competitors include other internationally active
banks from jurisdictions that adopt these standards more broadly.
70
The RBA acknowledges that the risks associated with a bail-in of creditors need to be
carefully considered, but notes that this does not necessarily preclude its inclusion in
the suite of available resolution tools. It advocates for taking a conservative approach
to implementing such features in Australia.
A very large number of submissions are concerned that introducing bail-in provisions
in Australia could lead to depositors’ funds being bailed in to recapitalise a failed
bank. The Inquiry strongly supports continuing the current Australian framework in
which deposits are protected through an explicit guarantee under the FCS, supported
by depositor preference. The Inquiry specifically does not recommend the bail-in of
deposits.
The ultimate shape of the framework will influence the cost-benefit analysis. In
assessing this, the most relevant factors are implicit guarantees, funding costs, lending
rates, GDP and credit ratings.
Benefits
If banks have sufficient loss absorbing and recapitalisation capacity, a failed ADI is
more likely to be resolved in a way that limits the effect of the failure on the broader
economy, while minimising the use of taxpayer funds. This is a substantial benefit. As
detailed in Recommendation 1: Capital levels, the costs of financial crises are wide
ranging and severe. That recommendation focuses on reducing the probability of crises
occurring in the first place, while this recommendation focuses on reducing the costs of
crises that cannot be avoided. The magnitude of these avoided costs will depend on
the specifics of the framework implemented. As an indicative measure, if the cost of
financial crises is reduced by 10 per cent, it would provide an expected average benefit
of 0.25–0.3 per cent of GDP per year ($4–$5 billion). 55
By making it more credible to achieve a resolution with minimal use of taxpayer funds,
this recommendation also reduces perceptions of an implicit Government guarantee.
There are clear benefits to the economy in minimising perceptions of implicit
guarantees, including reducing Government’s contingent liability and improving
efficiency by removing market distortions, thereby making the banking sector more
competitive.
Lending interest rates

Making it more credible and feasible for creditors to bear losses would raise the costs
of the relevant types of debt funding for affected ADIs by reducing perceptions of an
implicit guarantee.
Higher ADI funding costs could result in small increases in loan prices for customers.
Banks have acknowledged in submissions that the cost of other forms of regulatory
55 Based on the expected average cost of a financial crisis of 2½–3 per cent of GDP
($40–$50 billion) per year, as outlined in Recommendation 1: Capital levels.
71
capital would be less than the cost of increasing CET1 capital; the funding spread, and
corresponding effect on lending interest rates, for subordinated debt is a fraction that
of CET1 capital. Competitive pressure could see banks share some of the cost with
investors through a lower ROE. Thus, the effect on loan interest rates is likely to be
limited, even for a large increase in bail-in debt.
From an economy-wide view, reducing the implicit guarantee would offset at least
part of the cost to banks by providing a corresponding benefit to taxpayers and
Government, and reducing market inefficiencies. Greater volumes of new
subordinated debt could also reduce the cost of existing subordinated debt on issue,
since potential losses would be spread across a larger pool of claims. It should also
reduce the cost of more senior debt, as losses become less likely to reach senior classes.
The Inquiry notes that markets for subordinated debt with conversion and write-off
features are currently small and may require higher spreads to absorb large new
issuance. This would particularly be the case if new requirements were implemented
with short transitional arrangements.
GDP
The Inquiry expects the effect of higher lending rates on GDP to be minimal. An upper
bound would be to assume that the full funding cost increase is passed through to loan
interest rates, and that the RBA does not offset this through its setting of monetary
policy. As discussed in Recommendation 1: Capital levels, the small expected effect on
lending interest rates would lead to a correspondingly small effect on GDP.
However, a large part of the cost is offset by reductions in perceptions of an implicit

guarantee. In addition, the RBA would likely consider the effect on GDP when
formulating monetary policy. 56
Credit ratings
The net effect on credit ratings is unclear. Debt designed to more easily expose
creditors to loss through write-off or conversion features is likely to be rated lower
than debt without these features. However, it is not clear whether banks’ credit ratings,
which are based on the risk of loss to senior unsecured debt, would change as a result
of introducing a loss absorbing and recapitalisation framework.
If the loss absorbing and recapitalisation framework increases ADIs’ subordinated

debt, there would be a larger buffer before senior unsecured debt takes losses. It may
therefore make senior debt safer. However, introducing the framework may be taken
as a signal of a lower likelihood of Government support for banks, especially since this
is an intended outcome of the framework. Currently, the major banks receive a
56 For example, Battellino, R 2009, Some comments on bank funding, remarks to the
22nd Australasian Finance and Banking Conference, 16 December, Sydney; Hansard 2009,
Reference: Reserve Bank of Australia annual report 2008, House of Representatives Standing
Committee on Economics, 20 February, Canberra.
72
two-notch credit rating upgrade on the basis of expected Government support. 57

Credit rating agencies may reconsider this upgrade in light of credible mechanisms to
impose loss.
Conclusion
The Inquiry judges that there is a net benefit of a loss absorbing and recapitalisation
capacity framework.
Loss absorbing and recapitalisation capacity on its own does not guarantee a
successful resolution nor eliminate all perceptions of implicit guarantees. It must be
part of a broader resolution framework that includes strong crisis management tools
for regulators, as outlined in Recommendation 5: Crisis management toolkit.
The extent of the net benefit will be influenced by the ultimate shape of the framework,
including the quantum, the composition and the time given for transition. Generally,
costs will be higher the larger the capacity required, the more subordinated the eligible
instruments and the shorter the period required to build the capacity. Benefits will be
greater where loss absorbing and recapitalisation capacity is high and clear, and where
creditor hierarchy and triggers are transparent. However, if designed carefully and
according to the articulated principles, the framework can attain net benefits.
Sufficiency
To minimise the need for taxpayer support, ADIs need sufficient capacity to absorb
losses and, in some cases, provide the recapitalisation necessary to implement their
resolution strategy.
This may require enough capacity to fully recapitalise the institution. International
work proposes that G-SIBs need a range of 16–20 per cent of risk-weighted assets and
twice the Basel leverage requirement. 58 A similar quantum may be appropriate for
internationally active Australian ADIs.
For smaller banks, an orderly resolution may be possible through activating the FCS or
through a merger or acquisition at the point of resolution. In this case, the loss
absorbing and recapitalisation capacity sufficient to implement the resolution plan is
likely to be lower.
The Inquiry recommends considering a graduated approach across the banking sector
when developing the loss absorbing and recapitalisation capacity framework for
57 Standard & Poor’s 2013, Australia’s developing crisis-management framework for banks could
moderate the Government support factored into ratings, Standard & Poor’s.
58 Financial Stability Board 2014, Adequacy of loss absorbing capacity of global systemically important
banks in resolution, FSB, Basel, page 6.
73
Australia. This approach should take into account the likely resolution strategy for an
ADI.
Eligible instruments
The framework should consider a broad range of equity and debt instruments.
Equity instruments have the advantage of being well understood by investors. These
instruments have a long history of automatically absorbing loss without causing
systemic disruption. However, they are more expensive than debt funding and may
not be available in resolution, having already been depleted. Experiences overseas
suggest that ADIs only tend to enter resolution after significant losses have been
incurred and there is little or no equity value left. 59 That is, equity instruments may not
be available to assist in recapitalising a distressed institution.
Requiring eligible debt instruments would give the regulator greater confidence that
the loss absorbing and recapitalisation capacity will be available in resolution. These
instruments are not depleted until a trigger has occurred, so — once triggered — they
can act to replenish capital. This gives the regulator greater certainty about the
resources that will be available when conducting their resolution planning. Debt
instruments are also typically less expensive than equity instruments.
Additional Tier 1 and Tier 2 capital instruments with conversion and write-off
features, which already exist in the Basel framework, can provide loss absorbing and
recapitalisation capacity. Investors already hold these instruments. As these conversion
features are relatively new, instances of instruments being converted into equity or
written off are very limited. If constructed carefully, a new layer of contractual
instrument in the creditor hierarchy between Tier 2 and unsecured senior debt would
have similar benefits to Tier 2, at a lower cost. In substance, it should be no less
credible than a Tier 2 instrument.
Addressing challenges
Stakeholder submissions, and a wide range of policy research and commentary, note a
number of major difficulties in implementing a bail-in regime that can be credibly
activated in a crisis.
Most concerning is the possibility that activating a bail-in for creditors of one bank
may actually worsen the crisis. This could occur if converting one bank’s creditors
caused creditors of other banks to reassess the likelihood that they will take a loss,
resulting in investors withdrawing funds (or refusing to roll over debt) to other banks
in the system. This contagion could cause acute liquidity problems and distress in
other banks, exacerbating the crisis. Also, if banks were unable to access international
funding markets, it could take longer for them to resume lending to the economy once
the crisis is over, potentially prolonging an economic downturn.
59 Gracie, A 2014, Making resolution work in Europe and beyond — the case for gone concern loss
absorbing capacity, speech given at the Bruegel breakfast panel event, 17 July, Brussels.
74
Addressing these challenges is critical to developing a viable loss absorbing and

recapitalisation capacity framework. Although such difficulties give reasons to be
cautious, in the Inquiry’s view these can be addressed, especially given the
considerable work underway on these issues globally. In developing its own
framework, Australia should take account of this international work to create a system
that, where possible, overcomes the problems associated with bail-in by being credible,
predictable, in line with international practice, and having an appropriate transition
period.
Other considerations
To keep any costs to a minimum, an appropriate implementation period should be
allowed where the framework imposes a significant quantum.
Developing a successful loss absorbing recapitalisation framework depends on a large

number of other important aspects, which this Final Report will not discuss in detail.
These aspects include:
• Possible need for legislative change; for example, to ensure certainty of the creditor
hierarchy.
• Considering whether requirements form part of Pillar 1 or Pillar 2 requirements.
• Ensuring the legal basis for exposing creditors to loss is sound and the framework
adequately accounts for where an ADI is part of a group or operates across borders.
75
Transparent reporting
Recommendation 4
Develop a reporting template for Australian authorised deposit-taking institution capital

ratios that is transparent against the minimum Basel capital framework.
Description
APRA should develop a common reporting template that, where feasible, identifies the
effect of areas where Australia’s capital framework for ADIs is different to the
minimum requirements set out in the Basel framework.
Objective
• Reduce disadvantages that may arise for Australian ADIs due to difficulties in
comparing Australian ADI capital ratios to international peers.
Discussion
No benchmark of international practice exists for calculating capital ratios. All
countries use variations to the minimum Basel capital framework, making it
challenging to determine a common international benchmark against which to
compare Australian bank capital ratios. This inhibits the relative strength of Australian
banks from being accurately assessed against banks from other jurisdictions.
This problem arises because, in some areas, the Basel framework allows for more than
one approach, or provides that a requirement should be specified but leaves it to
national discretion to determine the detail. In addition, many individual jurisdictions
adopt stronger standards than the Basel minimums. As a result, no two jurisdictions
take exactly the same approach to calculating capital ratios.
Like banks in all advanced countries, Australian bank capital requirements are based
on the Basel framework but adjusted to meet domestic needs. This has resulted in
aspects being more stringent in some areas, and less so in others, than the approaches
taken in other jurisdictions. Thus, although Australian banks can be benchmarked
against the Basel minimum, they cannot be benchmarked against other countries’
practices.
Simply comparing Australian bank capital ratios to those reported by their

international peers may therefore be misleading.
76
To make informed decisions and price debt appropriately, investors assess differences
in banks’ financial strength, including capital. Although it is generally possible to
identify significant differences in jurisdictions’ approaches to calculating capital ratios,
estimating and comparing the effect of those differences is challenging. The banks have
made substantial efforts to raise investors’ awareness of aspects of Australia’s
requirements that are stronger than the minimums. However, investors are hesitant to
trust banks’ self-reported adjusted capital ratios.
Quantifying the cost of this lack of comparability is difficult. Australia’s major banks
have some of the highest credit ratings in the world, which may suggest that costs are
limited. 60 Likewise Australian bank equity valuations are among the highest in the
world. However, banks contend that the lack of transparency affects market pricing.
They also suggest that market access may be compromised in times of market stress,
when investors are particularly risk sensitive.
The Inquiry encountered significant difficulty in comparing Australian banks’ capital

ratios to those of international peers. As discussed in Recommendation 1: Capital levels,
there are limited data available that try to compare capital across countries on a
consistent basis, and every source that attempts this has drawbacks.
The Inquiry was presented with several estimates against different benchmarks, all of
which were only able to provide a partial analysis and yielded results that varied
markedly. 61 This demonstrates both the value of developing a consistent approach and
the difficulty of achieving it. Even where stakeholders provided estimates of how
Australian bank capital ratios compared to the Basel minimum requirements —
leaving aside the added difficulties of comparing directly to international banks — the
results had notable differences.
The major banks submit that APRA could adequately address this issue by developing
a standard template to quantify the areas where Australian bank capital ratios are
more or less conservative than the minimum Basel requirements. They note that this
work has begun but sought the Inquiry’s support to progress it as a priority.
APRA submits that, in implementing the Basel framework to suit the Australian
environment, its primary goals is ensuring capital adequacy for each ADI. However,
APRA also sees value in comparing capital ratios appropriately, particularly for the
largest banks operating internationally, and has no objection to ADIs reporting a
capital ratio based on Basel minimum requirements. Nevertheless, it argues that the
additional requirements imposed by each jurisdiction mean it is not practically
possible to compute a comparison to the practices of other jurisdictions.
60 Many factors contribute to Australian banks’ credit ratings in addition to their capital ratios,
including the strong Australian Government credit rating and the sound macro-economic
environment in Australia.
61 A number of submissions addressed this issue, including from APRA, the Australian
Bankers’ Association, the major banks and Mòrgij Analytics.
77
Conclusion
Without action, investors may not be able to assess Australian banks’ relative capital
position. This can reduce access to funding and raise funding costs, particularly at
times when investors are more sensitive to risk. Given the existence of a relatively
low-cost option to address this situation, it is not desirable to maintain the status quo.
This recommendation would be most beneficial if other countries implemented similar

reporting mechanisms. Recognising that national discretions can impair comparisons
across jurisdictions, the Basel Committee on Banking Supervision has been working to
address this issue, including by publishing survey data on how different countries use
discretions. 62 However, even in the absence of action by other countries, introducing
such reporting in Australia is still of benefit. It would translate Australian ADI capital
ratios into an easily understandable, known international benchmark, even if other
countries have differences within their own jurisdictions.
The Inquiry has not sought to quantify the extent to which transparent reporting may
affect funding costs or access to funding. However, it notes that the benefits are likely
to be more pronounced in times of market stress. Most of the cost of implementing this
option would fall to the major banks, which see a substantial net benefit in this change.
The Inquiry notes that APRA has begun developing reporting in conjunction with
industry in line with the current recommendation. Given this reporting would be most
beneficial to banks with investors that seek exposure across banks in multiple
jurisdictions, APRA should consider whether reporting should be voluntary to avoid
imposing costs on those banks for which it would serve no benefit.
An alternative option is to change the way capital ratios are calculated to be more
consistent with the Basel minimum framework, in effect reducing APRA’s use of
national discretion. This may achieve a similar outcome with regard to international
transparency. However, it would have a wider range of costs and take substantially
longer to implement than the recommended option. As such, the Inquiry does not
recommend this approach.
62 Basel Committee on Banking Supervision 2014, Basel capital framework national discretions,
Bank for International Settlements, Basel.
78
Crisis management toolkit
Recommendation 5
Complete the existing processes for strengthening crisis management powers that have been
on hold pending the outcome of the Inquiry.
Description
In September 2012, the previous Government consulted on a comprehensive package,
Strengthening APRA’s crisis management powers. 63 The CFR has also recommended
separate changes to resolution arrangements and powers for FMI. 64 In 2013, these
processes were put on hold as part of a Government moratorium on significant new
financial sector regulation pending the outcome of this Inquiry. Government should
now resume these processes, with a view to ensuring regulators have comprehensive
powers to manage crises and minimising negative spill-overs to the financial system,
the broader economy and taxpayers.
The Inquiry strongly supports enhancing crisis management toolkits for regulators. It
is important for the two processes to be concluded, giving due consideration to
industry views on the packages.
Objectives
• Promote a resilient financial system.
• Enable the orderly resolution of distressed financial institutions.
Discussion
Given the importance of ADIs, insurers, superannuation funds and FMI to the
functioning and stability of the financial system and economy, regulators need
comprehensive powers to facilitate the orderly resolution of these institutions.
Responding to local and global changes, CFR agencies reviewed the existing legislative
provisions for prudentially regulated institutions and FMI. These reviews paid close
attention to international standards and developments, particularly G20 and FSB
initiatives to promote resilient financial systems and frameworks that resolve financial
distress, including the FSB Key Attributes of Effective Resolution Regimes for Financial
63 Treasury 2012, Strengthening APRA’s Crisis Management Powers: Consultation Paper,

Commonwealth of Australia, Canberra.
64 Stevens, G 2012, ‘Review of Financial Market Infrastructure Regulation’, letter to
The Hon. Wayne Swan, MP, Deputy Prime Minister and Treasurer, 10 February.
79
Institutions (Key Attributes). 65 Although Australia has strong frameworks, the reviews
identified gaps and areas that could be strengthened.
The Government consultation paper Strengthening APRA’s crisis management powers

canvassed a number of options in relation to all APRA-regulated industries. The
package does not include statutory bail-in powers outlined in the Key Attributes or
general structural requirements, such as ring-fencing, being pursued in some
jurisdictions. It includes:
• Directions powers, including clarifying that APRA may direct a regulated

institution to pre-position for resolution — that is, require changes at an institution
to make it more feasible to successfully resolve that institution if it were to fail.
• Group resolution powers, including extending certain powers to authorised

non-operating holding companies (NOHCs) and subsidiaries in a range of distress
situations.
• Powers to assist with resolving branches of foreign banks.
The CFR recommendations for strengthening the crisis management framework for
FMI included:
• Introducing a specialised resolution regime for FMI.
• Clarifying the application of location requirements for FMI operating across

borders.
Since these processes were put on hold, international developments have included
updates to the Key Attributes, yielding additional guidance on areas such as
cross-border information sharing, and resolving FMI and FMI participants. Some
countries have also introduced structural reforms, such as mandating a form of
ring-fencing, or a NOHC structure for institutions with certain risk profiles or of a
certain size, with the aim of improving resolvability. These approaches emphasise
reducing risks to core banking activities from more complicated and risky forms of
banking, and simplifying institutions to make them more easily resolved.
Conclusion
The Inquiry believes progressing the packages would deliver a substantial net benefit.
A range of resolution options — more ‘tools in the toolkit’ — would maximise the
likelihood that a viable option will be available in any given situation to achieve an
orderly resolution. The Inquiry notes the high costs associated with the disorderly
failure of an institution, particularly where this creates financial system instability or
65 Financial Stability Board (FSB) 2014, Key Attributes of Effective Resolution Regimes for Financial
Institutions, FSB, Basel.
80
the need for Government support. The Inquiry also notes that many of the proposed
powers would have a limited regulatory burden in normal times.
In relation to the package of resolution powers for APRA, industry submissions largely
support the package, although they raise practical and legal issues with some of the
proposals. 66
APRA’s submission to the Inquiry stresses the vital role that crisis management
powers play in the prudential framework. 67 In any future crisis, these reforms would
provide a wider range of tools, making it more likely that a credible, low-cost option
for preventing a disorderly failure could be found, without risking taxpayer funds.
The RBA advocates for progressing the CFR proposals on FMI regulation as a matter of
priority. 68 It notes that the continuity of FMI services is critical for the financial system
to function. In addition, the RBA notes that, where FMI is domiciled offshore,
Australian regulators need to have sufficient influence to prevent Australian functions
from being compromised in a resolution.
The Inquiry does not recommend pursuing industry-wide structural reforms such as
ring-fencing. These measures can have high costs, and require changes for all
institutions regardless of the institution-specific risks. Neither APRA nor the RBA nor
the banking industry saw a strong case for these reforms.
Nevertheless, APRA submits that it may be beneficial to require structural changes for
specific institutions in some situations, where substantial risks or significant
organisational complexity may impede supervision or an orderly resolution. The
powers included in the consultation package provide sufficient flexibility to do this
effectively.
Given the time that has passed since the initial consultation in progressing the reform
packages — in particular, the considerable international developments over this period
— a view should be taken as to whether additional proposals warrant inclusion.
All proposals should go through the appropriate consultation, regulatory assessment

and compliance cost assessment processes.
66 Submissions on the consultation paper are available on the Treasury website, viewed
11 November 2014,
<http://www.treasury.gov.au/ConsultationsandReviews/Consultations/2012/APRA/
Submissions>.
68 Reserve Bank of Australia 2014, First round submission to the Financial System Inquiry,
page 4.
81
Financial Claims Scheme
Recommendation 6
Maintain the ex post funding structure of the Financial Claims Scheme for authorised
deposit-taking institutions.
Description
Government should retain the current FCS funding model for ADIs, under which
payouts are recovered from liquidating the failed ADI and, where this is insufficient,
an ad hoc levy can be placed on the banking industry.
Objectives
• Ensure the FCS has an appropriate and efficient funding structure.
• Minimise the ongoing regulatory costs of the FCS.

The FCS is a fundamental component in protecting depositors in Australia, providing
a guarantee on deposits of up to $250,000 per account holder per ADI. The FCS allows
depositors to access protected deposits quickly, without having to wait for a
liquidation process to be completed.
Currently the FCS is funded ex post. If an ADI fails and the FCS is activated,
Government provides the necessary funds and then reclaims them from the proceeds
of liquidating the institution. Where the liquidation proceeds are insufficient,
Government can place a levy on industry to make further recoveries.
A number of bodies, including the IMF and the CFR, proposed an alternative ex ante
funding model, which is also being consulted on by the International Association of
Deposit Insurers. 69 The former Government also announced it would adopt ex ante
funding. 70 Under this model, ADIs with FCS-protected funds would be charged an
ongoing levy to compensate for the guarantee the FCS provides.
69 International Monetary Fund (IMF) 2012, Australia: Financial System Stability Assessment, IMF,
Washington DC; Basel Committee on Banking Supervision and International Association of
Deposit Insurers 2014, Core Principles for Effective Deposit Insurance Systems, Bank for
International Settlements, Basel.
70 Commonwealth of Australia 2013, Economic Statement, August 2013, statement by the Hon.
Chris Bowen MP and Senator the Hon. Penny Wong, Canberra.
82
Conclusion
The proposed ex ante funding model has a number of appealing features, including:
• Being based on a user-pays principle.
• Enabling levy funds to be deployed to aid in wider ADI resolution purposes.
• Offering the potential to build a fiscal buffer.
However, an ex ante levy would be an ongoing cost for all ADIs. In contrast, the
current ex post model only imposes a levy if the FCS is triggered and insufficient funds
are recovered through liquidation to recoup the costs. Because Australia’s depositor
preference arrangements reduce the risk of an ADI’s assets being insufficient to meet
insured deposits, the case for an ongoing levy is less justified.
The Inquiry notes that the recommendations in this chapter would further strengthen
the resilience of the Australian banking sector by reducing the risk of failure and
mitigating the costs of failures that do occur. If adopted, these recommendations
weaken the case to charge an ex ante levy for the FCS.
The Inquiry notes that the consultation package outlined in Recommendation 5: Crisis
management toolkit, includes a number of measures designed to strengthen the FCS and
Government’s ability to recoup costs. These include an additional payment option that
allows APRA to transfer deposits to a new institution using the funding available
under the FCS.
On this basis, in the Inquiry’s view, it is preferable to retain an ex post funding model
that avoids placing an ongoing financial burden on the industry.
83
Leverage ratio
Recommendation 7
Introduce a leverage ratio that acts as a backstop to authorised deposit-taking institutions’

risk-weighted capital positions.
Description
APRA should introduce a leverage ratio as a backstop requirement, providing a floor
to ADIs’ risk-weighted capital requirements. This should be introduced as part of
Australia’s adoption of the Basel framework and in line with the international
timetable.
The minimum leverage ratio should be comparable with Australia’s global peers. In
the Inquiry’s view, an appropriate range is likely to be 3–5 per cent, calculated in
accordance with the Basel framework.
Objectives
• Limit systemic risk and the potential for shocks to be transmitted through the
financial system.
• Retain the risk sensitivity of capital requirements, while providing a mechanism

that accounts for limitations and risks in modelling risk weights.
• Maintain investor confidence in the strength of Australian banks.

Leverage is a useful and necessary part of the banking system. It allows a bank to take
savers’ funds — whether in the form of deposits or creditors lending to the bank —
and channel them to borrowers to fund investment in the economy. However, leverage
also introduces risks. A highly leveraged institution has smaller buffers available to
absorb loss before insolvency. Leverage can also amplify the effect of shocks on an
institution’s balance sheet. This may spread shocks to other institutions and cause
systemic risks.
A number of countries have introduced leverage ratios, including the United States,
the United Kingdom and Canada. Australia does not currently have a minimum
leverage ratio requirement, although APRA has indicated that it may introduce one in
line with the Basel framework. Details of how this would operate are being reviewed
internationally.
84
Currently in Australia, restrictions on leverage are achieved indirectly by ensuring

ADIs use capital funding in proportion with risk. In the Inquiry’s view, the practice of
relating capital requirements to risk is appropriate.
However, there are concerns that, in some instances, the risk-weighted approach may
lead to insufficient levels of capital. 71 This danger is possible under the standardised or
IRB approach, but is greatest for IRB models, as there is potential for ‘model risk’. For
example, if the historical data are too benign, the models that underlie the
risk-weighting system may underestimate the true risk, leading to inappropriately low
levels of capital. 72 Concerns have also been raised that banks may have the capacity —
and incentive — to manipulate IRB models to achieve a lower capital requirement.
Studies have revealed substantial variation among IRB risk-weight models across
countries. 73 Although this does not suggest IRB models are unsuitable, it does give
reason to be cautious about their outputs.
A number of ADIs support having capital requirements commensurate with risk,

meaning that capital requirements should generally be determined by the
risk-weighted capital ratio. Similarly, APRA supports the principle of aligning capital
with risk, being the primary driver of bank capital positions.
Both options would introduce monitoring and reporting costs for ADIs, although these
are not expected to be large. As a backstop, the leverage ratio would not generally
require ADIs to change their level of capital.
Conclusion
Whether a leverage ratio is a binding constraint or a backstop to the risk-weighted
approach, the benefits are similar. Both options discourage excessive leverage and
protect against risk being substantially underestimated, leading to weaker capital
positions. However, the costs and risks will be greater with a binding constraint.
In the Inquiry’s view, having a leverage ratio as a meaningful backstop provides

appropriate insurance against the risks inherent in risk-based capital requirements,
while retaining the advantages of having capital requirements commensurate with
risk.
71 For example Tarullo, D 2014, Rethinking the aims of prudential regulation, speech at the Federal
Reserve Bank of Chicago Bank Structure Conference, 8 May, Chicago.
72 Byres, W 2012, Regulatory reforms — incentives matter (can we make bankers more like pilots?),
remarks to the Bank of Portugal conference on Global Risk Management: Governance and
Control, 24 October, Lisbon.
73 Basel Committee on Banking Supervision 2013, Regulatory Consistency Assessment Programme
(RCAP): Analysis of risk-weighted assets for credit risk in the banking book, Bank for International
Settlements, Basel.
85
Direct borrowing by superannuation funds
Recommendation 8
Remove the exception to the general prohibition on direct borrowing for limited recourse
borrowing arrangements by superannuation funds.
Description
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. 74 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.
Objectives
• Prevent the unnecessary build-up of risk in the superannuation system and the
financial system more broadly.
• Fulfil the objective for superannuation to be a savings vehicle for retirement

income, rather than a broader wealth management vehicle (see Recommendation 9:
Objectives of the superannuation system in Chapter 2: Superannuation and retirement
incomes).
74 The term ‘borrowing’ includes all loans as defined by subsection 10(1) of the SIS Act.
86
Discussion
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. 75 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. 76 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. 77,78 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

page 2-116.
76 Australian Taxation Office (ATO) 2014, Self-managed superannuation fund statistical report —
June 2014 (Asset allocation tables), ATO, viewed 28 October 2014,
<https://www.ato.gov.au/Super/Self-managed-super-funds/In-detail/Statistics/Quarterly
-reports/Self-managed-super-fund-statistical-report---June-2014/>.
77 The lending institution can only make a claim on the asset against which a loan is made and
does not have recourse to make claims on the other assets held in the fund.
78 Reserve Bank of Australia 2014, First round submission to the Financial System Inquiry,
page 185.
79 Rice Warner 2014, Second round submission to the Financial System Inquiry, page 30.
87
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”. 80 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”. 81
Borrowing by superannuation funds also allows members to circumvent contribution

caps and accrue larger assets in the superannuation system in the long run (see the
Taxation of superannuation discussion in Chapter 2: Superannuation and retirement incomes.
Conclusion
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. 82,83 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.
80 Reserve Bank of Australia 2014, Second round submission to the Financial System Inquiry,
page 20.
82 Barton Consultancy 2014, Second round submission to the Financial System Inquiry, page 3.
88
Chapter 2: Superannuation and
retirement incomes
Australia needs an efficient superannuation system given the system’s size and
growth, the role it plays in funding the economy and its importance in delivering
retirement incomes. The superannuation system is large by international standards
and has grown rapidly since the Wallis Inquiry in 1997. It is the second largest part of
the financial sector and, according to some forecasts, could have assets that exceed
those of Australia’s banking system within the next 20 years. 1
Australia’s superannuation system has considerable strengths. 2 It plays an important

role in providing long-term funding for economic activity in Australia — both directly
and indirectly through funding financial institutions — and it contributed to the
stability of the financial system and the economy during the global financial crisis
(GFC).
Superannuation is also critical to help Australia meet the economic and fiscal
challenges of an ageing population. Life expectancy in Australia is the fourth longest of
any country, and is projected to continue to increase. 3,4 There will be economic benefits
if the growing proportion of older people can sustain their level of consumption in
retirement.
The Inquiry sees scope to improve the efficiency of the superannuation system in a
number of areas. The superannuation system is not operationally efficient due to a lack
of strong price-based competition and, as a result, the benefits of its scale are not being
fully realised. Substantially higher superannuation balances and fund consolidation
over the past decade have not delivered the benefits that would have been expected;
these benefits have been offset by higher costs elsewhere in the system rather than
being reflected in lower fees. Other design features also contribute to inefficiencies,
1 Industry Super Australia, using information from Deloitte, forecasts superannuation assets
will exceed those of the banking system by the early 2030s. Industry Super Australia 2014,
First round submission to the Financial System Inquiry, page 117.
2 For example, the 2014 Melbourne Mercer Global Pension Index ranks Australia’s
superannuation system second out of 25 countries. Its rating of ‘B+’ describes “… a system
that has a sound structure, with many good features, but has some areas for improvement
that differentiates it from an A-grade system”. Mercer 2014, Melbourne Mercer Global
Pension Index, Australian Centre for Financial Studies, Melbourne, page 7.
3 United Nations 2013, World Population Prospects: The 2012 Revision, United Nations, viewed
12 November 2014, <http://esa.un.org/wpp/Excel-Data/mortality.htm>.
4 Commonwealth of Australia 2009, Australian Life Tables 2005–07, Canberra, page 17.
89
leading to higher costs and sub-optimal outcomes for members, such as the
proliferation of multiple accounts.
Superannuation assets are not being efficiently converted into retirement incomes due
to a lack of risk pooling and an over-reliance on account-based pensions. This
contributes to a lower standard of living for Australians in retirement and, for some,
during working life — meaning people may have to save more than they did
previously to reach the same level of retirement income.
Tax concessions in the superannuation system are not well targeted at improving
retirement incomes, which has a number of consequences. It increases the cost of the
superannuation system to taxpayers; it increases distortions due to higher levels of
taxation elsewhere in the economy and due to the differences in the way other savings
vehicles are taxed; and it contributes to the broader problem of policy instability,
which imposes unnecessary costs on superannuation funds and their members and
undermines long-term confidence in the system.
In looking at superannuation policy settings from a financial system perspective, the

Inquiry has also considered the associated social policy objectives. However, the
Inquiry has not explicitly considered social policy settings, such as whether retirement
incomes are adequate, or Age Pension policy settings, because these are outside the
Inquiry’s terms of reference. The Inquiry has also made observations about the effects
of taxation policy on the superannuation system and has referred them to the Tax
White Paper.
Recommended actions
The Inquiry sees significant scope for the superannuation system to meet the needs of
superannuation fund members better and provide broader benefits to the financial
system and the economy. Specifically, the Inquiry believes action can be taken in the
following three areas:
• Set clear objectives for the superannuation system. A clear statement of the
system’s objectives is necessary to target policy settings better and make them more
stable. Clearly articulated objectives that have broad community support would
help to align policy settings, industry initiatives and community expectations.
• Improve operational efficiency during accumulation. Subject to the outcome of a

review, a formal competitive process may be needed to allocate new default fund
members to MySuper products.
90
A formal competitive process would extend competitive pressures from the

wholesale default fund market to the broader default fund market and improve
after-fee returns. 5 It would also reduce costs for funds and compliance costs for
employers, who would no longer be required to select default funds for employees.
This recommendation should only be implemented subject to the outcome of a

review of the superannuation system’s efficiency and competitiveness. This caveat
acknowledges it is too early to assess the effectiveness of the Stronger Super
reforms, although the Inquiry has reservations about whether these reforms alone
will significantly improve system efficiency and member outcomes.
• Improve efficiency in retirement. Greater use of risk pooling could significantly

increase retirement incomes generated from accumulated balances. This could
allow individuals to allocate consumption throughout their lives better (greater
dynamic efficiency) by reducing the savings required to achieve a target level of
income in retirement. This could be achieved by:
– Removing barriers to new product development.
– Using behavioural biases to encourage rather than discourage the use of

products that provide longevity risk protection.
This recommendation would involve trustees pre-selecting a comprehensive

income product for retirement (CIPR) option for their members. Pre-selected
options have been demonstrated to influence behaviour but do not limit personal
choice and freedom. They would bring the policy philosophy at retirement closer to
that of the accumulation phase.
Managing longevity risk through effective pooling in a CIPR could significantly

increase private incomes for many Australians in retirement and provide retirees
with the peace of mind that their income will endure throughout retirement, while
still allowing them to retain some flexibility to meet unexpected expenses. An
enduring income stream would give retirees the confidence to spend in retirement,
which would help to sustain economic growth as the population ages and reduce
the extent to which longevity risk falls on the taxpayer.
5 The wholesale default fund market refers to large corporations tendering for a default
superannuation fund for their employees. Lower fees reflect the buying power of a large
corporation and lower member acquisition costs for funds. Many award superannuation
fund members similarly receive wholesale benefits through lower fees as a result of lower
member acquisition costs.
91
To support and complement these recommendations:
• All employees should be able to choose the superannuation fund that receives their
Superannuation Guarantee (SG) contributions.
• Superannuation funds should provide retirement income projections on member

statements to improve member engagement (recommended in
Appendix 1: Significant matters).
• The Tax White Paper should consider the removal of tax barriers to a seamless
transition to retirement and target superannuation tax concessions to the
superannuation system’s objectives. Adjustments to tax settings and efforts to
improve equity have been major contributors to superannuation policy change in
the past. The Inquiry believes community concerns about these issues need to be
addressed to achieve greater policy stability and long-term confidence and trust in
the system.
The package of superannuation measures, including introducing a formal competitive

process to allocate new default fund members to MySuper products, would deliver
better outcomes and a more seamless experience for superannuation members
throughout their lives (illustrated for default fund members in Figure 6: The
superannuation system for default fund members). This package has the potential to
increase retirement income for a male on average weekly ordinary-time earnings by
25–40 per cent in retirement (excluding the Age Pension). 6 While these estimates are
illustrative and based on models which cannot fully reflect the unique circumstances
of different individuals, the Inquiry is confident that significant increases in retirement
incomes can be achieved. The package would also move the system’s focus away from
employers, towards individuals.
6 Estimates were prepared using Australian Government Actuary modelling and input from
Treasury models. The benefits of lower superannuation fees and savings from maintaining
a single superannuation account over a person’s working life (discussed in
Recommendation 10: Improving efficiency during accumulation) account for more than
10 percentage points, and the remaining portion reflects the use of a CIPR. The models
compare retirement income from an account-based pension, drawn down at minimum
rates, to the results from a CIPR. Increased income and improved risk management comes
at a cost of reduced flexibility and smaller bequests from superannuation. Further details
are provided in Recommendation 11: The retirement phase of superannuation. The combined
effects over 37 years of work would be that annual retirement income (excluding the Age
Pension) would increase from $26,000 to between $33,000 and $38,000.
92
Figure 6: The superannuation system for default fund members
The Inquiry has also made recommendations to improve the resilience of, and
confidence in, the superannuation system, including:
• Improving governance by requiring a majority of independent directors on

superannuation trustee boards and aligning penalties for director misconduct with
those of managed investment schemes (MISs).
93
• Improving the quality of financial advice and empowering consumers through

improved disclosure and transparency (recommended in Chapter 4: Consumer
outcomes).
• Restoring the prohibition on direct borrowing in superannuation funds to preserve

an important strength of the superannuation system, which was demonstrated
during the GFC (recommended in Chapter 1: Resilience).
Principles
In making its detailed recommendations, the Inquiry has been guided by the following
principles:
• Government intervention in the superannuation system should support a clear

objective to provide income in retirement.
• Retaining freedom and choice within a compulsory system is fundamental to

meeting the needs of individual superannuation fund members, even though this
may involve costs.
• The efficiency of the superannuation system should be improved by policy

measures aimed at removing barriers to innovation and increasing competitive
pressures.
• In designing superannuation policy settings, policy makers should recognise and

respond to consumers’ significant behavioural biases.
• Individuals should bear responsibility for their financial decisions. 7 However,

because of mandatory contributions and the implications of Age Pension outlays
for taxpayers, Government has a responsibility to adopt policy settings that deliver
appropriate outcomes for superannuation fund members.
Conclusion
Implementing the package of recommendations in this chapter, and continuing to
develop policy based on the principles outlined above, would improve outcomes for
superannuation fund members. The superannuation system would also support the
stability of the financial system and help Australia to manage the economic and fiscal
challenges of an ageing population.
7 Refer to Chapter 4: Consumer outcomes for more details.
94
Objectives of the superannuation system
Recommendation 9
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.
Description
Government should seek broad agreement on the following primary objective for the
superannuation system:
To provide income in retirement to substitute or supplement the Age Pension.
In achieving this primary objective, Government should also seek broad agreement on
the subsidiary objectives of the superannuation system, as set out in Table 3.
Table 3: Subsidiary objectives of the superannuation system

Subsidiary objective Why the objective is important
Facilitate consumption Superannuation is a vehicle for individuals to fund consumption in retirement
smoothing over the largely from working life income. The system should facilitate consumption
course of an individual’s smoothing while providing choice and flexibility to meet individual needs and
life preferences.
Help people manage Risk management is important as retirees generally have limited opportunities
financial risks in to replenish losses. The retirement income system should help individuals
retirement manage longevity risk, investment risk and inflation risk. Products with risk
pooling would help people to manage longevity risk efficiently.
Be fully funded from A fully funded system, as opposed to an unfunded system, is important for
savings sustainability and stability. The system is designed to be predominantly
funded by savings from working life income and investment earnings, where
superannuation fund members in general have claims on all assets in the
fund.
Be invested in the Superannuation funds are managed for the sole benefit of members, which
best interests of means the investment focus should be on maximising risk-adjusted returns,
superannuation fund net of fees and taxes, over the lifetime of a member. This results in auxiliary
members benefits to the economy by creating a pool of savings to fund long-term
investment.
Alleviate fiscal Government’s total contribution to the retirement income system, through
pressures on both the Age Pension and superannuation tax concessions, needs to be
Government from the sustainable and targeted. Higher private provisioning for retirement should
retirement income reduce the burden on public finances.
system
Be simple and efficient, The system should achieve its objectives at the minimum cost to individuals
and provide safeguards and taxpayers. Complexity is less appropriate for a compulsory system, as it
tends to add to costs and to favour sophisticated and well-informed investors.
Given the compulsory nature of SG contributions, the system needs
prudential oversight and should provide good outcomes in both the
accumulation and retirement phases for disengaged fund members.
95
The superannuation system spans two of the three pillars of Australia’s retirement
income system: the mandatory savings pillar and the voluntary savings pillar. 8
Objectives
• Provide a framework for evaluating the efficiency and effectiveness of the
superannuation system.
• Contribute to greater long-term confidence and policy stability through agreed

objectives, against which superannuation policy proposals can be assessed.
Discussion
The superannuation system does not have a consistent set of policies that work
towards common objectives. For example, the current framework provides significant
support and guidance to superannuation fund members during the accumulation
phase through mandatory savings and default arrangements. However, the framework
does not provide the same degree of support at retirement, when individuals confront
a complex set of financial decisions.
The lack of an agreed policy framework and objectives reduces the efficiency of the
system. Submissions acknowledge that this lack of clear purpose is affecting the
operational efficiency of the system. Some submissions state:
Without clarity of purpose, superannuation and retirement policy and regulatory

architecture cannot be aligned and, therefore, cannot deliver the right outcomes. This
ultimately drives up costs and complexity. 9
A coherent overarching framework will allow development of an efficient long-term

strategy and reduce the incidence of short-term policy changes. 10
The absence of agreed objectives contributes to short-term ad hoc policy making. It

adds complexity, imposes unnecessary costs on superannuation funds and their
8 As discussed in the Interim Report, the three pillars comprise the Age Pension, mandatory
SG contributions and voluntary savings, both inside and outside superannuation. The
mandatory superannuation pillar ensures a minimum level of retirement savings by
employees and the voluntary savings pillar enables individuals to tailor additional savings
to achieve their individual goals. Commonwealth of Australia 2014, Financial System Inquiry
Interim Report, Canberra, page 2-97.
9 Association of Superannuation Funds of Australia 2014, Second round submission to the
Financial System Inquiry, page 6.
10 Actuaries Institute 2014, First round submission to the Financial System Inquiry,
attachment, page 4.
96
members, and undermines long-term confidence in the system. Submissions note that
many superannuation policies have been introduced and then subsequently repealed
or amended (in some cases, repeatedly). One submission states:
Constant short-term change involves a significant and perhaps unnecessary cost for the
industry and consumers to bear. 11
The lack of an agreed policy framework also increases the cost of the superannuation
system to Government because tax concessions are not being efficiently targeted at
meeting the system’s objectives.
Rationale
Clearly defining the objectives of the superannuation system is a prerequisite to
achieving the objectives efficiently. Consistent policy settings across the accumulation
and retirement phases would meet the retirement income needs of Australians more
efficiently and effectively. It would also assist Government in implementing policy
settings that are well targeted and sustainable over the long term. One submission
notes:
Defining the objectives of superannuation will allow the efficacy of the retirement
income system to be measured. It will also enable a more reasoned assessment of the need
for future policy changes and hopefully see an end to the ad hoc policy tinkering of the
past two decades. The articulation of the objectives and system design principles will also
help foster a bi-partisan, enduring commitment to the superannuation system, ensuring
stability and long-term confidence in the system. 12
Objectives that guide policy making and frame community and industry debate would
help build confidence in the system by providing a framework for considered and
cohesive change. Greater clarity around objectives can help reduce complexity and
costs in the system. Importantly, in supporting greater policy stability, the Inquiry is
not seeking to avoid future change. The system needs to adapt to changing
circumstances but avoid unnecessary or ad hoc changes that cannot be sustained over
time.
Options considered
1. Recommended: Seek broad political agreement for the objectives of the
11 Actuaries Institute 2014, First round submission to the Financial System Inquiry, page 4.
12 Australian Institute of Superannuation Trustees 2014, Second round submission to the
Financial System Inquiry, attachment, page 5.
97
2. Recommended: Enshrine the objectives in legislation. Government should report

publicly on how policy proposals are consistent with achieving the objectives in the
long term.
3. Establish a publicly funded independent body to assess the superannuation

system’s performance and report on superannuation policy changes.

Seek broad political agreement for the objectives of the superannuation system
Given superannuation is both compulsory and a tax-preferred long-term savings
vehicle, Government has a clear role in defining the system’s objectives.
Submissions agree that articulating clear objectives is a critical step towards greater
policy consistency and stability, and a prerequisite to achieving the objectives
efficiently. In general, submissions nominate two major objectives: providing income
in retirement and reducing pressure on the Age Pension. A number of stakeholders
raise the importance of the superannuation system for national savings and funding
economic activity. However, funding economic activity is a consequence of a
well-designed long-term savings vehicle that invests in the interests of its members,
rather than an objective in itself.
The Inquiry’s single primary objective prioritises the provision of retirement incomes
and precludes the pursuit of other objectives at the expense of retirement incomes. It
will help reorient the community mindset around superannuation, away from account
balances and towards the provision of retirement incomes. Nobel Laureate Robert
Merton wrote: “Sustainable income flow, not the stock of wealth, is the objective that
counts for retirement planning”. 13
Assessing the current superannuation system against the primary and subsidiary
objectives outlined in this chapter identified a number of weaknesses that have given
rise to recommendations in this report. These include the lack of focus on retirement
incomes over other objectives, the lack of operational efficiency in the system, the lack
of risk management in retirement, the inefficiency in converting wealth to retirement
income, the ability of superannuation funds to borrow rather than be fully funded
from savings, poorly targeted tax concessions, and safeguards that could be
strengthened to assist members.
Enshrine the objectives in legislation and provide more Government reporting

Submissions strongly agree with the need for greater policy stability to promote
long-term confidence in the system. Submissions also acknowledge that the ability to
13 Merton, R 2008, The Future of Retirement Planning, CFA Institute: Research Foundation
Publications, vol. 2008, no. 1, page 11.
98
respond to changing circumstances is important but that new policies must be well
considered and take a long-term perspective.
Enshrining the primary and subsidiary objectives in legislation would provide a

framework against which Government and the broader community could assess
superannuation policy proposals. Parliamentary approval would be required to amend
the objectives over time.
Increased transparency around the objectives of policy proposals would help frame
parliamentary and public debate. This could be done in regulatory impact statements
at little cost. In addition, Government could periodically assess the extent to which the
superannuation system is meeting its objectives. This could be done in a stand-alone
report or as part of the Intergenerational Report, which is prepared every five years.
Establish a publicly funded independent body to assess the superannuation

system’s performance and report on superannuation policy changes
A number of submissions suggest establishing an independent authority for retirement
incomes. The authority would publish data, conduct research and analysis relevant to
retirement incomes policy, and assess policy changes or proposals over the long term.
Some stakeholders go further and propose that such a body should be responsible for
developing policy.
However, the Inquiry has concerns about the appropriate accountability mechanisms
for such an agency. It is difficult to set a mandate and target for an independent body
due to the complex trade-offs between stakeholder interests and policy objectives. The
Inquiry has not seen strong evidence that an independent body would significantly
improve policy outcomes. Establishing and operating a new authority would involve
costs to Government.
Conclusion
Defining the objectives of the superannuation system is necessary to build an efficient
superannuation system. The Inquiry recommends greater reporting by Government on
how policy proposals better fulfil the objectives of the system over the long term.
Stating the objectives would also help to align community expectations and industry
initiatives with policy settings.
The Inquiry recommends that the Tax White Paper consider the objectives of the
superannuation system when evaluating superannuation tax policy proposals.
A first step towards obtaining broad political agreement to superannuation system
objectives could be to establish a joint parliamentary inquiry to consider the
proposed objectives and make a recommendation to Parliament. Parliament could
enshrine the objectives in the preamble to a major piece of superannuation legislation
99
or in another instrument or charter. However, stating the objectives of the

superannuation system in legislation is only intended to guide the policy-making
process and is not intended to provide a platform for courts to reinterpret the law.
100
Improving efficiency during accumulation
Recommendation 10
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.
Description
Subject to the findings of a review of the efficiency and competitiveness of the
superannuation system, Government should introduce a formal competitive process to
allocate new workforce entrants to MySuper products. The competitive process could
be an auction or tender. Current default fund members would also benefit as funds
would not be allowed to price discriminate between their existing and new MySuper
members. This competitive process would replace the industrial relations system in
selecting default superannuation funds for workers.
The Productivity Commission (PC) should hold an inquiry by 2020, following the full
implementation of MySuper (part of the Stronger Super reforms) to determine whether
further reform would be beneficial.
Objective
• Enhance efficiency in the superannuation system to improve long-term net returns
to members and build trust and confidence in funds regulated by the Australian
Prudential Regulation Authority (APRA).
Discussion
As discussed in the Interim Report, funds could lower fees without compromising
returns to members. 14 Fees have not fallen by as much as would be expected given the
substantial increase in the scale of the superannuation system. As noted by the Super
System Review, a major reason for this is the absence of strong consumer-driven

page 2-100.
101
competition, particularly in the default fund market. 15 This reflects members’ lack of
engagement and reliance on employers to choose default funds for their employees.
The Stronger Super reforms implemented in response to the Super System Review
aimed to address these issues. Although it is too early to draw firm conclusions, the
Inquiry has some reservations about how effective these reforms will be in generating
competition and the extent to which they will improve after-fee returns for members.
In the Interim Report, the Inquiry compared the fees in Australia to those overseas.
Submissions challenge the observation that operating costs and fees appear high by
international standards. They argue that the different features and structures of
pension systems globally make comparisons difficult. A Deloitte Access Economics
report, commissioned by the Financial Services Council, argues “… fees can be driven
by a number of factors, and may not be directly comparable across jurisdictions”. 16 The
Inquiry accepts many of these arguments and acknowledges that some unique features
of the Australian system contribute to elevated costs and therefore higher fees.
Other submissions attempt to make international comparisons across funds. The

Association of Superannuation Funds of Australia (ASFA) states, “In international
terms, Australian defined contribution (DC) members are paying fees consistent with
members of similar funds overseas”. 17 Since the Australian superannuation system is
several times larger than DC systems overseas, Australian funds could be expected to
have lower fees after accounting for differences in features. 18
A major concern of the Inquiry, shared by the Super System Review, is that the
Australian system as a whole has been unable to realise the full benefits of scale. The
Deloitte Access Economics report concludes, “… using international experiences as a
benchmark, it appears that there may be scope for lower fees in the Australian
system”. 19 If fees and costs could be reduced, net returns, and ultimately retirement
incomes, could be higher.
In some cases, higher costs and fees may be in the interests of members. For example,
alternative asset classes, such as infrastructure and other unlisted investments, tend to
15 Commonwealth of Australia 2010, Super System Review Final Report, Part One: Overview and
Recommendations, Canberra, page 7.
16 Deloitte Access Economics 2014, Financial performance of Australia’s superannuation products,
Financial Services Council, Canberra, page 6.
page 2-100, Chart 4.1.
19 Deloitte Access Economics 2014, Financial performance of Australia’s superannuation products,
Financial Services Council, Canberra, page 6.
102
be more expensive to manage, but they may also diversify risks and offer higher
after-fee returns for members. Submissions support this point. 20
Factors driving higher costs and fees and a lack of price-based competition in Australia
include:
• Supply-side issues: market fragmentation; costly asset management and active

investment strategies; taxation and provision of insurance; and government policy
changes.
• Demand-side issues: weak member-driven competition due to lack of member

interest; complexity; lack of comparability of fees and performance; and agency and
structural problems.
Market fragmentation increases costs

The fragmented nature of the Australian superannuation system has limited the extent
to which superannuation fund members benefit from scale economies,
notwithstanding recent fund consolidations. This contributes to higher fees and lower
after-fee returns to members. Australia has 294 APRA-regulated funds, most of which
have a small asset base and tend to have higher fees than larger funds (Chart 2: Fees by
fund size). 21,22 In June 2013, around 80 per cent of these APRA-regulated
superannuation funds held only around 20 per cent of assets. 23,24
20 For example, Financial Services Council 2014, Second round submission to the Financial
System Inquiry, Chapter 1, page 27; SuperRatings 2014, Second round submission to the
Financial System Inquiry, page 15; Australian Institute of Superannuation Trustees 2014,
Second round submission to the Financial System Inquiry, page 19; Mercer 2014, Second
round submission to the Financial System Inquiry, page 25.
21 In this report, APRA-regulated funds refers to only those with more than four members.
22 Australian Prudential Regulation Authority (APRA) 2014, Statistics: Quarterly
Superannuation Performance (interim edition), June ed., APRA, Sydney, page 8.
23 Australian Prudential Regulation Authority (APRA) 2013, Superannuation Fund-level Rates of
Return, June ed., APRA, Sydney, pages 5–9.
24 Australian Prudential Regulation Authority (APRA) 2014, Statistics: Quarterly
Superannuation Performance (interim edition), June ed., APRA, Sydney, page 8.
103
Chart 2: Fees by fund size

APRA-regulated funds, as at 30 June 2013 for a $50,000 balance
Per cent Per cent
4.0 4.0
3.5 3.5
3.0 3.0
2.5 2.5
2.0 2.0
1.5 1.5
1.0 1.0
0.5 0.5
0.0 0.0
0 10 20 30 40 50 60 70
Funds under management ($ billion)
Source: Rice Warner. 25 Line of best fit added by Financial System Inquiry.
The substantial expansion in the scale of the superannuation system over the past
decade could have been expected to significantly lower fees for fund members. The
size of the average fund increased from $260 million in assets in 2004 to $3.3 billion in
2013, whereas average fees fell by 20 basis points over the same period. 26,27 This point
was highlighted in the Interim Report but not widely addressed in second round
submissions. Rice Warner estimates that system growth and scale could have reduced
fees by 45 basis points. 28 Two-thirds of the estimated benefits from scale and lower
margins over the past decade have been offset by increases in fund costs (Figure 7:
Drivers of changes in average fees between 2004 and 2013). 29
25 Rice Warner 2014, MySuper Fees, Data provided to the Financial System Inquiry,
6 November 2014.
26 Entities with more than four members. Australian Prudential Regulation Authority (APRA)
2014, Data provided to the Financial System Inquiry, 3 June 2014.
27 Rice Warner 2014, Data provided to the Financial System Inquiry, 17 June 2014.
28 Estimate based on data from Rice Warner 2014, MySuper Fees, Data provided to the
Financial System Inquiry, 6 November 2014.
29 Rice Warner 2014, Superannuation Fees, Data provided to the Financial System Inquiry,
23 July 2014.
104
Figure 7: Drivers of changes in average fees between 2004 and 2013

APRA-regulated funds; basis points (bps)
Source: Rice Warner. 30
Weak member-driven competition

Australia’s superannuation system is different from a traditional competitive market.
Compulsory contributions, coupled with a complex system, contribute to disengaged
consumers and weak member-driven competition. A high degree of fragmentation has
persisted because of the lack of strong competitive pressures. This is widely recognised
in submissions. ASFA explains, “In an efficient market, consumers (members) would
move away from less cost efficient funds to more cost efficient funds, eventually
driving merger activity. However, without engagement, the expected customer
movement away from these higher cost funds will not happen, removing a potential
driver of merger activity”. 31
Agency and structural issues

Another factor contributing to the lack of member-driven competition is the role of
employers in selecting default funds. Although the benefits from a fund’s performance
fully accrue to employees, much of the costs of administering SG contributions are
borne by employers. For this reason, the PC’s inquiry into default superannuation
funds in modern awards found employers “… might have little incentive to invest
30 Rice Warner 2014, Superannuation Fees, Data provided to the Financial System Inquiry,
23 July 2014.
105
time and effort into making choices that are in the best interests of their employees”.
The PC also found that employers face high search costs, may lack information and
expertise to make an appropriate choice for their employees and may choose a fund
based on auxiliary benefits specific to the employer, such as low administrative
requirements. 32
Although employers, as agents for their employees, are generally ineffective in driving
competition in the superannuation market, there are exceptions. Some large
corporations tender for their default fund to obtain wholesale fee discounts for
employees. ASFA notes, “Fee-based competition has always been strong in the tender
processes for default funds that have been undertaken by large employers”. 33 In
addition, some default funds specified in awards effectively benefit from lower
member acquisition costs to obtain wholesale fee discounts for employees. As a result,
an individual’s employer can have a significant bearing on their retirement income.
Preliminary evidence on the effectiveness of MySuper and SuperStream reforms

The Super System Review’s recommendations aimed to address many of the issues
above. MySuper was introduced as a simple, low-cost, default superannuation
product. SuperStream will reduce costs by streamlining the administrative functions of
superannuation funds. Other elements of the Stronger Super reforms included
measures to improve fee transparency and fund governance. 34 The Super System
Review argued that its package of reforms could reduce fees by up to 70 basis points
for the most expensive investment options in larger funds. 35
The Inquiry agrees with many submissions that it is too early to draw firm conclusions
about the long-term effects of these reforms on average fees and net returns to
members. Funds have only been able to offer MySuper products since 1 July 2013 and
many are still absorbing one-off costs of the reforms. Additionally, accrued default
amounts do not need to be rolled over into MySuper products until 2017.
Preliminary evidence shows a net reduction in average MySuper fees against

comparable default options of 15 basis points between 30 June 2011 and
31 March 2014. 36 The fall in average fees between 2011 and 2014 reflected a reduction
32 Productivity Commission 2012, Default Superannuation Funds in Modern Awards: Productivity

Commission Inquiry Report, Commonwealth of Australia, Canberra, page 60.
34 Commonwealth of Australia 2010, Stronger Super, Canberra, pages 15–63.
35 Commonwealth of Australia 2010, Super System Review Final Report, Part One: Overview and
Recommendations, Canberra, page 19.
36 Based on a $50,000 balance. Rice Warner 2014, MySuper Fees, Data provided to the Financial
System Inquiry, 6 November 2014, page 6, Table 4.
106
in asset-based fees, which were partially offset by higher fixed-dollar fees. Three of the
four market segments increased fees in default products between 2011 and 2014. 37
The Inquiry has some reservations about whether the legislated MySuper reforms will
significantly improve the competitive dynamics and efficiency of the superannuation
system and realise the full benefits of scale, as follows:
• Despite some early signs of fee reductions, the fees offered on MySuper products
still vary widely, with a difference of 136 basis points between the highest and
lowest fees (Chart 3: Range of MySuper fees). 38 Differences in asset allocation and
investment strategy could account for variations in fees. However, data suggests
that higher MySuper investment fees do not strongly correlate with the allocation to
growth assets. 39
• The reduction in MySuper fees against comparable default options appears to have
been largely due to the Future of Financial Advice reforms prohibiting commissions
in MySuper products, rather than the introduction of MySuper. Removing these
commissions is estimated to reduce fees by 25 basis points, which exceeds the
estimated reduction in fees to date for default products. 40 However, the reduction
in MySuper fees from removing commissions will not be fully realised until all
accrued default amounts are moved to MySuper products, which is required to be
completed by 2017.
There is a risk that some MySuper fee reductions are at the expense of member
returns through changes in asset allocation and investment strategy. 41 Furthermore,
MySuper trustees are required to consider annually whether members are
disadvantaged by the fund’s scale compared to MySuper members in other funds. 42
It is questionable whether this requirement will be sufficient to drive significant
fund consolidation in the absence of stronger competitive pressures.
6 November 2014.
38 Note that there are differences between the data used by Rice Warner and the MySuper data
for June 2014 published by the Australian Prudential Regulation Authority (APRA). This
reflects recent updates to data and differences in reporting fees between APRA’s data and
product disclosure statements.
6 November 2014, page 10, Graph 3.
6 November 2014.
41 For example, some MySuper products have benchmark asset allocations to cash and fixed
income of up to 50 per cent. Australian Prudential Regulation Authority (APRA) 2014,
Quarterly MySuper Statistics, June 2014, APRA, Sydney.
42 Superannuation Industry (Supervision) Act 1993, s29VN(b).
107
Chart 3: Range of MySuper fees

For a $50,000 balance in 2014
50% of funds’ fees are betw een

84 bps and 117 bps
Low est fee: 48 bps Highest fee: 184 bps
0 50 100 150 200

Annual fee (basis points)
Source: Rice Warner, using a combination of APRA data and product disclosure statement information. 43
Rationale
Government intervention in the superannuation system is warranted to improve the
system’s efficiency in the accumulation phase. The system lacks traditional market
forces, due in part to substantial Government intervention. Also, the outcomes of the
superannuation system ultimately affect both its members and taxpayers through the
level of Age Pension payments.
A more efficient system would ensure that all default fund employees, including the
disengaged, receive the benefits of wholesale competition — not only employees of
certain large corporations and those covered by modern awards. It would also allow
individuals to retain a single account throughout their working life to avoid paying
multiple fees. Finally, it would mean the majority of future scale economies would
benefit members through lower fees and higher retirement incomes, rather than being
eroded by higher costs.
Fees can have a significant effect on retirement incomes and the total level of
superannuation savings. For example, if average fees in APRA-regulated funds were
reduced by 30 basis points, this would increase total member balances and funds
available for long-term investment by more than $3.5 billion per annum. 44 Such a fee
6 November 2014.
44 A reduction in fees of 30 basis points corresponds to the difference between the average fee
of the top quartile of MySuper products and all MySuper products. The fee reduction could
be achieved through a formal competitive process, in part by better realising scale benefits.
By comparison, Rice Warner estimates potential scale benefits in the superannuation sector
of 20 basis points over the next four years: Rice Warner 2014, MySuper Fees, Data provided
to the Financial System Inquiry, 6 November 2014. The 30 basis point fee reduction has been
applied to assets of $1.2 trillion in APRA-regulated funds as at 30 June 2014. Australian
Prudential Regulation Authority (APRA) 2014, Quarterly Superannuation Performance (interim
edition), June ed., APRA, Sydney, page 8.
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reduction would increase the accumulated balance at retirement for a male employee
on average weekly ordinary-time earnings by around $32,000, and provide up to
approximately an extra $2,000 per year in retirement income (in 2014 dollars). 45
Options considered
The Interim Report raised the first option below. The second option was raised in
submissions and stakeholder discussions.
1. Recommended: 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 significantly improved competition and efficiency in
the superannuation system.
2. Allow employers to choose any MySuper product as the default product for their
employees and/or strengthen the MySuper licensing process.

Introduce a formal competitive process to allocate new default fund members to
MySuper products, unless a review determines it is not necessary
Under this option, each fund would be required to compete for new workforce
entrants to be allocated to the fund’s MySuper product, thereby building on the
MySuper framework. Individuals would retain the right to exercise choice (see
Recommendation 12: Choice of fund). Employers would no longer be required to select
default funds for employees, and there would be generally no need to specify default
funds in employment contracts, including awards.
This option would stimulate competition in the default fund market and extend the
benefits of wholesale competition, which are currently only obtained by larger
corporations and through awards, to the broader workforce. More of the benefits of
scale would accrue to members, ensuring fee reductions do not come at the expense of
lower net returns.
The benefits of this option would not be limited to new workforce entrants. As
mentioned, successful funds would be required to provide the same product to their
existing default members. Better outcomes in the default fund market would be
expected to have flow-on effects to the non-default (or ‘choice’) market. Fees charged
for default products provide a point of comparison against which more fee-sensitive
consumers can assess choice products.
45 Modelling prepared for the Financial System Inquiry using Treasury models, October 2014.
The models are based on a 30-year-old male worker in 2014 who retires at age 67.
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A number of stakeholders support a process to foster competition. National Seniors

Australia recommends “… the government further investigate auctioning management
rights to default super funds as a way of fostering fee competition between super
funds and, subject to a satisfactory auction design, commit to implementing this
approach”. 46 Other stakeholders believe the current level of competition between
MySuper products is reasonable.
Existing members would retain their active fund when they change employment,
without having to take action. Currently, in many cases, members have to consolidate
accounts or exercise choice when they change employers to remain in their fund. This
option addresses the main driver of account proliferation and would reduce the extent
of workers paying fees and insurance in multiple accounts or losing superannuation
accounts. 47 This could increase superannuation balances at retirement by around
$25,000 and retirement incomes by up to $1,600 per year. 48
This option would remove the role of the industrial relations system in selecting
default funds. This would reduce employers’ compliance costs and address concerns,
raised in several submissions, about superannuation funds offering employers
inducements to choose the fund. 49 It would also better align incentives between
employers and employees.
A potential downside of this option is less tailoring of life insurance policies and
investment strategies to specific demographics of fund members; for example, if
members work in the same industry. Some superannuation funds have been able to
tailor insurance and other product features because of the homogeneous nature of their
membership.
It is possible that the competitive process conducted by Government could create

perceptions that Government is implicitly underwriting product performance of the
46 National Seniors Australia 2014, Second round submission to the Financial System Inquiry,
page 5.
47 For example, as at 30 June 2014, there were six million lost superannuation accounts with a
total value of just under $16.8 billion. Australian Taxation Office (ATO) 2014, Lost and
ATO-held super overview, ATO, viewed 27 October 2014,
<https://www.ato.gov.au/About-ATO/Research-and-statistics/In-detail/Super-statistics
/Lost-and-ATO-held-super/Lost-and-ATO-held-super-overview>.
48 Modelling prepared for the Financial System Inquiry using Treasury models, October 2014.
Based on assumptions of 37 years of work with an average of 2.5 accounts over a person’s
working life, fixed fees of $80 per account and $140 for insurance per account per annum
(in 2014 dollars).
49 For example, see Association of Superannuation Funds Australia 2014, First round
submission to the Financial System Inquiry, page 31; Australian Institute of Superannuation
Trustees 2014, Second round submission to the Financial System Inquiry, page 35; and
Equip 2014, Second round submission to the Financial System Inquiry, page 9.
110
successful funds. Government should continue to make it clear that it does not
guarantee the performance of any fund, including those selected through any
competitive process.
Stakeholders raise a number of concerns with how a competitive process would be

designed. The Inquiry agrees with submissions’ arguments that a competitive process
would not be effective if it focused on fees alone. However, large corporates run
competitive tenders and there is no evidence to suggest that these tenders in the
wholesale market have either disadvantaged members or been unable to balance lower
costs with asset allocation strategies that maximise returns to members. See the
Implementation considerations section for a detailed discussion of potential design issues
and how these could be overcome.
Superannuation system review by 2020
Funds and their members have incurred significant costs as the Stronger Super reforms
have been implemented. Although the Inquiry has some reservations regarding the
extent to which the reforms will increase superannuation system efficiency, it
recognises the need for full implementation of MySuper to allow it the opportunity to
work before embarking on further reform. The outcomes of these reforms should be
reviewed after all accrued default amounts have been rolled into MySuper products in
2017, by which time MySuper products will have been in operation for at least four
years. Submissions support such a review.
Allow all employers to choose any MySuper product as the default fund for their
employees and/or strengthen the MySuper licensing process
The Inquiry considered two additional alternatives to the current arrangements.
The first alternative involves abolishing the new Fair Work Commission (FWC)
process for selecting default funds in awards and allowing all MySuper products to be
listed in awards. Under this alternative, employers could select any MySuper product
to satisfy the requirements under an award.
A number of submissions support this option, arguing that present arrangements are
costly to members, Government and industry, and duplicate APRA’s MySuper
licensing process. Some stakeholders are also concerned that the FWC selection
process lacks transparency.
The Inquiry believes that this alternative would only be effective if there were an
alternative quality filter for default fund selection. The PC’s inquiry into default funds
in awards found that a ‘quality filter’ is needed, stating: “The Stronger Super reforms
serve largely to standardise features and promote disclosure to improve comparability
between MySuper products, rather than filter out any products which may not
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represent the best interests of employees”. 50 The PC made a number of

recommendations to improve the effectiveness of this filter, which the Inquiry
supports and which are still to be implemented by Government.
This option could also increase employers’ compliance costs, particularly new
employers, by requiring them to select a fund from a large number of MySuper
products that are not easily comparable. In its report, the PC quoted CPA Australia as
saying, “To allow all MySuper products to be listed as default funds for a modern
award would result in overwhelming choice making it difficult for [employers] to
differentiate and make an informed choice in much the same way as if no funds were
listed”. 51
The second alternative involves strengthening the current requirements for MySuper
products, which could be achieved by imposing stricter MySuper licensing
requirements, including caps on fees. Fee caps could be effective in reducing fees, but
would not necessarily improve returns net of fees and may lead to clustering of fees
around caps. A stricter approach to regulating MySuper products would
fundamentally change APRA’s role from authorisation to approval. It would increase
the cost of the validation process for funds and risk APRA having to withdraw funds’
MySuper authorisation. This would have adverse implications for employers, who
would have to choose another default product for their employees, and contribute to
the proliferation of individuals with multiple accounts.
Conclusion
Introducing a formal competitive process has considerable merit and is likely to
deliver substantial benefits to superannuation fund members. It would stimulate
competition between funds on fees and returns to deliver better member outcomes.
Although this is expected to generate further fund consolidation, the Inquiry does not
have major concerns given the current high degree of fund fragmentation. The
recommendation would build on the recent Stronger Super reforms and extend the
benefits of wholesale competition to the broader default fund market.
Although industry would bear costs to participate in the competitive process, these
costs are expected to be small relative to the benefits for members from reduced fees.
While considering the Stronger Super reforms to be a positive and significant step
forward, the Inquiry has some reservations as to whether these reforms alone will
significantly improve superannuation system competition and efficiency. Recognising

112
it is too early to evaluate their effectiveness, the Inquiry recommends a review of the
superannuation system by 2020 before proceeding with further reform.
Review of the superannuation system by 2020
A PC inquiry into superannuation system efficiency and competitiveness should occur
by 2020, after the MySuper implementation is complete in 2017. The inquiry should
consider:
• The nature of competition in the superannuation default fund market, including

how employers select default funds.
• Changes in fees and returns net of fees and taxes (including links to scale
economies, asset allocation and/or type of investing) in both accumulation and
retirement products.
• The distribution of fees for similar products.
• Flow-on effects to the choice market.
The PC inquiry should determine whether implementing a formal competitive process

would deliver net benefits.
Design of the competitive process

Default funds for new members could be selected through a range of competitive
processes, including auctions or tenders. New workforce entrants could be assigned to
a MySuper product when they apply for a tax file number.
Designing a robust process will require careful thought and consultation. Without
pre-empting the findings of its inquiry, the PC should begin preliminary work to
design the competitive process. This work should commence from 2015 to provide the
inquiry with a clear proposal against which to assess the benefits of further policy
change.
In designing the competitive process, the merits of different approaches should be

considered, as well as the associated metrics and frequency of running the competitive
process using an evidence-based approach. This should include:
• Reviewing the strengths and weaknesses of competitive processes used in large

corporate tenders, used by the Northern Territory Government and in other
jurisdictions, such as Chile, New Zealand and Sweden.
• Quantifying the costs and benefits of different mechanisms.
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• Assessing the incentives embedded in the scheme to evaluate its robustness to

gaming and collusion.
Principles for designing the competitive process should include: 52
• Best interests: ensure incentive compatibility with meeting the best interests of
members, encourage long-term investing, discourage excessive risk taking and
encourage a focus on after-fee returns.
• Competition: drive pressure on funds to be innovative and efficient, diversify asset

allocation and maximise long-term after-fee returns by rewarding best performers.
Facilitate new superannuation fund entrants to the market.
• Feasibility: ensure the process is low-cost and easy to administer, and minimises
regulatory costs on industry.
• Credibility and transparency: make relevant information public; avoid room for
gaming the process; and ensure metrics are clear, simple, difficult to dispute and
difficult to manipulate.
• Regular assessment and accountability: regularly conduct a repeat process that

requires default funds to earn their right to receive new members, and ensure funds
are accountable for the outcomes they deliver members.
Criteria for selecting the successful funds should focus on expected after-fee returns
based on asset allocation and investment strategy, fees and past performance. This
would help avoid fee reductions at the expense of member returns. Any other
requirements deemed necessary could be included as pre-selection criteria to
participate in the competitive process.
The Inquiry agrees with stakeholders that the formal competitive process also needs to
be carefully designed and implemented (see Table 4: Potential design issues of a
competitive process).
52 Drawn in part from the PC’s recommended principles for designing a selection process:
Productivity Commission 2012, Default Superannuation Funds in Modern Awards: Productivity
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Table 4: Potential design issues of a competitive process

Potential design issues or concerns Response or design approach
A formal competitive process is Large corporate funds successfully run tenders. A number of
unproven. Furthermore, other jurisdictions use competitive tendering in pension funds; for
governments have a poor track example, New Zealand, Chile, and Sweden. Governments
record of running formal competitive around Australia run successful tenders, including the Future
processes. Fund, and the Northern Territory Government for its public sector
superannuation scheme.
The market disruption would be too The effect on market structure could be gradual, as only new
great. entrants to the workforce would be assigned to funds under the
competitive process. By default, existing members would remain
in their current fund, thereby minimising market disruption.
Unsuccessful funds may have increased switching rates;
however, current switching rates are very low. 53 All funds can still
compete for choice members.
A Chilean-style auction that selects A significant number of successful funds would be selected,
a single or small number of which would drive competition and innovation. Some market
successful bidders would inhibit consolidation is likely to occur, but excessive market
competition and innovation, and concentration can be avoided if a sufficient number of funds are
lead to excessive market selected through the competitive process.
concentration.
Fees should not be the sole focus. The Inquiry agrees with this sentiment and considers a focus
This would result in a ‘race to the solely on fees is not in members’ best interests. As discussed
bottom’ whereby funds change above, the focus should include expected ability to generate high
asset allocation and investment after-fee returns based on asset allocation and investment
strategies to reduce fees. strategy, as well as past performance.
How will the competitive process Competitive pressures will help to keep fund costs down as
lower fund costs? assets in the system continue to grow. Member acquisition costs
will fall as funds do not need to compete for default fund
members (outside the tender process). More consolidation of
funds and reduced proliferation of multiple accounts across
members will better realise the benefits of scale.
Focusing on the default fund market Successful funds would be required to offer the same fees and
and only targeting new entrants to MySuper products to all members (both new and existing). They
the workforce is too narrow-focused. could not price discriminate across the market. Outcomes in the
It will not address competition and default market represent a baseline against which choice
efficiency issues in the broader products could be compared and could be expected to drive
superannuation system. greater competition. Transfers to these funds would be facilitated
by the recommendations to allow all employees choice of fund
(discussed in this chapter) and increase member engagement
(see Appendix 1: Significant matters for further detail).
A competitive process would lead to Existing corporate funds could be allowed to continue to receive
the loss of existing high-performing new default fund members from new entrants to the workforce
corporate funds. provided the fund gives members comparable benefits to funds
successful in the formal competitive process.
53 A Roy Morgan Research report, based on approximately 30,000 interviews each year with
members of superannuation funds, shows rates of switching between superannuation
funds in the range of 2 per cent to 5 per cent since 2005. Roy Morgan Research 2013,
Superannuation and Wealth Management in Australia Report, December 2013, page 29.
115
Potential design issues or concerns Response or design approach

Any competitive process can be Careful design, rigorous execution and the highest standards of
gamed. probity and expertise will be required. As mentioned above, other
jurisdictions and corporations already run tenders successfully.
Past performance is not an accurate Past performance would be only one element of the selection
predictor of future performance. process when assessing expected ability to generate high
after-fee returns to members.
What would stop unsuccessful funds Funds that do this could be disqualified from future competitive
significantly increasing their fees for processes.
existing default fund members? Prompts on myGov for individuals to look at a central repository
of MySuper dashboards would also help encourage members to
engage with superannuation and transfer to the fund that best
meets their needs (see Appendix 1: Significant matters for further
details).
What if a successful high-performing Funds could lose the right to receive new members. Members
fund underperforms? would be advised if their fund was no longer deemed a
successful fund.
A competitive process would impose While SuperStream will simplify how contributions are made,
costs on employers, who would Government should consider implementing a national ‘payment
have to make contributions to hub’ or ‘clearing house’ by which employers make
multiple funds. superannuation contributions to multiple funds. This concept has
been implemented in other countries, including New Zealand and
Sweden.
116
The retirement phase of superannuation
Recommendation 11
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.
Description
Government should require superannuation fund trustees to pre-select an option for
members to receive their superannuation benefits in retirement. Details of the
pre-selected option would be communicated to the member during their working life.
At retirement, the member would either give their authority to commence the
pre-selected option or elect to take their benefits in another way. This approach would
simplify decisions at retirement and deliver better outcomes for retirees (Figure 8:
Stylised example of decision making for superannuation benefits). No income stream would
commence without the member’s instruction.
The pre-selected option should be a comprehensive income product for retirement

(CIPR) that has minimum features determined by Government. These features should
include a regular and stable income stream, longevity risk management and flexibility.
CIPRs would be low-cost and include a ‘cooling off’ period. Their design could vary
with the member’s known characteristics, such as the size of their superannuation
benefits, and take account of the possibility of cognitive impairment at older ages.
A combination of underlying products would likely be required to provide these

features; for example, an account-based pension paired with a pooled product that
provides longevity risk protection. To offer these products, funds may need to partner
with another provider, such as a life insurance company.
Regulatory impediments to developing retirement income products, which include tax

policy settings, need to be removed. These changes should not discourage the use of
CIPRs or other products that provide longevity risk protection.
117
Figure 8: Stylised example of decision making for superannuation benefits
Objectives
• Better meet the needs of retirees, including those who are disengaged or less
financially sophisticated, and provide a more seamless transition to the retirement
phase of superannuation.
• Achieve the objectives of the superannuation system (discussed earlier in this

chapter) by strengthening the focus on providing retirement incomes.
• Improve Australians’ standard of living during their working lives and retirement
through greater risk pooling.
Discussion
Complex decisions
Managing multiple financial objectives and risks in retirement is complex. For
example, retirees may seek to maximise income while trying to retain flexibility to
meet unexpected expenses and manage longevity, investment and liquidity risks.
Individuals have to manage these problems without the guidance that exists in the
accumulation phase, where funds are required to offer simple, low-cost default
118
accounts. MySuper is an accumulation product only, despite the Super System Review
recommendation that MySuper products include a retirement income stream. 54
Information from stakeholders suggests that many retirees find it challenging to

navigate the transition to the retirement phase of superannuation. When DC members
notify their superannuation fund of their retirement, many funds recommend they
speak to an affiliated financial adviser. Research has demonstrated that the quality of
this advice can vary significantly. 55 Anecdotal evidence suggests that some advisers
have limited knowledge of longevity risk and how it can be managed. 56 Although the
Inquiry makes recommendations to improve the quality of advice, it will take time for
such improvements to occur. Chapter 4: Consumer outcomes explores this issue in further
detail.
In any case, many people do not seek professional advice, and funds and advisers
overwhelmingly recommend account-based pensions. Stakeholders advise that, for
less financially literate individuals, the simplest option is to take the entire benefit as a
lump sum because other options can be difficult to understand and may require
completing complicated forms. A recent survey commissioned by AustralianSuper
found that “… 85% of pre-retirees are not confident in having an informed
conversation around retirement income”. 57 Managing income and risks can be
particularly difficult for people later in retirement if they suffer from cognitive
impairment.
Behavioural biases
The complexity of retirement decisions is compounded by behavioural biases. 58
Mandatory superannuation contributions have been used to overcome behavioural
biases in saving behaviour, such as decision making that disproportionately focuses on
the short term; however, these biases do not end at retirement. In part, behavioural
biases explain the dominance of account-based pensions and lump sums.
54 Commonwealth of Australia 2010, Super System Review Final Report, Part Two:
Recommendation Packages, Chapter 7: Retirement, Recommendation 7.1, Canberra, page 207.
55 Shadow shopping research conducted by the Australian Securities and Investments
Commission (ASIC) found that only 3 per cent of financial advice about retirement was
“good quality”. ASIC 2012, Report 279: Shadow shopping study of retirement advice, ASIC,
Sydney, page 8. This study was conducted before the Future of Financial Advice reforms.
56 Longevity risk is not covered in the Australian Securities and Investments Commission’s
compulsory RG 146 qualifications for superannuation advisers. This could be improved by
raising competency standards, as recommended in Chapter 4: Consumer outcomes.
57 AustralianSuper 2014, Data provided to Financial System Inquiry, 10 September 2014.
58 See Benartzi, S 2010, Behavioral Finance and the Post-Retirement Crisis, Allianz of America,
USA, for a discussion of these biases.
119
Limited range of income stream products

Australians who wish to convert their superannuation assets into an income stream
generally have the choice of an account-based pension or an annuity. A
well-functioning market would be expected to provide a wider range of products that
meet different needs and preferences. This would allow people to combine products to
achieve their desired levels of income, risk management and flexibility. However,
there are tax, regulatory and other impediments to developing innovative retirement
income products.
Despite the heterogeneous nature of retirees, at least 94 per cent of pension assets are
in account-based pensions, which provide flexibility but lack risk management
features and may not deliver high levels of income from a given accumulated
balance. 59,60 The lack of a significant market for products with longevity risk protection
sets Australia apart from most other developed economies. 61 Evidence suggests that
the major worry among retirees and pre-retirees is exhausting their assets in
retirement. 62 An individual with an account-based pension can reduce the risk of
outliving their wealth by living more frugally in retirement and drawing down
benefits at the minimum allowable rates. 63 This is what the majority of retirees with
account-based pensions do, which reduces their standard of living. 64,65 The difficulty in
59 Plan for Life 2014, Data provided to Financial System Inquiry, 23 June 2014.
60 A measure of income from a given accumulated balance, ‘income efficiency’ is the expected
present value of income in retirement as a percentage of a product’s purchase price. The
income efficiency of a 65-year-old male’s account-based pension, drawn down at minimum
rates, is around 70 per cent. Australian Government Actuary, Data provided to Financial
System Inquiry, 11 June 2014.
61 The size of Australia’s annuity market is only around 0.3 per cent of gross domestic
product, compared with 28.8 per cent in Japan, 15.4 per cent in the United States and more
than 40 per cent in some European countries. Organisation for Economic Co-operation and
Development 2013, ‘Survey of annuity products and their guarantees’, paper presented at
the Insurance and Private Pensions Committee meeting, Paris, 5–6 December.
62 More than half of the respondents to a survey were either worried or extremely worried
about outliving their savings. When asked to identify the single most important feature in a
retirement income product, twice as many members identified “income that lasts a lifetime”
as the second most popular response. Investment Trends 2013, December 2013 Retirement
Income Report, Investment Trends, Sydney. Note: Based on a survey of 5,730 Australians
aged 40 and older. Results from another survey suggest that more than 90 per cent of
Australians over the age of 50 believe that “money that lasts my lifetime” is somewhat
important or very important. National Seniors Australia and Challenger 2013, Retirees’ needs
and their (in)tolerance for risk, National Seniors Australia, Brisbane, page 10.
63 The regulatory prescribed minimum rates range from 4 per cent for people aged 55 to 64, to
14 per cent for those over the age of 95.
64 Most retirees draw down their account-based pensions at the minimum allowable rates.
Rothman, G and Wang, H 2013, ‘Retirement income decisions: take up and use of
Australian lump sums and income streams’, paper presented at the 21st Colloquium of
Superannuation Researchers, Sydney, 9–10 July, page 19.
120
managing this risk is also exacerbated by the uncertainty as to how long a retiree will
live. 66
Rationale
The potential gains to members, the economy and taxpayers from a more efficient
retirement phase are significant and warrant intervention. Higher income in retirement
and a wider range of retirement income products would better meet the varied needs
of retirees. The economy will benefit if the growing proportion of people in retirement
can sustain their level of consumption.
Combinations of products enable retirees to balance the three desired features of

retirement income products: high income, risk management features and flexibility
(Figure 9: Desired features of retirement income products). Pooling of longevity risk would
give retirees greater confidence to consume. Alternatively, by improving the
superannuation system’s efficiency in providing retirement income, people may be
able to save less during their working lives to reach a given level of retirement income.
65 Research suggests that these below-optimal rates result in lower welfare for individuals.
Bateman, H and Thorp, S 2008, ‘Choices and Constraints over Retirement Income Streams:
Comparing Rules and Regulations’, Economic Record, vol 84, pages S17–S31.
66 Although the life expectancy of a 65-year-old female today is about 89 years, 10 per cent of
65-year-old females will die before they reach 77 years and 10 per cent will live past
100 years. Even if individuals knew their life expectancy (which is generally not the case),
the probability of a 65-year-old dying at a particular age is no greater than about 5 per cent.
Commonwealth of Australia 2009, Australian Life Tables 2005–07, Canberra, using 25-year
mortality improvement factors.
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Figure 9: Desired features of retirement income products
Private provision of longevity risk protection could benefit taxpayers and the broader
economy. It would shift some of the longevity risk borne by Government, as the
provider of the Age Pension, to the private sector. Assets underlying products with
longevity risk protection could be invested with a longer time horizon, helping to fund
long-term investments and develop the corporate bond market in Australia as funds
seek more investments that provide a steady flow of income.
Options considered
The Interim Report broadly identified four options that would enable the retirement
phase to better achieve the objectives of the superannuation system and position
Australia to manage the challenges of an ageing population:
1. Recommended: Require superannuation trustees to pre-select a CIPR for

members.
2. Recommended: Remove impediments to retirement income product

development.
3. Provide policy incentives that encourage retirees to purchase retirement

income products that help manage longevity and other risks.
4. Mandate specific retirement income products (in full or in part, or for later
stages of retirement).
122

Require superannuation trustees to pre-select a CIPR for members
Under this option, superannuation fund trustees would be required to pre-select
CIPRs for members to receive their superannuation benefits. Members would retain
the freedom to take their benefits in another way if they desired. Appropriately
designed pre-selected options would offer an effective, low-cost means of improving
retirement income and risk management for superannuation fund members without
limiting personal freedom and choice. This option would also help to develop markets
for a wider range of income products with enhanced risk-management characteristics.
Greater use of products that pool longevity risk could significantly increase retirement
incomes. For many retirees, incomes from CIPRs could be 15–30 per cent higher than
those from the current typical strategy of drawing the minimum amount from an
account-based pension. 67 The Inquiry notes that one of the primary reasons why
incomes are significantly higher in products that pool longevity risk is that they reduce
bequests from superannuation. Although the system should accommodate bequests, it
should not do so to the detriment of retirement incomes.
Pre-selected options would simplify the process of using an accumulated balance to

generate an income stream. The member guides that exist for the accumulation phase
currently cease at retirement. Pre-selected options would bring the policy philosophy
in the retirement phase closer to that of the accumulation phase.
People can benefit from pre-selected CIPRs in different ways. CIPRs can improve
retirement incomes and risk management outcomes, especially for the disengaged and
those who are less financially sophisticated, by providing a comprehensive option that
balances a number of objectives and risks. The design of CIPRs can also guide more
engaged members by providing a framework for decision making. Johnson and
Goldstein (2013) suggest such an approach would be effective for three main reasons: 68
1. Effort — real or psychological costs of moving from the pre-selected option.
2. Implied endorsement — products are perceived to be recommended.
3. Loss aversion and reference dependence — decisions are affected by the

starting point.
67 Australian Government Actuary modelling prepared for the Financial System Inquiry
shows that CIPR examples 1, 2 and 3 described in the Implementation considerations section of
this recommendation increase expected income in retirement by 14 per cent, 30 per cent and
31 per cent respectively, excluding income from the Age Pension. Australian Government
Actuary, Data provided to Financial System Inquiry, 10 October 2014.
68 Johnson, E and Goldstein, D 2013, ‘Decisions by default’, in Shafir, E (ed.), The Behavioral
Foundations of Public Policy, Princeton University Press, Princeton, pages 417–427.
123
Pre-selecting options can have a significant influence on decision making. This was
shown in an Australian experiment that involved individuals allocating savings
between account-based pensions and annuities. The study found that the distribution
of allocations was strongly clustered around the pre-selected allocations (Chart 4).
Chart 4: Proportion of assets taken as an annuity with different pre-selected

allocations
25% pre-selected 50% pre-selected 75% pre-selected

Density
Density
Density
Allocation to annuities Allocation to annuities Allocation to annuities

69
Source: Bateman et al. This study referred to pre-selected options as defaults. The allocation to annuities
was pre-selected for participants who were able to change the allocation as they desired.
Although designing CIPRs would be more complex than designing accumulation

accounts, trustees are well placed to select appropriate CIPRs for their members,
within a defined framework. ASFA argues “… trustees should exercise their fiduciary
duty to consider longevity, market risk and inflation risk in designing post-retirement
arrangements in much the same way they need to consider investment risk and
insurance needs throughout the accumulation stage”. 70 Funds would incur the costs of
selecting, establishing and maintaining CIPRs, but these costs would be justified by the
benefits to members.
However, CIPRs would be less beneficial to individuals with very high or very low
superannuation balances. Those with small balances are likely to continue to take their
benefit as a lump sum and rely primarily on income from the Age Pension. Individuals
with very high balances may be able to generate satisfactory retirement income from
an account-based pension, drawn down at minimum rates.
69 Bateman, H, Eckert, C, Iskhakov, F, Louviere, J, Satchell, S and Thorp, S 2013, Default and
1/N Heuristics in Annuity Choice, School of Risk and Actuarial Studies Working Paper 2014/1.
124
A change in the way superannuation benefits are taken could affect Age Pension costs,
as discussed in the Implementation considerations section later in this recommendation.
Remove product development impediments

As discussed in the Interim Report, regulatory and other policy impediments are
hampering the development of retirement income products such as deferred lifetime
annuities (DLAs) and group self-annuitisation (GSA) schemes. 71 These impediments
include rigid standards to qualify for earnings tax exemptions. The Inquiry supports
the review of retirement income stream regulation being undertaken by Government,
which is examining ways to reduce or remove barriers to developing a market for
DLAs.
However, increasing the range of products alone will not be sufficient to improve
outcomes for retirees significantly. Behavioural biases and other system incentives will
continue to impede the widespread use of pooled longevity risk products, despite
evidence that many individuals would be better off. 72
Provide policy incentives to encourage the use of retirement income products that
manage longevity and other risks
Several submissions support using tax and Age Pension incentives to encourage
take-up of income products with longevity risk protection. The Australian Institute of
Superannuation Trustees (AIST) recommends “… policy incentives that encourage
retirees to purchase retirement income products that help them deliver their optimal
retirement experience”. 73 In the past, favourable treatment of products with better risk
management features by the Age Pension means test has been shown to increase their
use. 74
Although policy incentives would be likely to increase the use of superannuation to

generate retirement incomes, incentives generally increase the cost of the retirement
71 Deferred lifetime annuities are a form of lifetime annuity where the commencement of
income payments is delayed for a set amount of time after purchase. In a GSA scheme,
participants contribute funds to a pool that is invested in financial assets. Regular payments
from the pool are made to surviving members. GSAs allow pool members to manage
idiosyncratic longevity risk but do not completely eliminate the risks associated with
increases in life expectancies across Australia. GSAs differ from a lifetime annuity by not
providing a guaranteed income stream. Instead, the adjustments to payments over time are
subject to investment performance, mortality assumptions and experience.
72 Benartzi, S, Previtero, A and Thaler, R 2011, ‘Annuitization puzzles’, Journal of Economic
Perspectives, vol 25, no. 4, pages 143–164.
74 Sales of annuities fell significantly after both the reduction in the asset test exemption in
2004 and its abolition in 2007. Plan for Life 2014, Data provided to Financial System Inquiry,
28 March 2014.
125
income system to taxpayers. However, it is important that tax and Age Pension
settings do not discourage people from using CIPRs.
Mandate specific retirement income products

Mandatory use of certain retirement income products would achieve effective risk
pooling and ensure superannuation is used to provide income throughout retirement.
It would also overcome issues with adverse selection in products with longevity risk
protection.
Mandatory use of products that pool longevity risk could disadvantage groups with
lower life expectancies. 75 This could be mitigated by pricing products to reflect the
characteristics of members, including their life expectancy, although this would be
complex and add costs.
People tend to have diverse needs in retirement, and no given product or combination
of products will be appropriate for everyone. Many submissions caution that
compulsory income streams could result in poor outcomes for some individuals and
stifle innovation. Although this option could help achieve the objectives of the
superannuation system, it would remove individuals’ flexibility to tailor their
retirement plans to suit their needs and is not consistent with the Inquiry’s philosophy.
Conclusion
Pre-selected CIPRs and greater use of longevity risk pooling at retirement could
significantly improve the superannuation system’s efficiency in providing retirement
incomes and better meet the needs of retirees.
In making this recommendation, the Inquiry sought to balance the desire to increase
system efficiency in providing retirement incomes with a degree of individual freedom
and choice. The Inquiry favours an approach that preserves freedom and choice.
However, if introducing pre-selected CIPRs does not achieve the intended objectives of
this recommendation, Government could consider forms of defaults that commence
automatically on retirement. Tax and Age Pension incentives could also be used to
better achieve the objectives of the superannuation system.
High-quality advice may be useful to some individuals to help them manage their
financial affairs in retirement. Chapter 4: Consumer outcomes contains recommendations
to improve the quality of financial advice.
75 For a discussion of these issues, see Commonwealth of Australia 2010, Australia’s future tax
system: Report to the Treasurer, Part Two, Detailed analysis, vol 1 of 2, Canberra, page 122.
126
Developing CIPRs will take considerable time. This recommendation should be
implemented with sufficient lead time to allow superannuation funds to design
products or form partnerships with other providers.
As pre-selected CIPRs are expected to influence retirees’ decisions, it is important they

provide good outcomes for large numbers of members. This recommendation involves
trustees potentially designing, advising on and delivering CIPRs. For these reasons,
Government should establish a mechanism to ensure each CIPR provides the required
features, which should be specified in regulation. Ongoing regulatory oversight will
also be required. Meeting regulatory requirements should provide trustees with some
protection against breaching their fiduciary obligations.
CIPRs should be offered as a pre-selected option to all members of APRA-regulated

funds — not only to MySuper members. Decisions about retirement are more complex
than most decisions made in the accumulation phase. Individuals who leave the
default system are still likely to benefit from CIPRs. Self-managed superannuation
fund trustees should not be required to design or offer CIPRs because the trustees are
the fund’s members.
Government would need to consider how the Age Pension means test applies to new
income stream products. In principle, the means test should not discourage products
that manage longevity risk, should aim to provide neutral treatment of products with
longevity risk protection, and should not make it difficult for individuals to smooth
their income and consumption over retirement. Without some amendments to the Age
Pension means test, some CIPRs could increase the cost of the Age Pension to
taxpayers. 76
Design of CIPRs
People have different needs in retirement and will value the three desired attributes of
retirement products (income, risk management and flexibility) differently. CIPRs
should deliver a balance of these attributes. As no single product has all these features,
a CIPR is likely to be a combination of products. A working group convened for the
Inquiry by the Actuaries Institute recommends “… a portfolio approach is likely to be
more suitable than a single default product. A sensible default might include an
account-based product and another product with longevity risk protection”. 77
76 Under the principles of the current means test, products with longevity risk pooling tend to
increase Age Pension costs in the early years of retirement (due to faster depletion of assets
when the assets test is binding) and reduce costs in later years (because of higher income
when the income test is binding).
77 Working group convened for the Financial System Inquiry by the Actuaries Institute 2014,
Retirement Income: options for managing Australia’s longevity risk, Sydney, page 1.
127
Superannuation funds may work with life insurance companies, other funds or other
entities to provide CIPRs.
Many people will live for several decades after retirement. CIPRs should therefore
provide exposure to growth assets to increase retirement income. Rice Warner advises
that “… any investment period of 20 or more years requires a significant proportion of
growth assets.” 78 Using CIPRs will allow superannuation funds to take a longer-term
investment perspective and reduce the need for retirees to worry about sequencing
risk.
Although CIPRs may include a combination of products, members should still be able
to transition smoothly from the accumulation phase to the retirement phase. 79 Cooling
off periods coupled with the provision of a (diminishing) return of capital in the event
of early death may be appropriate for some pooled products. These products could be
purchased using either a one-off payment or a series of premiums.
CIPRs could vary with known characteristics of the member, including the size of their
superannuation benefits. A trustee could decide to recommend lump sum benefits to
members with balances below a certain (low) threshold.
Example CIPRs
Examples of CIPRs that would provide the required features are described in Table 5.
Table 5: Examples of comprehensive income products for retirement

Allocation to different products; per cent of accumulated balance 80
Longevity Allocation to Draw-down of Allocation to
product (a) longevity product account-based account-based
pension pension
CIPR 1 DLA 23% Exhaust balance at 77%
age 85
CIPR 2 Deferred GSA 17% Exhaust balance at 83%
age 85
CIPR 3 GSA 75% Minimum rates 25%
(a) Deferred products commence payments at age 85.
79 For example, an income product provided by a life insurance company could be paired with
an account-based pension in the same way accumulation accounts include life insurance.
80 These allocations were designed to smooth retirement income from the CIPR (excluding the
Age Pension). In practice, retirees would want to smooth total income, including the Age
Pension. This would alter the proportion invested in deferred products. The current Age
Pension means test makes it difficult to smooth total income.
128
The annual income expected to be generated by each of the above CIPRs for a male
retiring at 65 years of age with a superannuation balance of $400,000 (a typical balance
in a mature superannuation system) is shown in Chart 5: Expected annual income from
example CIPRs. The chart shows the amount of income he can expect to receive if he is
still alive at each age. The income from an account-based pension drawn down at
minimum rates — the most common strategy used by retirees at present — is included
for comparison. 81
The income streams represented in Chart 5 are only illustrative. They highlight the
benefits of pooling and the ability to draw down an account-based pension faster
without the retiree running the risk of outliving their wealth. The expected income
from products is sensitive to assumptions regarding investment returns, draw-down
rates and mortality.
Chart 5: Expected annual income from example CIPRs 82

For a 65-year-old male with a $400,000 accumulated balance (excludes Age Pension)
$30,000 $30,000
$25,000 $25,000
$20,000 $20,000
$15,000 $15,000
$10,000 CIPR 1 $10,000

CIPR 2
$5,000 CIPR 3 $5,000
Account-based pension drawn down at minimum rates
$0 $0
65 70 75 80 85 90 95 100
Age (years)
Source: Australian Government Actuary modelling. 83
81 The full set of assumptions underlying these results and a sensitivity analysis are available
in Australian Government Actuary 2014, Towards more efficient retirement income products:
Paper prepared for the Financial System Inquiry, November 2014.
82 Produced using a stochastic model. The aim of achieving a relatively smooth income stream
is affected by market and mortality variations.
83 Australian Government Actuary, Data provided to Financial System Inquiry,
10 October 2014.
129
Retirees using CIPRs would obtain significantly higher and smoother private
retirement incomes while reducing the risk of outliving their savings (Chart 5 and
Table 6). This is achieved through the loss of some flexibility and smaller bequests for
some. As a portion of each CIPR is invested in an account-based pension, individuals
retain some flexibility.
Table 6: Expected net present value of income from example CIPRs

For a 65-year-old male with a $400,000 accumulated balance (excludes Age Pension)
Expected income Increase over Increase over
throughout retirement account-based account-based
(NPV) 84 pension 85 pension (%)
Account-based pension drawn $275,000 _ _
down at minimum rates
CIPR 1 86 $314,000 $40,000 14
CIPR 2 $357,000 $82,000 30
CIPR 3 $359,000 $85,000 31
87
Source: Australian Government Actuary modelling.
84 Net present value, rounded to the nearest $1,000. Includes retirement income only (not
bequests).
85 Rounded to the nearest $1,000.
86 A similar increase in retirement income could be achieved with a combination of two thirds
of assets in an account based pension drawn down at minimum rates and one third of
assets used to purchase a GSA.
87 Australian Government Actuary, Data provided to Financial System Inquiry,
10 October 2014.
130
Choice of fund
Recommendation 12
Provide all employees with the ability to choose the fund into which their Superannuation
Guarantee contributions are paid.
Description
Government should remove provisions in the Superannuation Guarantee
(Administration) Act 1992 that deny some employees the ability to choose the fund that
receives their SG contributions due to the exclusions given to enterprise agreements,
workplace determinations and some awards. 88,89
Objective
• Remove barriers to members engaging with their superannuation by ensuring all
employees, to the extent possible, have the right to choose their superannuation
fund.
Discussion
A significant minority of employees cannot choose the superannuation fund that
receives their SG contributions. In particular, this affects employees with a
superannuation fund nominated in an enterprise agreement, a workplace
determination or a state-based award. A 2010 ASFA paper found that around
20 per cent of employees cannot choose their fund. 90 These exemptions contribute to
employees having multiple superannuation accounts and paying multiple sets of fees
and insurance premiums, which reduces retirement income. (See the
Recommendation 10: Improving efficiency during accumulation for further discussion on
the cost of multiple accounts.) For some individuals, lack of choice contributes to
disengagement with superannuation.
88 Superannuation Guarantee (Administration) Act 1992, Part 3A, s32C.

89 In principle, this recommendation should apply to all employees but, for Constitutional
reasons, the Commonwealth cannot instruct changes to state agreements and awards.
90 Clare, R 2010, ‘Choosing to choose’, Association of Superannuation Funds of Australia,
paper presented at the 18th Annual Colloquium of Superannuation Researchers, Sydney,
12-13 July, page 9.
131
When legislation was introduced to allow employees to choose their superannuation

fund, concerns were raised about the compliance costs to employers from having to
make contributions to multiple funds. However, changes in technology and the
introduction of SuperStream are reducing these costs. Many employers use clearing
houses to make payments to multiple superannuation funds, and Government already
provides a free clearing house service for small businesses.
Submissions note that choice contributes to higher superannuation fees in Australia

relative to some other countries. However, extending choice to the remaining
20 per cent of employees is not expected to increase costs significantly for industry.
Conclusion
As a general principle, the Inquiry believes everyone should be able choose the fund
that receives their SG contributions. The superannuation system should assist
members to achieve their individual goals and make savings decisions that suit their
personal circumstances. Several submissions highlight the benefits of choice in
providing flexibility for members and lowering fees through greater competition.
Accordingly, regulatory impediments to individuals exercising choice should be

removed. State governments should be encouraged to allow all employees choice.
132
Governance of superannuation funds
Recommendation 13
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.
Description
Government should amend the Superannuation Industry (Supervision) Act 1993 to
mandate that public offer APRA-regulated superannuation funds have a majority of
independent directors on their trustee boards. The chair should also be independent.
An arm’s length definition of independence should apply.
Government should introduce civil and criminal penalties for directors who fail to
execute their responsibility to act in the best interests of members, or who use their
position to further their or others’ interests to the detriment of members.
To ensure effective arrangements for dealing with conflicts of interest, each director’s
interests should be deemed to have been disclosed only when they have been
acknowledged by all other directors.
Objectives
• Improve the governance of public offer superannuation funds, thereby protecting
the best interests of members.
• Align the governance requirements and penalty regime for superannuation

directors with those applying to directors of responsible entities of MISs.
Discussion
Although there is little empirical evidence about the relationship between quality of
governance in Australian superannuation funds and their performance, high-quality
governance is essential to organisational performance. Some overseas research
suggests that good governance adds one percentage point to pension fund returns. 91
The governance framework for Australian superannuation funds has shortcomings
91 Ambachtsheer, K 2007, Pension Revolution: A Solution to the Pensions Crisis, John Wiley &
Sons, Hoboken, page 130.
133
that are inconsistent with good governance principles and, in the Inquiry’s view, need
to be addressed.
Including independent directors on boards is consistent with international best

practice on corporate governance. Independent directors improve decision making by
bringing an objective perspective to issues the board considers. They also hold other
directors accountable for their conduct, particularly in relation to conflicts of interest. 92
At present, independent directors are not required on the boards of public offer
superannuation entities. Some superannuation trustee boards have independent
directors but others do not. A recent survey by Mercer found that 11 out of 19 funds
without independent directors would not make changes to their board structure. Of
the remaining eight funds, five said they would only appoint independent directors if
it were mandated. 93
APRA recently issued prudential standards to improve the governance of

superannuation trustee boards and the way in which these boards prevent conflicts of
interest from influencing decisions. 94 However, structural requirements for the
superannuation trustee boards are not aligned to other entities that manage funds on
behalf of others, such as MISs. MISs must have either a majority of independent
directors on the board of the responsible entity of the scheme, or a majority of
independent members on their compliance committees. 95 The requirements for
superannuation funds are also inconsistent with governance requirements for many of
the entities they invest in, even though governance theory suggests that these
requirements should be aligned. 96 Under the ASX Corporate Governance Principles,
entities listed on the Australian Securities Exchange (ASX) are required to have a
majority of independent directors on an “if not, why not” basis. 97
The Super System Review recommended that at least one-third of board members
should be independent on those boards with equal representation (with the remainder
of positions equally split between employer and employee representatives), and a
92 Organisation for Economic Co-operation and Development (OECD) 2004, OECD Principles
of Corporate Governance, OECD, Paris, pages 64–65.
93 Mercer 2014, Super funds under-prepared for independent directors and increasing
scrutiny, media release, 22 July, Melbourne, viewed 7 November 2014,
<http://www.mercer.com.au/newsroom/2014-superannuation-governance-survey.html>.
94 Australian Prudential Regulation Authority (APRA) 2012, Prudential Standard SPS 510:
Governance, APRA, Sydney; APRA 2013, Prudential Standard SPS 521: Conflicts of Interest,
APRA, Sydney.
95 Corporations Act 2001, s601JA and s601JB.
96 Ambachtsheer, K 2007, Pension Revolution: A Solution to the Pensions Crisis, John Wiley &
Sons, Hoboken, page 41.
97 ASX Corporate Governance Council 2014, Corporate Governance Principles and
Recommendations: 3rd Edition, Recommendation 2.4, ASX Corporate Governance Council,
Sydney, page 17.
134
majority should be independent on all other boards. 98 This would improve the current
standards, but if independent directors are to have an effective influence on board
decisions, all superannuation funds need a majority of independent directors.
In defined benefit schemes sponsored by a single employer, equal representation of

employees and employers is appropriate and consistent with the governance models
of defined benefit pension funds internationally. These funds would continue to
operate using the structure for which equal representation was designed, with the
employer bearing the financial risk from the board’s decisions.
The equal representation model has less relevance in the current superannuation
system, which predominantly consists of public offer DC funds and funds less focused
on a single employer. As more fund members exercise choice, directors appointed by
employer and employee groups are less likely to represent the broader membership of
public offer funds (see Recommendation 12: Choice of fund). Given the diversity of fund
membership, it is more important for directors to be independent, skilled and
accountable than representative.
As part of Government’s recent consultation process on reforms to superannuation

fund governance, some stakeholders argued against mandating independent directors
on superannuation boards. 99 The main arguments opposing the proposal were that
appointing independent directors should be at the discretion of the fund based on its
particular circumstances and needs, and that those funds using the equal
representation model have generated higher returns than other funds in recent years.
However, there is no evidence to suggest that the performance of these funds is driven
by their equal representation model.
At present, superannuation directors are not subject to criminal or civil penalties in

relation to their duty to act in the best interests of members. A member who has
incurred loss or damage as a result of director misconduct can seek recovery through
civil action — or APRA can disqualify the director. This is inconsistent with the regime
applying to the directors of responsible entities of MISs under the Corporations
Act 2001, who are subject to criminal and civil penalties. 100 The absence of criminal and
civil penalties in relation to misconduct by superannuation directors represents a
significant gap in the current framework.
98 Commonwealth of Australia 2010, Super System Review Final Report, Part Two:
Recommendation Packages, Recommendation 2.7, Canberra, page 56.
99 For example, the submission by Industry Super Australia suggests placing a positive
obligation on funds to consider making up to one-third of the directors on their board
independent directors. Industry Super Australia 2014, In members’ best interests: ISA
submission to Government discussion paper, Industry Super Australia, Sydney, page 12.
100 Corporations Act 2001, s601FD and Part 2D.1.
135
APRA Prudential Standard SPS 521 includes a requirement to maintain a register of

director interests. Although these requirements are broadly appropriate, conflict of
interest requirements need to be particularly strong for superannuation funds because
there is a trustee relationship between the fund and members, and most members are
required by law to participate in the superannuation system. The requirements could
be strengthened by specifying that each board member must acknowledge when a
director adds an interest to the register. This would focus the attention of the board on
director interests and ensure a rigorous oversight process.
Some submissions are concerned that this requirement would expand boards and
increase costs to members. If superannuation fund boards expand to accommodate
more independent directors, boards should justify to their members and APRA why
such an expansion is required for the fund’s proper governance and operation.
The need to strengthen superannuation funds’ governance is particularly important

given that members lack the power to remove directors who breach their duties. In
MISs, unit-holders typically do not have rights to appoint or remove directors, but
they do have the right to vote to replace the responsible entity managing their funds.
Members in superannuation funds have no rights in this regard.
Conclusion
Requiring a majority of independent directors, with an independent chair, would
strengthen the governance of superannuation funds. The Inquiry is not convinced by
arguments that independent directors would have a negative effect on superannuation
returns.
Strengthening disclosure arrangements and introducing civil and criminal penalties for
director misconduct would increase the incentive for all directors to act in the best
interests of superannuation fund members.
The Inquiry notes that directors of life insurance companies are not subject to civil and
criminal penalties for breaching their duties to policy holders. Government should
consider whether there is a case for also aligning the penalties applying to life
insurance directors with those applying to MIS directors.
136
Taxation of superannuation
Observation
In reviewing the taxation of contributions and investment earnings in
superannuation, the Tax White Paper should consider:
• Aligning the earnings tax rate across the accumulation and retirement phases.
• Options to better target superannuation tax concessions to the objectives of the

Objectives
• Remove tax barriers to enable a more seamless transition to retirement.
• Better target superannuation tax concessions to achieve the objectives of the

superannuation system discussed earlier in this chapter and, in doing so, reduce the
cost of the superannuation system to Government, reduce distortions to the
allocation of funding in the economy, and improve long-term confidence and policy
stability in the superannuation system.
Discussion
Problem the observation seeks to address
As acknowledged in submissions, superannuation is seen as an attractive savings and
wealth management vehicle for middle- and higher-income earners due to the highly
concessional tax treatment of contributions and earnings (Chart 6: Share of total
superannuation tax concessions by income decile). According to Rice Warner, “It is
self-evident that the tax concessions for superannuation are tilted towards those
Australians who have the most income and wealth, and who have the highest personal
marginal tax rates”. 101
Superannuation tax concessions are not well targeted at the objectives of the
superannuation system discussed earlier in this chapter. As illustrated in Figure 4.3 of
the Interim Report, a small minority of members hold a high proportion of
superannuation assets. 102 Individuals with very large superannuation balances are able
to benefit from tax concessions on funds that are likely to be used for purposes other
than providing retirement income, such as tax-effective wealth management and estate
page 2-121.
137
planning. 103 The AIST supports “… a focus on promoting and delivering greater equity
in the system to build retirement incomes over the course of every person’s working
life, as opposed to making superannuation a tax effective wealth creation vehicle and
estate planning tool, for the few”. 104
As a result, the majority of tax concessions accrue to the top 20 per cent of income
earners (Chart 6). These tax concessions are unlikely to reduce future Age Pension
expenditure significantly. 105
Chart 6: Share of total superannuation tax concessions by income decile

Per cent Per cent
40 40
35 35
30 30
25 25
20 20
15 15
10 10
5 5
0 0
-5 -5
First Second Third Fourth Fifth Sixth Seventh Eighth Ninth Top
Incom e decile
Source: Treasury, based on an analysis of 2011–12 Australian Taxation Office data. 106
Poorly targeted tax concessions increase the cost of the superannuation system to
Government. In turn, this increases the fiscal pressures on Government from an ageing
population. Giving high-income individuals larger concessions than are required to
achieve the objectives of the system also increases the inefficiencies that arise from
page 2-126.
105 As noted in the Interim Report, “… the large number of accounts with assets in excess of
$5 million could each receive annual tax concessions more than five times larger than the
single Age Pension”. Commonwealth of Australia 2014, Financial System Inquiry Interim
Report, Canberra, page 2-120.
106 Treasury 2014, Data provided to the Financial System Inquiry, 29 October 2014.
138
higher taxation elsewhere in the economy, including differences in the tax treatment of
savings (refer to the Appendix 2: Tax summary).
In addition, tax concessions contribute significantly to policy instability and

undermine long-term confidence in the superannuation system. Around half of the
announced policy changes over the past 10 years appear to have been aimed at
addressing concerns related to the targeting and equity of tax concessions. 107 Despite
this, concerns remain and continue to undermine public confidence in the fairness and
sustainability of policy settings.
The differential tax rates on earnings between the accumulation phase (taxed at
15 per cent) and the retirement phase (tax-free) of superannuation have adverse effects
as they:
• Create a tax boundary that limits pension product innovation and acts as a barrier
to funds offering whole-of-life superannuation products. This increases costs in the
superannuation system by requiring multiple, separate accounts between the
accumulation and retirement phases. 108
• Can contribute to sub-optimal investment strategies in the years approaching

members’ retirement by focusing attention on investing until the point of
retirement (the end of the accumulation phase), rather than investing over the long
term beyond the point of retirement.
• Provide an opportunity for tax arbitrage in superannuation between the

accumulation and retirement phases. Capturing these benefits by allocating specific
assets to individuals can result in a shift away from investment pooling and
diversification in superannuation and reduce the efficiency of the system. It can
also provide non-neutral outcomes between different types of funds, as mentioned
in the Interim Report.
107 Financial System Inquiry analysis of Government policy announcements in annual Budget
documents, Mid-Year Economic and Fiscal Outlook statements, Pre-Election Fiscal
Outlooks and Economic Statements.
108 For example, if a retiree has commenced a pension and later decides to make a contribution
to superannuation, the retiree will need to open a new accumulation account and a new
pension superannuation account. This results in some members having multiple pension
accounts in retirement.
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Options considered
Align the earnings tax rate between the accumulation and retirement phases
As noted in some submissions, aligning the earnings tax rate between the
accumulation and retirement phases would result in significant simplification benefits.
This was also recommended by Australia’s Future Tax System Review (AFTS). 109
Aligning the earnings tax rate could be revenue-neutral for Government, would
reduce costs for funds, would help to foster innovation in whole-of-life
superannuation products, would facilitate a seamless transition to retirement and
would reduce opportunities for tax arbitrage. However, a positive tax rate in
retirement could reduce equity for some lower-income individuals taking income
streams.
Better target tax concessions

The Inquiry considered two options to better target superannuation tax concessions at
achieving the objectives of the system. Both options would limit tax concessions for
individuals with large superannuation balances.
1. Reduce the non-concessional contribution cap and better target superannuation

contribution tax concessions
Some submissions suggest applying a more neutral tax treatment of superannuation
across taxpayers. This could be done by implementing the AFTS recommendation to
tax superannuation contributions at marginal rates less a flat-rate rebate.
Tightening the non-concessional contribution cap — currently $540,000 over three

years — would help to target the tax concessions for superannuation contributions
better by reducing the extent to which individuals could accrue very large balances in
the system in the future. The administrative and compliance costs would be relatively
low. However, it would reduce individuals’ flexibility to save for their retirement at
different times of their life and could adversely affect individuals with broken work
patterns.
109 AFTS made a number of recommendations regarding the taxation of savings and
superannuation. AFTS recommended taxing long-term savings (including superannuation)
at a lower rate to avoid discriminating against individuals who choose to defer
consumption and save. It also recommended implementing a more neutral tax treatment of
superannuation contributions across taxpayers. This Inquiry endorses these
recommendations. Commonwealth of Australia 2010, Australia’s future tax system: Report to
the Treasurer, Canberra.
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2. Levy additional earnings tax on superannuation account balances above a certain

limit
This option imposes a higher rate of earnings tax on individuals with superannuation
balances in excess of a certain limit. It would target superannuation tax concessions to
achieve the objectives of the system and reduce costs to taxpayers. It would also
facilitate the removal of the non-concessional contribution cap.
The Inquiry is aware that similar policy proposals in the past have not succeeded due
to their complexity and the high costs of implementation. 110 Industry express a strong
view that imposing a different rate of earnings tax inside a pooled superannuation
trust based on members’ individual incomes would impose high compliance costs and
complexity on funds. Submissions also stress the need to avoid options that impose
large compliance costs on funds. 111
To avoid these large compliance costs, stakeholders raise alternative implementation

options to which the Inquiry is attracted. One approach is to apply the higher rate of
earnings tax to affected individuals outside the superannuation system, with the
option of paying the tax liability out of superannuation benefits — similar to the
mechanism for applying the tax on excess contributions. To reduce complexity further,
the tax could be calculated on a simplified tax base. 112 This option would increase
Government revenue. 113
Conclusion
Superannuation taxation arrangements should be reformed to place policy settings on
a more sustainable footing over the long term. Superannuation tax arrangements
should be targeted to achieve the objectives of the superannuation system, reduce the
cost of the retirement income system to Government, better position Australia to meet
110 The previous Government proposed capping earnings tax concessions in retirement at
$100,000 before a higher rate of tax would apply. The proposal was not implemented. In
addition, the high costs of administration resulted in the abolition of reasonable benefit
limits in 2007.
111 For example, see Mercer 2014, Second round submission to the Financial System Inquiry,
page 32; Association of Superannuation Funds of Australia 2014, Second round submission
to the Financial System Inquiry, page 57.
112 For example, the Australian Taxation Office could calculate superannuation earnings net of
taxes and fees using existing account balance and contribution data, without the need for
additional reporting. A less attractive alternative is to deem a rate of earnings on account
balances based on industry-wide average returns, or based on long-run average returns.
This could be justified on the basis of being a penalty rate of tax that seeks to discourage
higher balances. The account balance limit could only apply in the retirement phase, if that
further reduced implementation costs.
113 The increase in Government revenue in the short term would be reduced by
implementation costs for the Australian Taxation Office.
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the fiscal challenges of an ageing population and reduce funding distortions in the
economy.
The choice between options to better target superannuation tax concessions rests partly
on the treatment of very large superannuation balances already in the system, which
are likely to be used for purposes other than providing retirement incomes. Tighter
contribution limits could reduce the future prevalence of very large superannuation
balances. On the other hand, account balance limits would address the
disproportionate allocation of tax concessions to individuals with very large balances
now and in the future, and reduce the costs of these concessions.
The Inquiry has not recommended a specific option because a range of relevant
considerations fall outside its scope — in particular, interactions and alignment with
the broader taxation system.
Prior to implementation, Government should consult with industry to avoid
unintended consequences for industry and fund members.
Individuals have made superannuation contributions and decisions based on the

existing rules and tax arrangements. If Government introduces a higher rate of
earnings tax for account balances above a certain limit, transitional arrangements
should be considered. For example, individuals with account balances above the limit
could be given the opportunity to transfer assets out of the superannuation system
without detriment.
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The arrival of digital technology — the synthesis of computing and communications
technology — marks the advent of one of the most ubiquitous generally applicable
technologies the world has ever seen. Its impact has been, and continues to be,
revolutionary for most industries, altering business operations and resulting in major
productivity gains.
For the financial system, technology-driven innovation is transformative. New

business models, products and services are emerging, driving competition and
changing the way users interact with the system. Opportunities for innovation are
abundant as, fundamentally, the sector revolves around recording, analysing and
interpreting transactions and managing associated information flows. With no physical
products to manage, these processes readily lend themselves to improvements via
digital technologies. Consequently, the sector has already invested significantly in a
range of technologies, leading to:
• Increased self-service. The introduction of the ATM represented a major first step
towards self-service. More recently, it has been followed by online banking and
insurance products, and the growth of comparator sites.
• Evolving infrastructure and delivery models. Cloud computing, real-time online

‘chat’ services and mobile payments platforms are changing the physical
infrastructure used in financial services’ operations and delivery.
• Alternative business models. Technology is facilitating the disintermediation of

traditional institutions, attracting many new entrants and non-traditional
businesses. New technology-enabled mechanisms for accessing finance and
obtaining credit are emerging in the Australian market, such as crowdfunding and
peer-to-peer lending.
• Fast, frictionless payments. Electronic payments are growing in volume and

progressing towards real-time funds transfers. Friction is diminishing with
contactless terminals and the growing use of biometrics for payment authorisation.
Some consumers are also accessing alternative mediums of exchange, such as
digital currencies.
• Increased use of data. The financial sector’s ability to capture, store and analyse
vast amounts of data enables firms to customise products for consumers, more
finely segment customer groups and sharpen targeting of marketing initiatives. It is
also improving risk modelling, risk-based pricing and research.
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• Increased potential for international integration and dependency. Users and

intermediaries can access international products, services and markets more easily,
and foreign players have more opportunities to enter and compete in local markets.
As observed in the Interim Report, the disruptive effects of innovation have the
potential to deliver significant efficiency benefits and improve user outcomes,
notwithstanding costs associated with adjustment for industry, and possible
uncertainty for some consumers about change.
As technology continues to increase network speeds, broaden distribution networks

and heighten levels of interconnectivity, these changes can also amplify the risks of
innovation across the system. The pace of technology-driven market developments can
challenge regulatory frameworks and make it difficult for regulators to adapt with
sufficient speed. Failure to manage these risks may result in system-wide impacts
and/or adverse consumer outcomes.
Recommended actions
The Inquiry believes the innovative potential of Australia’s financial system and
broader economy can be galvanised by taking action to ensure policy settings facilitate
future innovation that benefits consumers, businesses and government. Specifically,
the Inquiry believes action can be taken in the following areas:
• Industry and government can work together to identify innovation opportunities

and emerging network benefits. Where competitive forces prevent these
opportunities from being fully realised, government should facilitate industry
coordination. The Inquiry recommends establishing a permanent public–private
sector collaborative committee to facilitate financial system innovation and enable
timely and coordinated policy and regulatory responses.
Digital identity is a significant current example of an area where network benefits

can be harnessed more effectively through public–private sector collaboration, and
Government facilitating industry action. The Inquiry recommends developing a
national strategy for a federated-style model of trusted digital identities in which
public and private sector identity providers would compete to supply trusted
digital identities, enhancing consumer choice, privacy, innovation and system
efficiency.
• Government and regulators can remove unnecessary impediments to innovation.

The Wallis Inquiry advocated functional frameworks to ensure risks emanating
from similar economic functions are regulated in the same way and to provide
entities performing the same function with competitive neutrality. This Inquiry
believes graduating such functional frameworks can reduce barriers to innovation,
while ensuring regulation is broadly risk-based. Graduation involves providing
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lower-intensity regulation for new entrants that pose smaller risks to the system —
that is, it targets regulation to where it is most needed in the system.
A dynamic and efficient payments system is an important component of the

broader financial system as it underpins most transactions in the economy. At
present, payments regulation is complex and fragmented. Developing clearly
graduated functional regulation would facilitate innovation in the payments
system. The Inquiry recommends mandating the ePayments Code, narrowing the
scope of the Australian Financial Services Licence (AFSL) regime, and introducing a
new two-tier framework for prudential regulation of purchased payment facilities.
The Inquiry also recommends broadening the application of interchange fee caps
across payment systems (including companion card systems) and proposes
lowering current caps. Significant changes are recommended to the current rules on
customer surcharging by merchants to allow system providers to ban customer
surcharging for low-cost payment methods and apply fixed limits for medium-cost
payment methods. Only higher-cost system providers would remain subject to the
current arrangements.
Further graduating the regulation of market-based financing could improve the

financial system’s efficiency in funding future growth. Amending restrictive
regulation that prevents small firms from seeking financing online from the general
public could facilitate innovation in this area. The Inquiry recommends facilitating
crowdfunding by adjusting fundraising and lending regulation, streamlining
issuers’ disclosure requirements and allowing retail investors to participate in this
new market with protections such as caps on investment.
Amending unnecessarily technology-specific regulation and removing superfluous

regulation can facilitate innovation. Technology-specific regulation can impede
innovation by preventing the adoption of best technology or innovative
approaches. For example, regulation may entrench the use of cheques or
paper-based disclosure documentation, creating inefficient outcomes.
See Recommendation 39: Technology neutrality.
• Government and regulators can support data-driven business models. As

increasing amounts of data are collected and more sophisticated analytical
techniques emerge, data can be used to develop alternative business models,
products and services that improve consumer outcomes and system efficiency.
These innovations can be facilitated by increasing access to de-identified and
aggregated public sector data, improving consumers’ access to their personal
information, and enabling access to private sector data where this does not reduce
incentives to collect the data. These processes could be aided by developing
standards for accessing and formatting data, including product information, and
addressing consumer privacy concerns to strengthen confidence and trust in the
use of data. The Inquiry recommends Government commission the Productivity
Commission to hold an inquiry into the costs and benefits of increasing access to
and improving the use of data, subject to privacy considerations.
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• Regulators need flexibility to respond to future developments. As market

developments occur, regulators need to balance the benefits and risks of innovation
and take a system-wide view. Regulators need appropriate frameworks, skills,
capabilities and powers to manage emerging risks. Regulators should also have
appropriate accountability mechanisms to assess the impacts of their policies on
competition, innovation and efficiency. These mechanisms are discussed in
Chapter 5: Regulatory system.
Principles
The Inquiry believes policy settings should facilitate innovation and market
developments where these improve system efficiency and consumer outcomes. In
making the following recommendations, the Inquiry has been guided by these
principles:
• Industry and government should work together to identify innovation

opportunities and emerging network benefits. Government should facilitate
industry coordination where competitive forces prevent these opportunities from
being fully realised.
• Regulation should be functional to ensure competitive neutrality and facilitate

innovative business models. Regulation should also be graduated to enable market
entry and ensure regulation is targeted to where it is most needed. At times, this
may increase risks for some consumers, but it is expected to improve consumer
outcomes overall.
• Regulation should aim to be technology neutral in design. Regulation should only

be technology specific where selecting a common standard would improve overall
system efficiency. Review mechanisms are needed to ensure technology-specific
regulation does not become an impediment to innovation over time.
• Policy settings should aim to reduce information asymmetries by improving access

to public and private sector data, subject to appropriate privacy safeguards to
preserve consumer confidence and trust in the system, and maintaining private
sector incentives to collect data.
Conclusion
The Inquiry believes implementing the package of recommendations in this chapter,
and continuing to develop policy based on these principles, will contribute to
developing a dynamic, competitive, growth-oriented and forward-looking financial
system for Australia.
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Collaboration to enable innovation
Recommendation 14
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.
Description
Government should establish a committee to facilitate financial system innovation, the
Innovation Collaboration (IC), consisting of senior industry, Government, regulatory,
academic and consumer representatives.
The minister responsible should propose and take forward an implementation

approach for forming and operating the IC. The IC should include representatives
from: financial sector start-ups and innovators; consumer groups; academia; and
relevant Government agencies and regulators, such as the Australian Securities and
Investments Commission (ASIC), the Australian Prudential Regulation Authority
(APRA), the Reserve Bank of Australia (RBA) and the Australian Taxation Office.
The IC should aim to:
• Improve Government and regulator awareness and understanding of financial

system innovation and the benefits of emerging business models. 1
• Identify and promulgate action on emerging network benefits and innovation

opportunities that provide user benefits and positive system-wide effects, and
identify impediments to innovation.
• Facilitate interactions between financial sector innovators, Government and

regulatory agencies in a single coordinated forum.
• Enable submissions to be made to the Council of Financial Regulators (CFR) where

system-wide regulatory responses may be required.
1 These are often referred to as ‘disruptive’ business models — those that disrupt existing
value chains in financial services. Examples include crowd financing mechanisms that
remove the need for a financial institution to intermediate between borrower and lender.
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Objectives
• Embed understanding of, and openness to, financial sector innovation within
Government and regulators through closer collaboration with industry and
innovators.
• Ensure Government, regulators, industry, consumers and academia work together

to identify financial system–wide opportunities and potential network benefits,
where Government may need to coordinate and facilitate industry action.
• Ensure financial system innovators, start-ups and/or firms with innovative

products have a single entry point for dealing with regulators and Government on
innovation and a forum in which their views can be heard.
Discussion
Innovation is an essential ingredient in building a dynamic, competitive,
forward-looking and growth-oriented financial system. Although the benefits of
innovation are difficult to quantify, efficiency gains and improved consumer
convenience are evident in a range of areas, such as online banking, payments and
insurance. As the pace of technology-enabled innovation accelerates, it is crucial that
Government and regulators be aware of, and enable, the benefits of innovation to flow
through the financial system while appropriately managing risks.

Low awareness of, and impediments to, innovation
For many innovators, the entry point into the Australian financial system is via
regulators: organisations with strong ‘safety’ mandates and generally low-risk
appetites. Stakeholder discussions indicate Government and regulators have limited
understanding of and openness to innovation, resulting in regulatory approaches that
unnecessarily impede innovation in some areas. In some cases, regulators may not
have regard to the whole-of-system benefits of innovation where such developments
fall beyond the breadth of their existing regulatory mandates.
Siloed perspectives and inability to identify system-wide opportunities

Existing Government structures and regulatory architecture tend towards a siloed
view of the financial system. They also have a low awareness of issues that are
increasingly important to the financial sector (but were not traditionally so), such as
data use and privacy. Lack of industry input and the absence of a system-wide
perspective hamper efforts to identify system-wide opportunities and network benefits
efficiently. Consequently, Government and regulators may fail to take timely, or any,
action to facilitate or coordinate innovation that is beneficial to consumers and overall
system efficiency.
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Inability to influence Government and regulators in a coordinated way

In the absence of a forum with a system-wide view, there is no mechanism to influence
Government and regulators when a coordinated change, a regulatory response or
harmonised processes are needed. In some cases, innovations do not clearly fit into
existing regulation or under the responsibility of a single regulator. For example,
elements of some payments system innovations (discussed later in this chapter) may
be affected by financial system licensing, taxation, and privacy and data requirements
that fall under the remits of several regulators and Government agencies.
No single point of contact for innovators

Lack of a single point of entry for innovators, start-ups and those with innovative
products can be a significant challenge given the complexity of regulation and
regulatory mandates. Stakeholders, particularly new entrants, point to a lack of
consolidated entry and liaison points where impediments can be discussed and, if
necessary, arguments put forward for their removal. Innovators often do not have a
voice with regulators or at regulatory forums and tend to have limited understanding
of regulation.
Potential impacts on international competitiveness

In many countries, policy settings are deliberately pro-innovation as governments seek
to foster dynamic, vibrant financial services sectors. In Asia, the monetary authorities
of Hong Kong, Singapore and Malaysia, for example, have statutory mandates to
promote and market financial sector development, including providing streamlined
entry points for new entrants. 2
The Financial Conduct Authority in the United Kingdom runs Project Innovate to
support industry innovation that improves consumer outcomes. 3 The United Kingdom
‘fintech’ industry also has its own industry body, Innovate Finance, to support
technology-led financial services innovators. 4,5 This body affords members a single
2 Hong Kong Monetary Authority 2014, Hong Kong as an International Financial Centre,
Hong Kong Monetary Authority, viewed 31 October 2014,
<http://www.hkma.gov.hk/eng/key-functions/international-financial-centre.shtml>;
Monetary Authority of Singapore 2014, Singapore Financial Sector, Monetary Authority of
Singapore, viewed 31 October 2014,
<http://www.mas.gov.sg/singapore-financial-centre.aspx>; Bank Negara Malaysia 2013,
Financial Sector Development, Bank Negara Malaysia, viewed 31 October 2014,
<http://www.bnm.gov.my/index.php?ch=en_fsd&pg=en_fsd_intro&ac=737&lang=en>.
3 Wheatley, M 2014, Making innovation work for firms and customers, address at Bloomberg by
Chief Executive, Financial Conduct Authority, 19 May, London.
4 ‘fintech’ refers to a synthesis of technology and financial services.
5 Innovate Finance 2014, Vision, Innovate Finance, viewed 16 October 2014,
<http://innovatefinance.com/#content-region>.
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point of access to regulators, policy makers, investors, customers, educators, talent and
commercial partners.
Conclusion
The pace of innovation in the financial sector is rapid. Estimates suggest $27 billion of
current banking industry revenue is under threat of digital disruption. 6 Accordingly,
Government and regulators need to be aware of innovative developments to respond
in a considered, timely and coordinated manner. Various industry bodies support
more collaboration between industry and policy makers. 7
With a mix of stakeholders, the recommended IC model merges industry and policy
expertise to help identify innovation opportunities. Innovators could access a forum
that offers them a better entry point to financial sector regulators and improves their
potential to influence across agencies — if necessary, through the CFR.
The Inquiry considered alternatives to the IC model, including a solely industry-led

model. However, with no direct link to Government, there was concern such a model
would have limited ability to influence policy. The Inquiry also considered extending
existing regulator mandates to include business promotion, as occurs in other
jurisdictions. Chapter 5: Regulatory system recommends ASIC’s mandate include a
specific requirement to consider competition issues, a complement to this
recommendation.
Industry should note that international experience suggests the best results for
collaboration occur where the fintech industry has its own representative body of
innovators and new entrants to ensure it can speak with a unified voice. Industry
representatives might then also be selected and rotated from this body for the IC.
6 KPMG 2014, Unlocking the potential: the Fintech opportunity for Sydney, The Committee for
Sydney, Sydney.
7 Refer, for example, to Australian Bankers’ Association 2014, Second round submission to the
Financial System Inquiry, page 80; Australian Payments Clearing Association 2014, Second
round submission to the Financial System Inquiry, page 16; Association of Superannuation
Funds of Australia 2014, Second round submission to the Financial System Inquiry,
page 117.
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Digital identity
Recommendation 15
Develop a national strategy for a federated-style model of trusted digital identities.
Description
Government should, in consultation with the private sector, develop a national

identity strategy based on a federated-style model in which public and private sector
identity providers would compete to supply trusted digital identities to individuals
and businesses. 8
Government should identify a minister responsible for the strategy. The strategy
should detail policy principles for the model (see below), intended outcomes, an
implementation approach, and a high-level structure for the trust framework 9 needed
to implement the model. Consideration should also be given to initial seed funding if
required; for example, for pilot projects.
The model should be:
• Voluntary, and enable consumer choice and convenience.
• Transparent and privacy enhancing.
• Cost effective, flexible and innovative, and enable the best use of technology.
• Secure, resilient and interoperable.
A joint public–private sector taskforce should be established to develop the detail of

the trust framework and standards required to deliver the model. Standards would
8 A federated model is a decentralised model where multiple identity credentials are

produced by government and commercial providers to provide access to public and private
sector services in a contestable market. In contrast, under a syndicated model, a single
identity credential is issued, typically by government, providing single sign-on access to
public and private sector services.
9 A trust framework is an agreed set of standards and rules that enables parties accepting
digital identity credentials to trust the identity, security, and privacy policies of parties
issuing credentials, and vice versa. OIX Open Identity Exchange 2014, Trust Frameworks,
OIX Open Identity Exchange, viewed 19 November,
<http://openidentityexchange.org/resources/trust-frameworks/>.
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need to address identity proofing, authentication, sharing of legal liability, fraud,

accreditation mechanisms for identity providers and the role of trust brokers.
Objectives
• Articulate a strategic vision and coordinated approach to digital identity
management in Australia that enables the development of a competitive, innovative
and dynamic market for identity services and maximises network benefits.
• Improve the efficiency of digital identity processes in the financial system,

minimise costs and regulatory burden for institutions, and draw on the respective
strengths and expertise of the public and private sectors.
• Facilitate innovation by improving consumer choice and convenience, and reducing

friction in the digital economy.
• Ensure digital identity management processes help to prevent crime, improve

security and enhance privacy.
Discussion
Box 8: The future of digital identity

Digital identity relates to how parties — whether individuals, businesses or
government — confirm the identities of other parties for online financial
transactions. Currently, this usually involves two main stages:
• Identity verification. For an individual, this is based on confirmation of
attributes such as name, date of birth and address using government-issued,
paper-based credentials like drivers’ licences and passports. Increasingly, these
attributes are able to be verified via online mechanisms.
• Identity authentication. After identity verification, the individual will usually be

issued with credentials they can use to authenticate they are the right person
when attempting to access a service. These credentials often include a user name
and password plus a token or e-certificate for additional security. Over time,
other methods incorporating biometrics may become more common.
The Inquiry’s recommended strategy for a federated-style system of trusted digital

identities would improve convenience and security for individuals by reducing
reliance on paper-based mechanisms; enhance privacy and enable consumer choice
in identity providers; improve efficiency by reducing repetitive processes
undertaken by individuals, businesses and government, and reducing the number
of credentials managed by each party; and facilitate innovation and best use of
technology through the development of a competitive market for identity services.
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Participants in Australia’s financial system have always needed, and continue to need,
confidence in peoples’ identities. Australia’s current identity infrastructure is
fragmented, consisting of a largely uncoordinated network of identity credentials. 10
The system has developed organically, driven by different standards, policies and
legislative requirements. Australia has no clear strategic vision for digital identity
management and, consequently, little coordination and limited ability to attain
potential network benefits that would lower costs and reduce duplicative processes.
Many public sector stakeholders have interests in digital identity management and,
although Government has some existing governance mechanisms, the lack of clear
ownership of identity policy is impeding progress.
Previous industry attempts to coordinate on identity issues have been unsuccessful,

such as the Trust Centre initiative announced in 2006 involving a number of the major
banks. Despite the potential efficiency benefits, competing commercial interests have
limited industry’s ability to collaborate. 11
Consumers’ preferences for accessing financial services online are increasing the need
for efficient and secure digital identity solutions. Australia’s current approach to
identity management results in significant process duplication, as individuals apply to,
and government and businesses undertake to, verify and re-verify identities at
multiple points. Traditionally, identity verification has involved paper-based and
face-to-face processes, which are slow and onerous for consumers, and costly and
cumbersome for organisations.
Of eight major streams of regulatory reform since 2005, research by the Australian
Bankers’ Association (ABA) shows industry project expenditure has been highest in
relation to the Anti-Money Laundering and Counter-Terrorism Financing Act 2006, which
includes Know Your Client (KYC) identification rules. 12 Anti-money laundering
(AML) projects have resulted in an estimated $725 million in expenditure (more than
10 No single government identity credential exists; instead, approximately 20 government

agencies manage more than 50 million core identity credentials. A comparable number of
credentials are also issued by private sector and other organisations. Sourced from
Attorney-General’s Department 2014, National Identity Proofing Guidelines, Draft Version 5.1,
Commonwealth of Australia, Canberra, page 3. Refer also to the Interim Report for further
discussion.
11 The 2006–07 Trust Centre was initiated by Westpac and involved St.George Bank, National
Australia Bank and the Commonwealth Bank. Refer to Finextra 2006, ‘Westpac backs
customer ID management initiative’, Finextra, 10 November, viewed 29 September 2014,
<http://www.finextra.com/news/fullstory.aspx?newsitemid=16141>; Finextra 2007,
‘Westpac exits The Trust Centre’, Finextra, 27 November, viewed 29 September 2014,
<http://www.finextra.com/news/fullstory.aspx?newsitemid=17782>.
12 Australian Bankers’ Association 2014, data provided to the Financial System Inquiry,
9 July 2014.
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three times as much as the next highest expenditure) related to the United States’
Foreign Account Tax Compliance Act, highlighting the KYC regulatory burden and
potential to reduce costs by improving identity processes. 13
Fraud concerns are increasing, and the Australian Institute of Criminology observes
that “Criminal misuse of identity not only impedes consumer activity and confidence
in the financial system, but costs business and government substantial sums in
responding to and preventing these crimes”. 14 In 2011, Australians lost an estimated
$1.4 billion through personal fraud incidents. 15 Each year, an estimated 4–5 per cent of
Australians experience identity crime resulting in financial loss. 16 Identity theft and
false identities are key enablers of superannuation fraud, and serious and organised
crime. 17 An enhanced digital identity infrastructure can help to reduce this risk.
Context
Existing elements for a federated-style model
Australia already has a number of elements in place for a federated-style system of
trusted digital identities, as set out in Table 7: Existing elements for a federated-style model.
13 The other six streams were the ePayments Code, Financial Claims Scheme, Future of
Financial Advice reforms, National Consumer Credit Protection Act 2009, over-the-counter
derivatives reforms and privacy reforms.
14 Smith, R G and Hutchings, A 2014, Identity crime and misuse in Australia: Results of the 2013
online survey, Research and Public Policy Series 128, Australian Institute of Criminology,
Canberra, page ix.
15 Australian Bureau of Statistics (ABS) 2012, Personal Fraud, 2010–2011, cat. no. 4528.0, ABS,
Canberra.
16 Attorney-General’s Department 2014, National Identity Proofing Guidelines, Draft Version 5.1,
Australian Government, Canberra, page 3.
17 Australian Crime Commission 2011, Organised Crime in Australia 2013, Australian
Government, Canberra, pages 26, 43–45, 78.
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Table 7: Existing elements for a federated-style model 18

Elements Description
Document Verification A secure online service that enables government agencies, financial
Service institutions and other businesses to verify information on identity
documents directly with the document issuing agency
Third Party Identity Services Framework and standards for accrediting commercial identity service
Assurance Framework providers, issued by the Department of Finance
National e-Authentication Framework and standards for authenticating the identity of another party
Framework to a desired level of assurance or confidence
National Identity Proofing A best-practice, risk-based approach for government to verify the identity
Guidelines of a person using evidence to meet the required level of assurance
Gatekeeper Public Key A framework that enables accredited third parties to provide digital
Infrastructure Framework certificates for verifying and authenticating identity when dealing with
public sector agencies
myGov digital credentials Provides secure single sign-on access to various government services
including Medicare, Centrelink, electronic health records, the Australian
Taxation Office, and a digital mailbox to receive government
correspondence
VANguard Delivered by the Department of Industry, VANguard acts as a ‘trust
broker’ for business-to-government and government-to-government
transactions. It provides authentication services that enable government
agencies to accept a business user’s previously established digital
credentials such as AUSkey, Medicare and Verisign
Australian Business Register Provides business identification services for dealing online with
government, including issuance of a unique identifier, known as an
Australian Business Number (ABN)
AUSkey Linked to the ABN, AUSkey is a secure digital credential that
authenticates the identity of businesses for online transactions with
Commonwealth, state, territory and local government agencies
Private sector digital identity Many private sector organisations, such as banks, already have
credentials high-quality and high-assurance digital credentials in place
International and other developments

Other countries have adopted various approaches to digital identity. As noted in the
Interim Report, the United States, the United Kingdom and Canada have adopted
federated models. New Zealand, India and Estonia have syndicated models, with
high-assurance, government-issued credentials incorporating biometrics designed to
18 Based on a number of Australian Government sources: Attorney-General’s Department

(AGD) 2013, Documentation Verification Service — About DVS, Canberra; Australian
Government Information Management Office (AGIMO) 2013, Third Party Identity Services
Assurance Framework, Department of Finance, Canberra; AGIMO 2009, National
e-Authentication Framework, Department of Finance and Deregulation, Canberra; AGD 2014,
National Identity Proofing Guidelines, Draft Version 5.1, Canberra; AGIMO 2009, Gatekeeper
Public Key Infrastructure Framework, Department of Finance and Deregulation, Canberra;
Australian Government, About myGov, Canberra; Australian Government, VANguard
Government Authentication Services: About us, Canberra; Australian Business Register 2014,
Second round submission to the Financial System Inquiry.
155
enable digital service delivery. Private sector initiatives include the work of
organisations such as the FIDO Alliance, Open Identity Exchange and Edentiti. 19
For entity identification, international developments include initiatives to develop a

Global Legal Entity Identifier System to provide unique identifiers to companies
participating in global financial markets. 20 The aim is to create legal entity identifiers
for each entity to enable improved efficiency in global transactions.
Rationale
Developing a national identity strategy based on a federated-style model, with a
framework and common standards, would support the growth of a competitive
market in identity services that enables best use of technology and promotes
innovation. A federated-style model suits the Australian context as Australia has not
had a history of government-issued identity cards and has a strong privacy ethos
compared to other jurisdictions. This model has the potential to provide consumers
with choice and convenience while enhancing privacy. Australia already has in place
many foundational elements for a federated-style system, and this model seeks to
leverage and build on these existing effective elements.
Options considered
The Inquiry considered different models as a basis for a national digital identity
strategy:
1. Recommended: Develop a national identity strategy based on a

federated-style system in which public and private sector identity providers
compete to supply trusted digital identities to individuals and businesses.
Government (in consultation with the private sector) sets up a trust framework
and standards to facilitate a competitive market in identity services, and
enable consumer and business choice in credentials.
2. Develop a national identity strategy based on a syndicated model in which a

single government identity credential is issued to provide individuals (and
businesses) with single sign-on access to public and private sector services.
19 FIDO Alliance 2014, About the FIDO Alliance, FIDO Alliance, viewed 1 October 2014,
<https://fidoalliance.org/about>; Open Identity Exchange (OIX) 2014, About, OIX, viewed
1 October 2014, <http://openidentityexchange.org/about/>; Edentiti 2014, Home, Edentiti,
viewed 1 October 2014, <http://www.edentiti.com/edentitisite/index.html#home>.
20 Legal Entity Identifier Regulatory Oversight Committee (LEIROC), The Legal Entity Identifier
Regulatory Oversight Committee — LEIROC, LEIROC, viewed 1 October 2014,
<http://www.leiroc.org/>.
156

National strategy for a federated-style identity model
Developing a national strategy in consultation with the private sector would support
both common understanding and stakeholder buy-in. Innovation would be enhanced
by a competitive market for identity providers. Several submissions note the
importance of enabling continuing innovation in identity solutions. 21 One industry
body has already indicated its willingness to help coordinate industry-wide views. 22
Another stakeholder supports a decentralised model, as relying on multiple possible
corroborating sources of identity may prove more secure over the long term. 23
Currently, identity must be verified and authenticated at multiple points during the
provision and consumption of financial services. A streamlined process would reduce
the high compliance costs associated with AML KYC requirements. Within
Government services, improvements in identity management are already delivering
significant efficiency gains, as shown in Box 9: myGov case study — quantification of
efficiency benefits below. The efficiency benefits of implementing coordinated digital
identity management across the entire financial system are likely to be many multiples
of the estimates shown below.
21 Refer, for example, to National Seniors Australia 2014, Second round submission to the
Financial System Inquiry, page 30; Centre for Digital Business 2014, Second round
submission to the Financial System Inquiry, page 24.
22 Australian Payments Clearing Association 2014, Second round submission to the Financial
23 Centre for International Finance and Regulation 2014, Second round submission to the
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Box 9: myGov case study — quantification of efficiency benefits

myGov is an online gateway to multiple government services using a single set of
digital credentials. Almost one in three adult Australians are now registered to
access government services via myGov. 24 The Department of Human Services
conservatively estimates that myGov will generate around $547 million in efficiency
savings and reduced red tape burden over 10 years, as shown in the table below. 25
Considerable work is underway to simplify digital identity processes and expand
the usage of myGov to other government agencies at both the Commonwealth and
state/territory levels. myGov’s efficiency benefits indicate it has the potential to play
an ongoing and significant role in Australia’s future identity model.
myGov element Efficiency improvements Average annual savings
1. Account creation Time, cost and resource savings from reduced $1.7 million
and linking duplication in identity verification processes and
creation of accounts
2. Account Time, cost and resource savings from having a $28 million
management single account and set of credentials rather than
multiple accounts
3. Easy access to Improved convenience and time savings to $9 million
multiple services authenticate identity for linked services
4. Easy access to Improved convenience and time savings with $2 million
digital mail single log-in to one mailbox for all linked
services
5. Managing mail Time savings from single mailbox and reduction $14 million
in managing physical mail
Enhanced digital identity processes improve efficiency and security across the digital
economy. Even in the current fragmented identity environment, one firm’s shift to
electronic methods for identity verification has reduced costs by more than
30 per cent. 26 This firm also observed that 86 per cent of fraud and suspected money
laundering events occurred where accounts had been established using face-to-face
document verification after initial electronic verification failed. In contrast, 14 per cent
of fraud and suspected money laundering events occurred when accounts had been
opened using electronic verification. 27 A number of submissions note that increased
24 PSnews online 2014, ‘myGov users pass five million’, PSnews online, 30 September, viewed
2 October 2014,
<http://www.psnews.com.au/aps/Page_psn4292.html?utm_source=psn429&utm_medium=
email&utm_content=news2&utm_campaign=newsletter_aps>.
25 Department of Human Services 2014, data provided to the Financial System Inquiry,
23 September 2014.
26 ING Bank Australia 2014, Second round submission to the Financial System Inquiry, page 1.
27 ING Bank Australia 2014, Second round submission to the Financial System Inquiry, page 1.
158
access to government data would also improve data matching rates for identity
verification. 28
A federated-style identity model would involve implementation and set-up costs for
both Government and the private sector. This would include the initial investment to
develop a trust framework. Appropriate privacy protections and mechanisms would
need to be considered to maintain consumer confidence and trust in the system.
Mechanisms for ongoing public–private sector collaboration and review could also be
required.
National strategy for a syndicated identity model

A syndicated (centralised) system of digital identity across public and private sector
services has the potential to generate the most significant network benefits. One
submission advocated developing a single database for KYC to meet all local and
global identity requirements to maximise cost savings. 29 However, a syndicated model
with a high-assurance digital identity for use across the economy also involves
significant costs for Government and potentially the private sector.
Public sector stakeholders indicate that current Government deployment of identity

services could not be expanded simply. It would require significant further investment
to ensure adequate assurance levels. For the private sector, a Government-operated
system could present costs in terms of adapting to Government-issued credentials and
future flexibility. It could impede the adoption of innovative solutions and deployment
of the best available technology, reducing overall efficiency over time.
Many Australians may object to this option on the basis of privacy concerns. It could
be viewed as a digital version of the unpopular Australia Card initiative, which was
rejected in 1987, or the Access Card, which was terminated in 2007. 30,31
Conclusion
A national strategy based on a federated-style model best balances the attainment of
network benefits with ongoing innovation in digital identity solutions, contributing to
overall financial system efficiency. It draws on the strengths of the public and private
28 Refer, for example, to Association of Superannuation Funds of Australia 2014, Second round
submission to the Financial System Inquiry, page 121; and ING Bank Australia 2014, Second
29 Stockbrokers Association of Australia 2014, Second round submission to the Financial
30 Fraser, A 2014, ‘MPs urged to spruik doomed Australia Card’, The Australian, 1 January,
viewed 1 October 2014,
<http://www.theaustralian.com.au/in-depth/cabinet-papers/mps-urged-to-spruik-doomed-
australia-card/story-fnkuhyre-1226792641896>.
31 Centre for Digital Business 2014, Second round submission to the Financial System Inquiry,
page 9.
159
sectors and facilitates the best use of technology. It enhances consumer choice and
convenience and, with appropriate design, could enhance privacy and security.
A coordinated approach would also facilitate innovation across the broader economy
by helping to reduce ‘e-friction’.
A syndicated model potentially presents significant network benefits. However, there

would be a trade-off with ongoing innovation in digital identity solutions, as the
Government-issued identity credential would be locked in as the single solution across
the system and any innovative changes would need to be driven by Government.
Maintaining such a solution would be at significant cost to Government, could
produce less flexible outcomes and could impede the continued best use of technology.
Over time, this could result in less efficient outcomes for the financial system
compared with a federated-style model.
The Inquiry believes a federated-style model is preferable on the basis of cost,

innovation and efficiency, and future flexibility for consumers, businesses and
Government.
Public–private sector taskforce and timing
The Inquiry recommends establishing a joint public–private sector taskforce with a set
operating time frame; for example, over a 12-month period concluding at the end of
2015. The taskforce should consist of public and private sector stakeholders and, where
possible, be representative of multiple sectors and levels of government. Terms of
reference should be published and include dates for major milestones.
The taskforce should select a small number of pilot programs to be completed over the
next two years to inform its development of the trust framework. It should consider
whether any interim steps are needed to prepare for implementing the digital identity
model. Steps might include amending AML KYC requirements, expanding
government datasets included in the Document Verification System (DVS), enabling
broader access to DVS, and changing privacy requirements for access to, and use of,
certain datasets.
The taskforce should also consider establishing a mechanism to enable private sector
input into the ongoing review and maintenance of the trust framework to ensure it
remains fit for purpose.
160
Clearer graduated payments regulation
Recommendation 16
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.
Description
Australia has a complex framework for regulating payments. Relevant provisions are
contained in numerous laws, regulations and instruments administered by ASIC,
APRA and the Payments System Board (PSB).
• The regulators should publish a clear guide to the framework for industry, and in
particular for new entrants, that outlines thresholds and regulatory requirements.
Government and ASIC, in consultation with the other regulators, should simplify and
improve consumer protection regulation for retail payment service providers. 32 In
doing so, they should make the following changes:
• Narrow the AFSL regime for non-cash payment facilities so that only service
providers that provide access to large, widely-used payment systems require an
AFSL. This would remove the need to exempt services linked to small payment
systems from the regime, such as public transport cards and road toll devices.
– The thresholds of ‘large’ and ‘widely used’ could cover a system providers with
annual transaction values over $100 million and more than 50 payee groups or
annual transaction values over $500 million and more than five payee groups.
– The definition of a payee group should be designed from the customer’s

perspective. A system that provides access to several merchants would be
32 For the two payments recommendations, the term ‘service providers’ refers to entities that
enable end-users (consumers and businesses) to make and receive payments in payment
systems. The most common example of a service provider is a Bank. See Figure 10: Overview
of the payments system and Figure 11: Retail payments system fees and charges for more
information.
161
considered to provide access to a single payee group where the customer

associates the merchants with a single merchant brand. 33
– Thresholds should be designed to provide clear guidance for new entrants,

rather than to substantially alter the current regulatory perimeter.
• Government and ASIC should extend basic consumer protection regulation under
the currently voluntary ePayments Code to all service providers. 34
APRA, in consultation with other regulators, should develop a separate, two-tier

prudential payments regime for purchased payment facilities (PPFs) 35 to replace the
current single-tier regime, which is a modified version of the authorised deposit-taking
institution (ADI) regime. 36
• The new regime would offer PPFs a choice between two tiers. The lower tier would
maintain the current 100 per cent liquidity ratio requirement but reduce other
prudential requirements to lower compliance costs. The higher tier would reduce
liquidity requirements but strengthen other prudential requirements. Lower
liquidity requirements would ensure competitive neutrality between PPFs and
other ADI service providers.
• APRA should publish clear thresholds for the new regime so that it only captures
PPFs of sufficient scale. For example, it could only apply to PPFs that hold more
than $50 million of stored value and enable individual customers to hold more than
$1,000. 37 APRA should remove exemptions for services providers that do not allow
deposits to be redeemed for Australian currency. 38
The regulators should review the extent to which their current powers enable them to
regulate system and service providers using alternative mediums of exchange to
33 An example is a gift card grouping several merchants under a single shopping centre brand,
or a frequent flyer program providing access to several merchants.
34 The ePayments Code is enforced by ASIC and provides some consumer protections. The
code provides guidance for setting and changing terms and conditions, and rules for
determining who pays for unauthorised transactions and recovering mistaken internet
payments.
35 PPFs hold stored value relating to payment systems but are not traditional ADIs. An
example is PayPal.
36 Some payments systems use ADI accreditation as a means of assurance for providing access
their systems. The PSB should work with industry to ensure that entities regulated under
the new two-tier regime, as well as entities that will shortly no longer require a specialist
credit card institution ADI licence, will still be able to access core payments infrastructure,
including the New Payments Platform.
37 The current prudential threshold for stored-value holdings is $10 million.
38 This could result in prudential regulation applying to some service providers, such as
providers of prepaid cards that operate on widely-used systems.
162
national currencies, such as digital currencies. 39 For example, the RBA should review
the definitions in the Payment Systems (Regulation) Act 1998 to ensure they are
sufficiently broad.
Objectives
Ensure retail payments system regulation:
• Maintains confidence and trust in the payments system.
• Is better understood by industry, particularly new entrants, and accommodates

rapid market development.
• Provides adequate consumer protections.
• Provides competitive neutrality for PPFs.
Discussion
Given its vital role in the economy, the payments system must be efficient and trusted.
Currently, Australia’s payments industry is undergoing rapid innovation, giving
consumers access to an increasing array of online and mobile payment options.
Over the past five years, the volume of non-cash payments in Australia has grown at
an annual rate of 8–9 per cent. 40
Payments system regulation needs to be able to accommodate future changes in

structure and technology. Figure 10: Overview of the payments system presents an
overview of Australia’s payments system. In the past, regulation focused on ADIs
(Area A), which were the main service providers. But now, non-traditional business
models have emerged (Areas B to E). The Inquiry expects that new PPFs (Area C) will
emerge in the future, including PPFs that may be attached to supply chains and other
on-line purchasing systems.
Some payment systems also incorporate new mediums of exchange such as digital
currencies. International peer-to-peer networks that process digital currency payments
on distributed ledgers (Area D) are difficult to regulate because there is no clearly
identifiable operator. 41 However, commercial services using digital currencies in
‘closed loop’ systems (Area C) could be regulated like other retail payment services.
39 An example of a digital currency is Bitcoin.

40 Reserve Bank of Australia (RBA) 2014, Payments System Board Annual Report, RBA, Sydney,
page 19.
41 A distributed ledger is a public ledger for determining who owns an asset — in this case, a
digital currency. Transactions are processed by open-source peer-to-peer systems and then
recorded on public ledgers, of which several copies are held by users of the system.
No single party operates the system or is responsible to its users.
163
Figure 10: Overview of the payments system
Although payment services linked to funds at risk in investment products (Area B) are
rare, these could grow in the future. Eventually, these could be linked to managed
investment schemes (MISs), as well as superannuation funds, allowing members to
make payments with their superannuation balances during the drawdown phase. 42
Regulation should not impede such developments.
42 The Inquiry’s recommendation would ensure that basic consumer protections would apply
to these service providers, but would not affect how these service providers are prudentially
regulated, as the funds used for making payments would not be considered ‘stored value’.
164

Some submissions note that current retail payments system regulation is fragmented,
complex and lacks clarity. 43 It is not always applied on a functional basis and may not
accommodate future innovation, such as digital currencies.
Elements of graduated, functional regulation exist. However, regulation generally

lacks clear criteria and transparent thresholds. Combined with regulator discretion in
administering the law, this generates complexity and uncertainty, particularly for new
entrants.
The ePayments Code provides some consumer protections; however, it is not

mandatory and as such does not cover all consumers. 44 The application of the AFSL
regime is complex and costly. ASIC has given multiple class orders and individual
exemptions because the breadth of current regulation captures entities that should not
need an AFSL. 45
Before the Wallis Inquiry, participation in payment systems tended to be restricted to

banks. Reforms post-Wallis sought to expand access to payment systems, but
recognised that this could involve entities holding funds equivalent to deposits.
Government sought to address this issue by introducing a prudential regime for PPFs.
However, the scope of the prudential regime for PPFs is unclear because it involves a
number of exemptions and declarations. 46 The current PPF regime also involves
significant compliance costs and does not provide competitive neutrality with other
ADIs. Although PPFs have simpler capital requirements than traditional ADIs, they
have significantly stricter liquidity requirements. 47 This can place PPFs at a
competitive disadvantage and provides a perverse incentive for smaller service
providers to limit their growth to avoid entering the PPF regime.
43 For example, refer to Australian Payments and Clearing Association 2014, Second round
submission to the Financial System Inquiry, pages 10–11.
44 Examples of non-subscribers to the ePayments Code include a three-party system provider
as well as some banks, credit unions, building societies and finance companies.
45 This has included relief for gift cards, prepaid mobile accounts, loyalty schemes and
electronic road toll devices. For further details, refer to Australian Securities and Investment
Commission (ASIC) 2005, Regulatory Guide 185, Non-cash payment facilities, ASIC, Sydney.
46 For example, whether a PPF is redeemable for Australian currency currently determines
whether that facility falls within APRA’s prudential regime or whether it should be subject
to RBA authorisation. To date, exemptions and declarations have meant that no PPFs are
authorised by the RBA.
47 PPFs must hold high-quality liquid assets that are of equal value to their stored-value
liabilities, while standard ADIs have lower liquidity requirements.
165
Options considered
The Inquiry considered maintaining the existing approach of using various
exemptions to narrow the scope of the AFSL regime to target the entities that should
be regulated. Although this would involve relatively small costs over the immediate
term, the complexities and impediments to innovation that the current approach
creates would grow over time. A more transparent approach to regulation that does
not require exemptions would improve industry understanding and provide greater
certainty. The Inquiry also considered maintaining the voluntary nature of the
ePayments Code as an alternative to extending it to all service providers. However, the
Inquiry believes the ubiquity of electronic payments necessitates consistent consumer
protections to maintain confidence and trust in the system.
The Inquiry also considered maintaining the current prudential regime for PPFs as
well as reducing the liquidity requirements of the current regime. However, both
approaches maintain relatively high compliance costs for PPFs with simple business
models. The recommended two-tier approach allows PPFs to trade off compliance
costs and competitive neutrality to suit their business models, rather than have
regulation determine this for them. The Inquiry also considered maintaining the
current thresholds and exemptions for applying prudential regulation, but these create
uncertainty for industry. Increasing thresholds ensures smaller service providers are
not unintentionally captured.
Regulators should review the extent to which their current powers enable them to
regulate system and service providers using alternative mediums of exchange to
national currencies, such as digital currencies. The Payment Systems (Regulation)
Act 1998 empowers the PSB to regulate “funds transfer systems that facilitate the
circulation of money”. It is not clear that the PSB can regulate payment systems
involving alternative mediums of exchange that are not national currencies. Currently,
national currencies are the only instruments widely used to fulfil the economic
functions of money — that is, as a store of value, a medium of exchange and a unit of
account. 48
Digital currencies are not currently widely used as a unit of account in Australia and as
such may not be regarded as ‘money’. However, their use in payment systems could
expand in the future. It will be important that payments system regulation is able to
accommodate them, as well as other potential payment instruments that are not yet
conceived. Current legislation should be reviewed to ensure payment services using
alternative mediums of exchange can be regulated — from consumer, stability,
competition, efficiency and AML perspectives — if a public interest case arises. This
review could take place within a broader review of the system’s capacity to
accommodate future payment systems.
48 Robleh, A 2014, ‘The economics of digital currencies’, Bank of England Quarterly Bulletin, Q3,
Vol 54, No. 3.
166
Conclusion
The recommended approach to clearly graduate regulation provides increased
certainty to industry while accommodating innovation. The functional criteria for
determining when regulation should apply are broad so thresholds can be adjusted to
reflect market developments.
Replacing piecemeal exemptions in the AFSL regime with functional regulation would
improve efficiency and ensure current and future business models are appropriately
regulated. Extending the ePayments Code to all service providers would help protect
all consumers from fraud and unauthorised transactions.
Giving PPFs flexibility could generate lower compliance costs, enhance competitive
neutrality and better facilitate participation from non-traditional financial institutions,
supporting innovation and competition.
Ensuring current regulation can accommodate services using alternative mediums of

exchange would support innovation and confidence in the payments system.
167
Interchange fees and customer surcharging
Recommendation 17
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.
Description
To improve the transparency and efficiency of interchange fee regulation, 49 the PSB
should consider:
• Publishing thresholds for determining which system providers will be regulated.
• Broadening interchange fee caps to include all amounts paid to customer service
providers in payment systems, 50 including service fees in companion card
systems. 51
• Lowering interchange fees by reducing interchange fee caps, but also:
– Replacing three-year weighted-average caps with hard caps, so every

interchange fee falls below the interchange fee caps. This would also reduce
differences in fees paid by small and large merchants.
– Applying caps as the lesser of a fixed amount and a fixed percentage of

transaction values, instead of only one of these components. 52 This would also
49 Interchange fee regulation is enforced through standards that cap interchange fees paid by
merchant service providers to customer service providers (see Figure 11: Retail payments
system fees and charges). The caps are currently applied on a three-year weighted-average
basis. The caps are 12 cents per transaction for debit systems and 0.5 per cent of transaction
values for credit systems.
50 That is, all amounts paid by merchant service providers and system providers to customer
service providers.
51 These are individually negotiated fees between payments system operators and customer
service providers rather than centrally established fees.
52 The proposal would add a fixed-percentage component to debit system caps (which already
have a fixed-amount component) and a fixed-amount component to credit systems (which
already have a fixed-percentage component).
168
increase the use of electronic payments for smaller-value transactions and

ensure fees reflect costs for larger-value transactions. 53
The Inquiry considers that surcharging regulation should ensure merchants can
surcharge to reflect their relative costs of accepting different payment methods. 54 This
could be better achieved by providing merchants with clearer surcharging limits,
which could reduce over-surcharging and improve enforceability. To implement this,
the PSB should consider allowing:
• Low-cost system providers, such as systems subject to debit interchange fee caps, to
prevent merchants from surcharging. This would prevent customers from being
surcharged for using low-cost payment mechanisms that involve minimal
acceptance costs for merchants, relative to other payment methods.
• Medium-cost system providers, such as systems subject to credit interchange fee

caps, to apply surcharge limits set by the PSB. This would make it easier to prevent
over-surcharging, while still allowing merchants to reflect their relative costs of
accepting different payment methods.
• Higher-cost system providers to continue to apply reasonable cost-recovery rules.

This would give merchants the flexibility to reflect the different costs of higher-cost
payment methods.
The PSB should consider whether mechanisms are required to prevent merchants from
only accepting payment methods they can surcharge. The PSB may also wish to
consider other alternatives to improve the accuracy and efficiency of surcharging.
Objectives
• Clarify regulation and enhance competitive neutrality between system providers.
• Improve the efficiency and effectiveness of price signals, and reduce the potential
for cross-subsidisation between customer groups and merchant groups.
53 This proposal would have a greater impact on credit systems than debit systems. If the PSB
is inclined to implement this proposal for credit systems, it may wish to phase in fixed-value
caps to smooth transitional costs.
54 Surcharging regulation is enforced through standards that currently prevent system
providers from banning merchants from surcharging, while still allowing system providers
to restrict merchants from surcharging above their reasonable cost of accepting different
payment methods (see Figure 11: Retail payments system fees and charges).
169
The scenarios set out in Box 10 illustrate some of the practical outcomes these
proposals could achieve, particularly in reducing costs and over-surcharging.
Box 10: Cameos on how the proposed reforms would improve outcomes
170
Discussion
Following the Wallis Inquiry, Australia was one of the first countries to implement
interchange fee caps. Interchange fee caps have since become more common and are
currently applied in 38 jurisdictions. 55
As outlined in the Interim Report, the Inquiry believes interchange fee caps improve
the efficiency of the payments system. 56 Without interchange fee caps, price signals for
customers are less clear and outcomes are less efficient because customers can be
encouraged to use higher-cost payment methods.
Figure 11: Retail payments system fees and charges shows the cycle of potential fees and
charges involved in payment systems. For each transaction they accept, merchants
(Box E) pay merchant service fees to merchant service providers (Box D), which in turn
pay interchange fees to customer service providers (Box B). Customer service
providers can then pass some of this revenue on to customers (Box A) in the form of
reward points and other benefits.
Merchants can complete this cycle by surcharging their customers to recoup their
transaction acceptance costs. However, this can be difficult when the system provider
has high market penetration, as surcharging can cause the customer to switch to
another merchant that does not surcharge. 57 Merchants can either absorb the costs of
high-reward payment methods (involving high interchange fees and therefore high
merchant service fees) or pass them on to all customers in the form of higher prices.
Interchange fee caps restrict this cycle by limiting how much revenue customer service
providers can pass on to customers using higher-cost payment methods, in the form of
reward points or other benefits.
Some submissions argue that, rather than reducing the prices merchants charge for
their products, interchange fee caps increase merchant profit margins. 58 They note that
there is a lack of clear evidence showing caps have reduced product prices. Although
caps are unlikely to result in immediate price reductions, the Inquiry agrees with the
55 Hayashi, F, Maniff, J 2014, Interchange fees and network rules: a shift from antitrust litigation to
regulatory measures in various countries, Federal Reserve Bank of Kansas City, Kansas City,
page 1.
page 2-28.
57 The Inquiry has received confidential feedback from merchants, including large merchants,
that feel unable to surcharge customers due to the risk of losing customers.
58 For example, see Visa 2014, Second round submission to the Financial System Inquiry,
page 14; MasterCard 2014, Second round submission to the Financial System Inquiry,
page 6.
171
RBA that the competitive process should drive down prices over time and improve
efficiency. 59
Some jurisdictions, particularly the European Union, are now implementing lower
interchange fee caps than Australia and applying caps more functionally to capture all
amounts paid to customer service providers. 60 The European Union is also considering
allowing interchange fee–regulated system providers to impose more prescriptive
surcharge rules on merchants.
Figure 11: Retail payments system fees and charges
page 4.
60 European Commission 2013, New rules on Payment Services for the benefit of consumers
and retailers, media release, 24 July, Brussels, viewed 18 November,
<http://europa.eu/rapid/press-release_IP-13-730_en.htm?locale=en>.
172

Interchange fee caps
Thresholds for interchange fee regulation. Currently, the rationale for limiting
interchange fee regulation to selected system providers lacks transparency. Publishing
thresholds for designating system providers for interchange fee standards would give
system and service providers, particularly new entrants, certainty about how
regulation is applied. This would support innovation by enabling providers to plan for
future growth and development, and would also enhance competitive neutrality.
Thresholds could be based on a combination of system providers’ annual transaction
values and market shares.
Broadening interchange fee caps to include all payments made to customer service
providers. Incentive payments used in most systems and service fees used in
companion card systems can achieve the same outcome as interchange fees; however,
they are not currently captured by interchange fee caps. Applying interchange fee caps
on a broader functional basis would help prevent alternative payments from avoiding
caps and provide competitive neutrality for four-party and companion card payments
system providers.
Lowering interchange fee caps. Payments system efficiency could be increased by

lowering interchange fee caps. The Inquiry acknowledges that lowering interchange
fee caps would disrupt business models and involve transitional costs. Lower
interchange fee flows may cause some service providers to reduce customer rewards.
The Inquiry considers that these costs would be outweighed by lower product prices
for all consumers, resulting from lower fees charged to merchants, and reduced
cross-subsidisation.
Replacing three-year weighted-average caps with hard caps. The current approach of
using three-year weighted-average caps enables system providers to meet the caps by
charging high fees for transactions involving smaller merchants without market
power, while setting low fees for merchants with market power and high transaction
volumes. 61 Introducing hard caps would help address this imbalance while also
reducing total interchange fees.
Applying caps as the lesser of a fixed amount and a fixed percentage of transaction
values. Applying fixed-percentage caps to debit systems, in addition to existing
fixed-value caps, would ensure low fees for small value transactions. This would
increase the rate of merchants accepting these transactions. Applying fixed-value caps
to credit systems, in addition to fixed-percentage caps, would ensure the proportional
cost of fees decreases as the value of transactions rises, better aligning fees with the
costs of processing transactions. However, this could significantly affect some credit
61 American Express 2014, Second round submission to the Financial System Inquiry, page 13.
173
card system and service providers. If the PSB is inclined to implement this approach, it
should phase in fixed-value caps to smooth transitional costs.
The Inquiry considered banning interchange fees altogether. This could improve
efficiency by forcing customers and merchants to pay directly for the benefits they
each receive. There are examples of payment systems operating without interchange
fees in other countries. 62 However, the Inquiry considers that banning interchange fees
would have high transitional costs. Instead, the Inquiry recommends that the PSB
consider reducing interchange fees in the short term, and then consider further
lowering fees in the longer term, depending on market conditions.
Table 8: Summary of interchange fee cap options

Option Potential for Competitive Simplicity and Compliance
inefficient neutrality for clarity of costs
63
cross-subsidies system providers regulation
Recommended
Broaden Reduced Increased No change Transitional costs
application of
caps
Lower caps Reduced No change No change Transitional costs
Introduce hard Reduced No change Increased Transitional costs
caps
Apply caps as Reduced Increased Decreased Transitional costs
lesser of fixed (larger for credit
amount and systems)
fixed percentage
Alternative
Ban interchange Significantly No change Increased High transitional
fees altogether reduced costs
Remove Significantly Increased Significantly Decreased
interchange fee increased increased
caps
Customer surcharging standards

Functional application of surcharging standards. Merchant surcharging standards do
not currently apply to all system providers. This allows unregulated system providers
to ban merchants from surcharging, even if they operate higher-cost systems.
62 For example, domestic debit card systems in Canada, New Zealand, Norway, Luxembourg,
Finland and Denmark have set their interchange fees to zero. Hayashi, F, Cuddy, E 2014,
Credit and Debit Card Fees in Various Countries, Federal Reserve Bank of Kansas City,
Kansas City, page 5.
63 This includes cross-subsidies between customers using lower-cost and higher-cost payment
methods, and between smaller and larger merchants.
174
Applying surcharging standards to all system providers would address this concern
and ensure consistency for merchants and customers.
Providing clearer surcharging limits. The Inquiry agrees with the RBA that
surcharging can improve the efficiency of the payments system by providing accurate
price signals to customers. 64 In addition, some consumer groups, such as Choice,
acknowledge that accurate surcharging can provide positive outcomes. 65
However, the current reasonable cost surcharge rules are difficult for system providers
to enforce, potentially complex for merchants to comply with and can cause frustration
for consumers, as evidenced by the more than 5,000 submissions the Inquiry received
on the matter. 66 The rules are complex because each merchant needs to calculate its
acceptance costs, which can involve subjective judgements about a number of factors. 67
The rules are difficult to enforce because system providers have limited visibility of
these calculations.
The Inquiry proposes that the PSB consider the following alternative arrangements to
simplify compliance and improve the accuracy of surcharging:
• Allow low-cost system providers to ban surcharges to encourage consumers to use

low-cost payment methods. System providers could qualify as ‘low-cost’ if their
interchange fees are below debit interchange fee caps. To ensure competitive
neutrality, three-party systems could qualify if the costs they charge merchants are
equivalent to those of other low-cost system providers.
• Allow medium-cost system providers to enforce set surcharge limits to simplify

surcharging for merchants and improve customer understanding. The PSB could
set limits to approximate payment acceptance costs. System providers could qualify
as ‘medium-cost’ if their interchange fees are below credit interchange fee caps. To
ensure competitive neutrality, three-party systems could qualify if the costs they
charge merchants are equivalent to those of other medium-cost system providers.
• Allow higher-cost system providers to continue to enforce reasonable

cost-recovery surcharging rules but require them to disclose this so their customers
page 6.
65 Choice 2014, Second round submission to the Financial System Inquiry, page 22.
66 These submissions were part of a campaign against surcharging, which encouraged
submissions to the Inquiry. The organiser of the campaign provided a submission:
Bartosch, K 2014, Second round submission to the Financial System Inquiry.
67 Reserve Bank of Australia (RBA) 2012, Guidance Note: Interpretation of the Surcharging
Standards, RBA, viewed 3 November 2014,
<http://www.rba.gov.au/payments-system/reforms/cards/201211-var-surcharging-stnds
-guidance/guidance-note.html>.
175
better understand why they may be surcharged. Although this retains the
weaknesses of the current arrangements, it would be difficult to determine fixed
surcharging limits for different higher-cost system providers. Maintaining the
current arrangements would give merchants the flexibility to surcharge for the
different acceptance costs of higher-cost payment systems.
These options could reduce over-surcharging by giving merchants clearer guidance on

maximum surcharge limits. They would allow customers to avoid paying surcharges
by using low-cost payment methods. The PSB should also consider whether
mechanisms are required to prevent merchants from only accepting payment methods
they can surcharge.
These new rules would be easier to comply with and enforce as merchants, system
providers and customers would know the surcharge limits for low- and medium-cost
payment methods.
These proposals would make surcharging arrangements more effective, but not
perfectly accurate. The PSB would need to estimate set surcharge limits for
medium-cost systems and equivalent acceptance costs for three-party systems. A
transitional period would be needed to give merchants and service providers time to
adapt to the new rules. The Inquiry supports the PSB considering these proposals in
greater detail and implementing a solution that improves the effectiveness of
surcharging.
Enforcing reasonable cost surcharge limits. The Inquiry considered imposing the
current reasonable cost surcharging rules through Government regulation. However,
regulators indicated this would involve considerable administration costs, as
reasonable acceptance costs would need to be determined on a case-by-case basis. This
option would also require strengthening regulators’ powers to seek documents to
prove over-surcharging, and creating new penalties to discourage over-surcharging.
Conclusion
The proposals for interchange fee standards should improve clarity, enhance
competitive neutrality, improve the efficiency of price signals and reduce
cross-subsidisation. The proposals for surcharging standards should make surcharging
standards simpler and more accurate, while encouraging system providers that are not
subject to interchange fee standards to reduce their costs.
176
Crowdfunding
Recommendation 18
Graduate fundraising regulation to facilitate crowdfunding for both debt and equity and,
over time, other forms of financing.
Description
Government should continue its current process to graduate the fundraising regime to
facilitate securities-based crowdfunding. This would enable entities to make public
offers of securities to a potentially large number of people (the ‘crowd’). The risks
associated with crowdfunding investments would require some adjustments to
consumer protections, including capping individuals’ investments and clearly
communicating the risks.
Government should then use the policy settings for securities as a basis to assess wider
fundraising and lending regulation to ensure it facilitates other forms of
crowdfunding, including peer-to-peer lending.
A range of crowdfunding models is emerging globally. Crowdfunding facilitates the

funding of projects or businesses, where small amounts of money are raised from the
‘crowd’ via an online facilitator (or platform). 68 Financial crowdfunding models
include:
• Securities-based crowdfunding, where the ‘crowd’ invests in an issuer in exchange

for securities — either equity (crowd-sourced equity funding, CSEF) or debt. 69
• Peer-to-peer lending, where an online intermediary facilitates lending between

individuals, often in the form of unsecured personal loans, potentially to fund a
business. 70
68 Crowdfunding can be financial or non-financial. Non-financial crowdfunding is where

entities seek donations in exchange for some non-financial reward. This is not regulated as
funding.
69 Crowdfunding does not include non-public offers of securities. In Australia, the Australian
Small Scale Offerings Board provides offers of securities to retail investors under the
‘20 in 12’ prospectus exemption in s708(1) of the Corporations Act 2001.
70 Ontario Securities Commission (OSC) 2012, OSC Exempt Market Review: Considerations for
New Capital Raising Prospectus Exemptions, OSC Staff Consultation Paper 45-710.
177
Objectives
• Graduate fundraising regulation to facilitate innovations in fundraising emerging
from new technologies and ensure policy settings are consistent across funding
methods.
• Provide firms, particularly small and medium-sized enterprises (SMEs), with

additional funding options.
Discussion
Funding for SMEs is essential to facilitate productivity growth and job creation in the
Australian economy. However, compared with large corporates, SMEs — particularly
start-ups — generally have more limited access to external financing and higher
funding costs. These issues are discussed in more detail in the Interim Report. 71
Globally, crowdfunding is emerging as an alternative funding source for SMEs. Since

2009, overall fundraising via crowdfunding has grown by around 50 per cent annually,
although crowdfunding still accounts for a very small share of total financing. 72
In Australia, current regulatory settings impede the development of crowdfunding. 73
• Offers of securities — Proprietary companies are generally prohibited from

making public offers of securities (equity and debt), and shareholder numbers are
capped at 50 non-employee shareholders. Start-ups or other small businesses have
no viable alternative structures, as the public company structure has costly
compliance requirements.
• Peer-to-peer lending — Licensing requirements apply to direct lender–borrower

models and intermediated lending models that operate as a MIS. 74
The regulatory framework should facilitate financing via the internet.

page 2-59.
72 The European Securities and Market Authority (ESMA) surveyed estimates of market
growth and size. It notes that estimates suggest “activity has been growing fast, at yearly
rates above 50 per cent since 2009”, and “there seems to be a 50/50 breakdown between
financial and non-financial categories”. ESMA 2014, Position Paper: Crowdfunding, European
Union, Paris, page 3.
73 Corporations and Markets Advisory Committee 2014, Crowd sourced equity funding: Report,
Commonwealth of Australia, Canberra, page 14.
74 For example, RateSetter and SocietyOne.
178
Context
Other jurisdictions are adjusting regulatory regimes to accommodate crowdfunding.
For securities-based crowdfunding, both the United Kingdom and New Zealand
implemented regulatory regimes in mid-2014. Canada is finalising its proposed regime
for equity and debt fundraising. In the United States, regulators are yet to settle rules
for CSEF. 75 Peer-to-peer lending is more advanced globally than CSEF, as
accommodating peer-to-peer lending typically has required less significant regulatory
adjustment.
In Australia, Government will consult on a proposed regulatory model for CSEF. The
2014 Corporations and Markets Advisory Committee’s (CAMAC) CSEF report
considered that, for CSEF to operate in the best interests of investors and issuers, a
specific regulatory structure is required. Elements of the CAMAC proposal include:
• Placing a cap on an issuer’s fundraising — no more than $2 million in any 12-month

period — and limited disclosure requirements.
• Introducing caps on investments by investors — $2,500 per issuer, and $10,000

overall, in any 12-month period — and communicating the high risks to investors.
• Requiring issuance to occur via a licensed intermediary that is prohibited from

providing investment advice, soliciting investors and lending to investors. 76
Conclusion
The Inquiry recommends that Government should graduate fundraising regulation to
facilitate securities-based crowdfunding and consider more holistic regulatory settings
to facilitate internet-based financing. A well-developed crowdfunding system can aid
broader innovation and competition in the financial system. Submissions generally
support a more accommodative regulatory regime and note that crowdfunding would
give some SMEs, particularly start-ups, more funding options. 77 Stakeholders suggest
that Australia is already lagging other jurisdictions in facilitating crowdfunding. 78
75 Corporations and Markets Advisory Committee (CAMAC) 2014, Crowd sourced equity
funding: Report, Commonwealth of Australia, Canberra.
76 Corporations and Markets Advisory Committee (CAMAC) 2014, Crowd sourced equity
funding: Report, Commonwealth of Australia, Canberra.
77 Banki Haddock Fiora 2014, Second round submission to the Financial System Inquiry,
Attachment B, page 4.
78 For example, Australian Private Equity and Venture Capital Association 2014, Second round
179
ASIC highlights the risks associated with crowdfunding, particularly CSEF. 79 For
investors, these include fraud, issuer failure and dilution — that is, initial ‘crowd’
investors could be diluted by subsequent equity issues. For issuers, risks include action
by investors if outcomes do not meet their expectations. The Inquiry acknowledges
these risks. However, measures such as limiting individuals’ investments and
communication to them of the risks of crowdfunding would help mitigate such
concerns.
For securities-based crowdfunding, Government should promptly allow issuers to

make public offers of simple securities, including common shares and non-convertible
debt. 80
For peer-to-peer lending, the current MIS regime may be able to accommodate
different types of platforms — including pooled investment mechanisms and ‘bulletin
board’ models — where investors choose to lend to specific ventures. Consideration
should be given to graduating the MIS regime, but also to facilitating other
mechanisms for direct lending, with policy settings consistent with securities-based
crowdfunding.
When new regulatory settings are in place, Government should monitor crowdfunding
activity to determine whether settings require adjustment. Of particular interest would
be consumer protection concerns and the allocative efficiency of crowdfunding. To this
end, crowdfunding platforms could be required to make information about their
activities public, which would support research and policy analysis. 81
Other recommendations in this chapter could help facilitate crowdfunding, including

Recommendation 14: Collaboration to enable innovation, Recommendation 19: Data access and
use and Recommendation 20: Comprehensive credit reporting.
79 Australian Securities and Investments Commission, First round submission to the Financial
System Inquiry, pages 84–85.
80 This approach is similar to that being considered by the Ontario Securities Commission
(OSC). OSC 2014, Introduction of Proposed Prospectus Exemptions and Proposed Reports of
Exempt Distribution in Ontario, OSC, Ontario.
81 Such as funds raised, average investment, and degree that offers are over- or
under-subscribed.
180
Data access and use
Recommendation 19
Review the costs and benefits of increasing access to and improving the use of data, taking
into account community concerns about appropriate privacy protections.
Description
Government should commission the Productivity Commission (PC) to commence, by

the end of 2015, an inquiry into the costs and benefits of increasing access to and
improving the use of data, subject to privacy considerations. Increasing access to data
could enhance consumer outcomes, better inform decision making, and facilitate
greater efficiency and innovation in the financial system and the broader economy but
could also involve privacy risks.
The PC should consider potential mechanisms to:
• Increase private sector, academic and community access to public sector data.
• Encourage the use of appropriately de-identified public data to inform government,

private sector and consumer decision making.
• Improve individuals’ access to public and private sector data about themselves,
such as by defining relevant data, standardising its collection and aggregation in
datasets, and formalising access entitlements and arrangements.
• Increase access to private sector data while maintaining private sector incentives to
collect data, such as through data-sharing arrangements, cost-recovery
arrangements and user charges.
• Further standardise the collection and release of public and private sector data and
product information, so datasets can be created and combined more effectively.
• Enhance and maintain individuals’ confidence and trust in the way data is used.
The PC should report to the Treasurer on how better use of data can improve user
outcomes, including potential amendments to the Privacy Act 1988 (Privacy Act) and
other legislation.
Objectives
• Improve the quality of business and consumer decision making, public policy
development and implementation, and research into how the financial system and
broader economy function.
181
• Better enable innovative business models that rely on data, where they improve
user outcomes and overall system efficiency.
• Increase the utility of public institutions that hold data.
Discussion
Data is becoming increasingly integral to how the financial system and broader
economy function. By 2020, the amount of data held globally is predicted to be
44 times larger than it was in 2009. 82 Ever-expanding computational power and
smarter algorithms are enabling this data to be used more effectively. This is helping
businesses better understand and meet the needs of consumers, improve product
offerings, manage risks and reduce costs.
National governments globally are encouraging these trends through open data
policies. 83 Some private sector organisations, non-government organisations and
academic institutions have also incorporated open data policies or are actively
contributing to the amount of publicly available data. 84 However, to date, and
especially in Australia, there has been very little debate around whether Government
policies could increase access to private sector data to boost innovation and
competition.
The increasing use of data is not without risk. The 2014 update of the Australian
Privacy Principles made significant progress in defining how individuals can access
and control their personal data. 85 Globally, there is growing debate about the use of
data and how societies should balance privacy and efficiency considerations. 86
The scenario set out in Box 11: A cameo on the potential benefits of enhanced data usage,
based on existing and/or emerging data-driven financial products and services from
around the world, highlights the power of data to drive competition and improve user
outcomes.
82 Gantz, J and Reinsel, D 2010, The digital universe decade — are you ready? International Data
Corporation iView, Framingham, Massachusetts, page 2.
83 Davies, T 2014, Open data policies and practice: an international comparison, Paper for European
Consortium for Political Research Panel P356 – The Impacts of Open Data, page 1.
84 Herzberg, B 2014, The Next Frontier for Open Data: An Open Private Sector, World Bank,
viewed 22 October 2014,
<http://blogs.worldbank.org/voices/next-frontier-open-data-open-private-sector>.
85 Privacy Amendment (Enhancing Privacy Protection) Act 2012, which amends the Privacy
Act 1988.
86 For example, see Acquisti, A 2010, The Economics of Personal Data and the Economics of Privacy,
Organisation for Economic Co-operation and Development, Paris.
182
Box 11: A cameo on the potential benefits of enhanced data usage
183
Access to public sector information

As the PC has previously noted, “... unlike many other countries, Australia makes
relatively little use of its public [sector] data resources, even though the initial costs of
making data available would be low relative to the future flow of benefits”. 87 The
National Commission of Audit noted that Australian governments have only released
around 3,200 datasets, compared with 10,000 datasets in the United Kingdom and
200,000 datasets in the United States. 88 The PC also observed that, “... academics,
researchers, data custodian agencies, consumers and some Ministers are eager to
harness the evidentiary power of administrative data, but this enthusiasm generally is
not matched by policy departments”. 89
This reluctance could be due to the costs of making data available and usable, and
risks around quality assurance. However, these considerations should be weighed
against the fact that decisions not to release data prevent public and private sector
decisions from being better informed. The Inquiry is mindful that financial regulators
release significant amounts of data, but sees scope to release more, including both
aggregated data and de-identified datasets of personal information.
Access to personal information

The Australian Privacy Principles give individuals the right to access personal
information about themselves; however, a number of impediments are still preventing
consumers from being able to use their data effectively:
1. Little guidance is available on how personal information should be provided,

including delivery method, timelines and standards for representing data.
2. In most cases, consumers are unable to authorise trusted third parties to access
their personal information directly from their service provider. This reduces
the ability of competitors to offer consumers better value or tailored services,
or develop advice services to better inform consumer decision making.
87 Productivity Commission 2013, Annual Report 2012–13, Chapter 1: Using administrative data
to achieve better policy outcomes, Commonwealth of Australia, Canberra, page 1.
88 National Commission of Audit 2014, Towards Responsible Government: The Report of the
National Commission of Audit, Phase One, Chapter 10.5: Data, Commonwealth of Australia,
Canberra, page 235.
89 Productivity Commission 2013, Annual Report 2012–13, Chapter 1: Using administrative data
to achieve better policy outcomes, Commonwealth of Australia, Canberra, page 1.
184
3. Confusion exists over what constitutes personal information, which may limit
individuals’ access to data. 90
Access to private sector data

In many circumstances, private sector organisations have strong incentives to restrict
access to the data they hold, as it serves as a competitive advantage. However, this
may create inefficiencies where the benefits to the economy of releasing data are
greater than the benefits to individual institutions of restricting access. In this sense,
publicly accessible data can suffer from the ‘common good’ problem: it is
undersupplied because the gains to society are difficult to monetise.
The Inquiry does not suggest that all, or even most, private sector data should be
released publicly. In many cases, private returns are necessary to justify investments in
developing datasets. The challenge is to maintain commercial incentives for
developing datasets, while facilitating the release of data where this improves
efficiency.
Standards for datasets and product information

Standards for collecting and representing data can improve the use of data and
enhance its network qualities. They can enable datasets to be combined and aid
algorithms that mine datasets to find meaning. Although progress has been made in
standardising data collection, particularly through programs such as Standard
Business Reporting, much work still needs to be done. In some cases, poor
coordination prevents standards from being developed or widely used. Another
contributing factor is the cost involved in adjusting how data is collected and
represented to comply with standards.
Confidence and trust

For the potential of data to be fully realised, individuals must have confidence and
trust in how their personal information is stored and used. Without confidence and
trust, individuals would be unwilling to volunteer their personal information and may
avoid using services that develop datasets based on observations of individuals’
behaviour. 91 Some reports suggest that individuals do not understand how their
90 For example, see Grubb, B 2014, ‘Spies can access my metadata, so why can’t I? My
15-month legal battle with Telstra’, Sydney Morning Herald, 10 October, viewed
23 October 2014,
<http://www.smh.com.au/digital-life/consumer-security/spies-can-access-my-metadata-
so-why-cant-i-my-15month-legal-battle-with-telstra-20141010-1146qo.html>.
91 For example, payment services that collect data on individuals’ purchasing decisions.
185
personal information is currently collected and used. When they do find out, they can
lose trust and may stop using services that collect their personal information. 92
Rationale
A number of submissions support data sharing within privacy limitations and
increasing the use of standards, including those from Choice, the Office of the
Australian Information Commissioner, the Association of Superannuation Funds of
Australia and the ABA. Others note the benefits to policy makers, regulators and
researchers of having access to high-quality data for understanding how the financial
system functions and improving policy decision making. 93 Although issues regarding
accessing and using data are important for the financial system, they also have much
broader implications.
The outcomes of the proposed PC inquiry should improve the way Australia’s
financial system data ecosystem functions by increasing data sharing and the utility of
datasets. As the Privacy Act has only recently been updated after an extensive review,
any PC recommendations to amend the Privacy Act could be considered in a broader
post-implementation review of the Privacy Act. This would ensure another forum to
explore potential trade-offs between efficiency and protecting individuals’ privacy.
Both processes would foster much-needed public debate on these complex issues,
which Government, business and society will need to grapple with for some time to
come.
Option considered
Recommended: The PC should consider the costs and benefits to the financial system
and broader economy of mechanisms to: increase access to public sector data;
individuals’ access to their personal information; access to private sector data; the use
of standards for datasets and product information; and confidence and trust in the use
of data. The PC should recommend where amendments to the Privacy Act and other
legislation could enable better use of data and improve public welfare.

The costs and benefits of potential options the PC inquiry could consider are discussed
below. The cost of the actual PC inquiry is likely to be minimal, considering the
potential benefits of improving the use of data.
92 For example, see World Economic Forum and Bain and Company 2011, Personal Data: The
Emergence of a New Asset Class, World Economic Forum, page 6.
93 For example, see Centre for International Finance and Regulation 2014, Second round
submission to the Financial System Inquiry, pages 20–21.
186
Access to public sector data

Broadening access to public sector data has significant benefits. One report suggests
this could add around $16 billion per annum to the Australian economy, as a
conservative estimate. 94 The Inquiry strongly supports the National Commission of
Audit’s recommendations to extend and accelerate publishing de-identified
administrative data and stocktake suitable datasets for public release. 95
However, the main challenge will be overcoming the disincentives to release data. The
PC may wish to consider price signals to address this, such as a program that provides
additional funding to agencies for the first year they release new datasets or charging
agencies for each year they do not release data.
Access to personal information

Some submissions note that individuals would benefit from being able to access their
personal information more readily and in more standardised formats, such as in
machine-readable format, and from being able to share their information with trusted
third parties more seamlessly. 96 Consumers could better understand their
circumstances and improve their decision making, as well as identify better-value
offerings from other service providers.
Consumers are increasingly using online resources to inform their financial decision
making — up from 25 per cent in 2005 to 40 per cent in 2011, 97 and the Inquiry believes
this could grow significantly. When considering options in the Australian context, the
PC may wish to consider regulatory models such as ‘midata’ in the United Kingdom 98
and Smart Disclosure in the United States. 99 It may also be possible to create standard
protocols to enable consumers to allow trusted third parties to access some of their
personal information. For example, the PC could consider whether introducing such
standards could facilitate opportunities for ‘data banks’ to store personal data that
94 Lateral Economics 2014, Open for Business: How open data can help achieve the G20 growth
target, Lateral Economics, Melbourne, page 10.
95 National Commission of Audit 2014, Towards Responsible Government: The Report of the
National Commission of Audit, Phase One, Chapter 10.5: Data, Recommendation 61,
96 Refer, for example, to Choice 2014, Second round submission to the Financial System
Inquiry, pages 26–31.
97 ANZ 2011, Adult Financial Literacy in Australia: Full report of the results from the 2011 ANZ
Survey, ANZ, Melbourne, page 102.
98 United Kingdom Department for Business, Innovation and Skills 2011, The midata vision of
consumer empowerment, media release, 3 November, London, viewed 18 November 2014,
<https://www.gov.uk/government/news/the-midata-vision-of-consumer-
empowerment>.
99 United States Government 2014, An introduction to smart disclosure, Data.gov,
Washington DC, viewed 11 November 2014,
<https://www.data.gov/introduction-smart-disclosure-policy/>.
187
individuals volunteer. Individuals could then choose to provide access to parts of this
information to trusted third parties.
Access to private sector data

Increasing access to private sector data would have large efficiency benefits across the
economy. It would support innovation and competition, as new entrants and smaller
businesses with smaller datasets could better compete with larger incumbents. Online
comparator sites and other advice services could better serve their clients, and
consumers could make more informed choices. Industry and government should
continue to progress initiatives for sharing data with consent, and initiatives allowing
greater access to commercial data where this would improve user outcomes. In
particular with greater flexibility of disclosure mechanisms, issuers and firms should
make available prominently and publicly at no cost, mandated disclosure in a central
place. For example, all PDSs of an issuer could be made available on their website.
The PC should consider the conditions under which the release or sharing of private
data would create net benefits to the economy, and not reduce incentives for
businesses to collect the data in the future. In many cases, potential disincentives could
be addressed by compensating businesses that share their data. It may be efficient to
charge users of data to fund this compensation, such as through an access regime. In
other cases, businesses could be compensated through greater access to others’ data. 100
Alternatively, if the data is viewed as a ‘pure’ public good, Government may be
justified in compensating providers and releasing the data for free.
Standards for datasets and product information

Standardising datasets can improve data functionality by improving ease of use and
allowing datasets to be combined. This can assist the process of turning data into
meaningful information. The Standard Business Reporting initiative has invested
considerable resources to standardise financial datasets and currently operates on a
voluntary basis. 101 The PC may wish to consider whether additional actions are
necessary to unlock the potential of data through standardisation — both for public
and private sector datasets.
Standards could also cover how financial product information is reported, so third
parties could use automated processes to create market-wide datasets of available
products. 102 The Inquiry believes new advice and comparison services would be
100 For example, financial institutions share consumer credit data through credit bureaus.
101 Australian Business Register 2014, Second round submission to the Financial System
Inquiry, page 2.
102 For example, a 2010 Choice survey found that credit card providers use at least 10 different
billing methods, making it difficult for consumers to compare information. Choice 2014,
Second round submission to the Financial System Inquiry, page 27.
188
developed if product information was better standardised, supporting consumers in

making more informed choices and enhancing competition.
Although the Inquiry’s first preference would be for private sector models to develop,
some stakeholders are concerned that comparison services can face conflicted
incentives, which may lead them to provide poor advice or misleading comparisons. 103
The PC may wish to consider these issues, particularly in circumstances where
Government provision is the most effective option. 104 Government provision can avoid
conflicted incentives, but it can come at a cost to taxpayers and involve moral hazard.
The Inquiry encourages the PC to consider these issues further.
Confidence and trust

Increasing confidence and trust in the way data is collected and used can increase the
amount of data institutions are able to collect and use. As a result, some restrictions on
the use and collection of data can actually increase the amount of data available. The
Privacy Act is a vital piece of infrastructure in Australia’s data ecosystem.
The PC may wish to consider other means of enhancing confidence and trust and
reduce the risk of it being eroded. These outcomes can be achieved by ensuring
individuals benefit from sharing their personal information and have visibility and
control over how their information is used. Specific options could include
standardising processes for correcting data errors and limiting how widely data can be
shared. Increasing transparency through data breach reporting and greater disclosure
of how data is used and collected could also assist, particularly in building sustainable
levels of confidence and trust over time. The PC may also wish to consider how to best
balance efficiency and security in relation to controls on international data transfers.
Conclusion
The PC is best placed to consider the costs and benefits to consumers, the financial
system and the broader economy of increased access to and improved use of data, and
to explore options the Inquiry has not considered.
103 Choice 2014, Second round submission to the Financial System Inquiry, supplementary
document, page 3.
104 There are already examples of state governments providing comparator services for
electricity and gas (see www.yourchoice.vic.gov.au and www.energymadeeasy.gov.au), and
the Federal Government will establish a comparator service for insurance in North
Queensland by March 2015. Cormann, M (Minister for Finance and Acting Assistant
Treasurer) 2014, Initiatives to help address insurance affordability for North Queensland,
media release, 23 October, Canberra, viewed 23 October 2014,
<http://www.financeminister.gov.au/media/2014/1023-initiatives.html>.
189
Comprehensive credit reporting
Recommendation 20
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.
Description
Industry should continue to implement the new comprehensive credit reporting (CCR)
regime on a voluntary basis. This would allow credit providers to share individuals’
‘positive’ credit history data, such as loan repayment history.
Industry believes that CCR will not be operational until March 2015, at the earliest.
Also, industry suggests that significant portions of credit data will not be exchanged
until late 2016 or early 2017, reflecting, in part, major transitional issues for credit
providers. 105
In 2017, Government should review industry’s participation in CCR to determine

whether a regulatory incentive or legislation for mandatory reporting is required.
Government could also consider expanding CCR to include more data fields.
Objectives
• Reduce information imbalances between lenders and borrowers, and facilitate
competition between lenders.
• Improve access to and reduce the cost of credit for borrowers, including SMEs.
Discussion
Industry participation in CCR
At present, credit providers have limited access to credit data on competitors’
customers. The previous credit reporting regime was based on sharing ‘negative’
credit events, such as an individuals’ history of defaults.
105 Australian Retail Credit Association (ARCA) 2014, Additional material to the Financial System
Inquiry, ARCA, Sydney, page 4.
190
More comprehensive sharing of credit data would reduce information imbalances

between lenders and borrowers. It would also facilitate borrowers switching between
lenders and greater competition among lenders. Overall, more comprehensive credit
reporting would likely improve credit conditions for borrowers, including SMEs.
Personal credit history is a major factor in credit providers’ decisions to lend to
consumers, but also to new business ventures and smaller firms.
Empirical evidence suggests CCR reduces the likelihood that originated loans will
default (reducing interest rates) and/or increases the availability of credit. 106 Most
OECD countries have some form of ‘positive’ credit reporting, either via a public credit
register or private reporting body, reflecting the benefits of more comprehensive credit
reporting. 107
In Australia, legislation for CCR came into effect in March 2014, although the regime is
not yet fully implemented. Industry is developing a data-sharing agreement based on
reciprocity between credit providers. Under the proposed agreement, each participant
would select the data categories they wish to share, and in turn gain access to the same
categories from other participants (via credit reporting bodies). Data exchange would
be supported by a compliance framework, where participants would be able to raise
instances of non-compliance by other participants. 108 The Australian Retail Credit
Association (ARCA) anticipates finalising the agreement by March 2015 at the
earliest. 109
Participation in CCR is voluntary, so the pace and extent of eventual participation in

the regime is not yet clear.
For credit providers, participation will depend on the perceived net benefits, which
will differ between different classes of credit provider. For a major institution with a
relatively large customer base, early and full participation may provide, at least
106 International Finance Corporation 2012, Credit Reporting Knowledge Guide, International
Finance Corporation (part of the World Bank), Washington, DC. Also see Barron, J and
Staten, M 2003, ‘The Value of Comprehensive Credit Reports: Lessons from the U.S.
Experience’, in Credit Reporting Systems and the International Economy, ed. Miller, M, MIT
Press, Boston.
107 Expert Group on Credit Histories (to the European Commission) 2009, Report of the Expert
Group on Credit Histories, DG Internal Market and Service, Paris; Rothemund, M and
Gerhardt, M 2011, The European Credit Information Landscape, European Credit Research
Institute, Brussels; Australian Law Reform Commission 2008, Australian Privacy Law and
Practice, Volume 3, Report 108, Commonwealth of Australia, Canberra.
108 The Australian Retail Credit Association (ARCA) 2014, Second round submission to the
Financial System Inquiry, page 3. Under the proposed agreement, there are three tiers of
data: negative (data typically disclosed pre-March 2014); partial (information on current
credit accounts, plus ‘negative’ data); and comprehensive (repayment history plus ‘partial’
data).
109 The Australian Retail Credit Association (ARCA) 2014, Second round submission to the
191
initially, relatively larger benefits to other, smaller participants than for the institution
itself.
As participation and system-wide data grow, net benefits increase for all CCR
participants. Further, credit providers that do not participate are at risk of adverse
selection with respect to potential new borrowers; a risk that becomes more acute as
industry participation increases. 110
Ultimately, the system would be expected to deliver better credit outcomes for
providers that participate relative to those that do not. It is difficult to determine
ex ante the level of participation at which this would occur, but Veda suggests that this
is likely to occur before participation reaches 50 per cent. 111
Extension to SME data

Submissions generally argue that the costs of mandatory reporting of SME data would
outweigh the benefits. Reporting of SME data would impose further compliance costs
on credit providers. However, the additional data would not likely reduce information
imbalances. This is because the credit health of the business owner(s) as an individual
remains the primary information source for credit decisions, rather than information
about the SME itself.
Expanding CCR data fields

Submissions generally support expanding CCR data with more data fields —
particularly account balances. However, additional data fields would have to be
balanced against privacy concerns, and would require amendment of the Privacy Act.
The need for additional data fields could be considered in the proposed review of CCR
participation and the proposed PC inquiry into data access and use (see the previous
recommendation).
Conclusion
The Inquiry believes that CCR would lead to better credit decisions across the system
including for SMEs, and supports industry efforts to expand credit data sharing under
the new voluntary CCR regime. However if, over time, participation is inadequate,
Government should consider legislating mandatory industry participation, or a
regulatory incentive. The Inquiry does not support mandating reporting of SME data.
In principle, the Inquiry supports expanding the number of CCR data fields, as
theoretical and empirical studies suggest that more, high-quality credit data lead to
better credit decisions and improved credit conditions for borrowers.
110 Johnson, S 2013, ‘Consumer lending: implications of new comprehensive credit reporting’,
JASSA — The FINSIA Journal of Applied Finance, no. 3.
111 Based on modelling undertaken by Veda (a major credit bureau), which models the impact
of rising industry participation in comprehensive credit reporting on lenders’ credit
decisions.
192
The financial system plays a vital role in meeting the financial needs of individual
Australians. To fulfil this role effectively, consumers should be treated fairly and
financial products and services should perform in the way consumers are led to
believe they will. Consumers have a responsibility to accept their financial decisions,
including market losses, when they have been treated fairly. However, financial
system participants, in dealing with consumers, should have regard to consumer
behavioural biases and information imbalances. Recent consumer experiences reveal
poor industry standards of conduct and areas for enhancement in the current
framework.
The current regulatory framework focuses on disclosure, financial advice and financial
literacy, supported by low-cost dispute resolution arrangements. Product disclosure
plays an important part in establishing the contract between issuers and consumers.
However, in itself, mandated disclosure is not sufficient to allow consumers to make
informed financial decisions. As the Interim Report noted, affordable, quality financial
advice can bring significant benefits to consumers, especially where they may not be
equipped to make complex financial decisions.
The framework needs to more effectively align the governance and corporate culture
of financial firms, employees and other representatives. Currently, in seeking to align
commercial incentives with consumer outcomes, the regulatory framework is focused
on point of sale. Recent examples of poor conduct suggest the alignment needs to start
at the point of product design, and then be strengthened through distribution and
advice.
Improved financial literacy enables consumers to be more engaged and to make more
informed decisions about their finances. The Inquiry notes support from submissions
on the importance of financial literacy for consumers. There are numerous examples of
financial industry and Government programs that aim to educate consumers and raise
their awareness of financial management issues, and the Inquiry encourages
continuation of these efforts. However, in the Inquiry’s view, increasing financial
literacy is not a panacea. Further measures are needed to support the fair treatment of
consumers.
The Inquiry also supports continuing industry and Government efforts to increase
financial inclusion. Reviews and proposed changes to the financial services framework
should involve consumer organisations in policy development, alongside industry,
regulators and other stakeholders.
In making its recommendations, the Inquiry has deliberately focused on the issues of
most concern and has not suggested changes to current arrangements that are
193
generally working well, such as alternative dispute resolution systems. The Inquiry
recognises the importance of continuing to have an adequate consumer dispute
resolution system.
The Inquiry also considered the scope for self-regulation. Industry self-regulatory
approaches are often more successful in setting governance, customer service or
technical standards that supplement the law, than in addressing sector-wide conduct
issues, particularly where there are commercial pressures that may undermine
standards. In some cases, there may also be a first-mover disadvantage. In these cases,
government regulation may be required. On this basis, the Inquiry looks to firms and
industry to take forward initiatives for a number of the recommendations in this
chapter. These include raising industry standards and levels of professionalism, more
effectively disclosing risk and fees, and improving guidance and disclosure for general
insurance.
This Inquiry’s recommendations focusing on consumer outcomes, in this and related

chapters, combine deregulatory elements, self-regulation and new regulation. They
build on recent changes, such as the Future of Financial Advice (FOFA) and product
disclosure reforms, accommodate and promote market discipline and aim to reduce
calls for future significant changes to the regulatory framework.
A number of recommendations focus on increasing accountability of issuers and

distributors. In the Inquiry’s view, firms that already invest in customer-focused
business practices and procedures would not be required to change their operations
significantly. The Inquiry’s expectation is that costs involved in changing practices
should be low. In addition, the Inquiry believes that, in complying with these
recommendations, firms would also be likely to benefit from long-term savings
through increased customer retention and avoid further regulatory costs.
In the Inquiry’s view, these recommendations should also have limited effect on
incentives for product innovation. To the extent that there is a change in the design or
distribution of certain products, the Inquiry considers that this is appropriate to
promote consumers buying products that meet their needs.
Underlying a regulatory framework is the essential requirement that regulators are

strong, independent, accountable and focused on enforcing the existing framework in
a timely and proactive way. This chapter should therefore be read together with
Chapter 5: Regulatory system, which makes recommendations to strengthen the
Australian Securities and Investments Commission (ASIC).
Recommended actions
The Inquiry recommends taking the following actions to promote the fair treatment of
consumers, to improve efficiency and build confidence and trust in the financial
system.
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1. Make issuers and distributors more accountable for design and distribution of
products and introduce a product intervention power. To promote positive consumer
outcomes, product issuers and distributors should take greater responsibility for the
design and targeted distribution of products. This should strengthen consumer
confidence and trust in the system and reduce the number of cases where consumer
behavioural biases and information imbalances are disregarded. ASIC should also be
enabled to take a more proactive approach to reduce the risk of significant detriment to
consumers.
2. Focus financial firms and advisers on the interests of consumers. To build

confidence and trust in the financial system, firms need to take steps to create a culture
that focuses on consumer interests. This should include addressing conflicted
remuneration in life insurance advice and stockbroking. Underscoring the importance
of improved standards and accountability, the Inquiry recommends giving ASIC
enhanced powers to ban individuals from financial firm management. The Inquiry
recommends lifting the minimum competency standards for financial advisers,
improving transparency of adviser firm ownership and relabelling general advice
(see also Recommendation 40: Provision of financial advice and mortgage broking). In
addition, the Inquiry recommends enabling better access to quality guidance for home
building and contents insurance to reduce the risk of underinsurance.
3. Facilitate innovative forms of disclosure, including by encouraging industry to

further use technology. Although the disclosure regime has evolved to reduce
complexity over the last decade, consumer behavioural biases and commercial
disincentives limit its effectiveness. The Inquiry sees scope to promote efficient
communication of information to consumers in a way that responds to technological
advances and changing consumer preferences (see also Recommendation 39: Technology
neutrality). Risk and fee disclosure remains variable and consumer understanding low.
In addition, industry should develop consistent standards to improve disclosure of
risk and fees.
The Senate Economics References Committee’s report on ASIC’s performance was

released shortly before publication of the Inquiry’s Interim Report. The Inquiry
indicated that it would consider the Senate Committee’s recommendations in its final
deliberations. In particular, the Senate Committee recommended that this Inquiry
consider the adequacy of Australia’s conduct and disclosure approach to the
regulation of financial firms. The Inquiry has considered issues raised by the Senate
Committee, and makes recommendations in this chapter, including in relation to
product issuer and distributor accountability, product intervention power, adviser
competency and register, and banning powers. 1
1 The Senate Economics References Committee 2014, Performance of the Australian Securities
and Investments Commission, Canberra, page 393, 443.
195
Figure 12 illustrates the Inquiry’s recommendations in the context of a typical product

life cycle.
Figure 12: Recommendations to improve consumer outcomes
196
Principles
In developing recommendations to improve consumer outcomes in the financial
system, the Inquiry has been guided by the objective of ensuring the fair treatment of
participants, particularly consumers of financial products and services. The principles
underlying this objective are:
• A fair, well-functioning financial system allows consumers to take on risk to make a

return. Inevitably, this means consumers will incur gains and losses from market
movements.
• Consumers should bear responsibility for their financial decisions. To assist them in
doing this:
– Consumers should receive fair treatment from financial firms.
– Consumers should have access to competent, good-quality, customer-focused

advice and guidance.
– Information provided to consumers should be accessible, engaging and

understandable.
– Financial literacy strategies should be an important element of the consumer

framework.
• Product issuers and distributors should take responsibility for the design, targeting
and distribution of financial products.
• ASIC should be proactive in its supervision and enforcement to reduce the risk of
significant detriment to consumers.
• Consumers should have access to timely and low-cost dispute resolution.
Conclusion
The Inquiry considers implementing the following package of recommendations
would enhance the fair treatment of consumers. It would strengthen the accountability
of product issuers and distributors, reduce the risk of significant consumer detriment
from unfair treatment, and encourage a customer-focused culture in financial firms.
Implementing these recommendations would strengthen consumer confidence and
trust in the system and improve system efficiency.
197
Strengthen product issuer and distributor accountability
Recommendation 21
Introduce a targeted and principles-based product design and distribution obligation.
Description
Government should amend the law to introduce a principles-based product design
and distribution obligation. 2 The obligation would require product issuers and
distributors to consider a range of factors when designing products and distribution
strategies. In addition to commercial considerations, issuers and distributors should
consider the type of consumer whose financial needs would be addressed by buying
the product and the channel best suited to distributing the product. Industry should
supplement this principles-based obligation with appropriate standards for different
product classes.
The obligation would cover:
• During product design, product issuers should identify target and non-target
markets, taking into account the product’s intended risk/return profile and other
characteristics. Where the nature of the product warrants it, issuers should
stress-test the product to assess how consumers may be affected in different
circumstances. They should also consumer-test products to make key features clear
and easy to understand.
• During the product distribution process, issuers should agree with distributors on
how a product should be distributed to consumers. Where applicable, distributors
should have controls in place to act in accordance with the issuer’s expectations for
distribution to target markets.
• After the sale of a product, the issuer and distributor should periodically review
whether the product still meets the needs of the target market and whether its risk
profile is consistent with its distribution. The results of this review should inform
future product design and distribution processes. This kind of review would not be
required for closed products. 3
2 This obligation would not apply to credit products regulated under the National Consumer
Credit Protection Act 2009, because the responsible lending obligation currently requires
assessment of suitability on an individual basis.
3 Closed products are those not accepting new customers or funds, of which legacy products
are a subset.
198
These requirements would be scalable, depending on the nature of the product.

Compliance with this obligation should be straightforward for simple products that
are likely to be suitable for most consumers. For example, simple, low-risk products
such as basic banking products would not require extensive consideration and may be
treated as a class, with a standard approach to their design and distribution.
A serious breach of this obligation should be subject to a significant penalty.
Objectives
• Reduce the number of consumers buying products that do not match their needs,
and reduce consequent significant consumer detriment.
• Promote fair treatment of consumers by firms that design and distribute financial
products.
• Promote efficiency and limit or avoid the future need for more prescriptive
regulation.
• Build confidence and trust in the financial system.
Discussion
The existing framework relies heavily on disclosure, financial advice and financial
literacy. However, disclosure can be ineffective for a number of reasons, including
consumer disengagement, complexity of documents and products, behavioural biases,
misaligned interests and low financial literacy. 4 Many consumers do not seek advice,
and those who do may receive poor-quality advice. Many products are also distributed
directly to consumers.
Such issues have contributed to consumer detriment from financial investment

failures, such as Storm Financial, Opes Prime, Westpoint, agribusiness schemes and
unlisted debentures, which have affected more than 80,000 consumers. Losses from
these failures totalled more than $5 billion, or $4 billion after compensation and
liquidator recoveries. 5 Although these losses have a number of contributing causes,
poor product design and distribution practices that disregarded consumer behavioural
biases and information imbalances played a significant role. A recent independent
report on improving consumer compensation arrangements identified scope to make

page 3–57.
5 These figures include losses involving the more substantive cases of financial investment
failures in the last 10 years, such as Storm Financial, Opes Prime, Westpoint, Great
Southern, Timbercorp and Banksia Securities.
199
product issuers more responsible for product distribution. 6 Although FOFA has made
significant changes to reduce incentives for inappropriate distribution where personal
advice is provided, more can be done during the product design phase to complement
these measures.
The current quality of product design and distribution controls is variable. ASIC’s
report on Regulating Complex Products observed that some consumers acquire
structured products that are riskier than they realise. 7 For example:
• Insufficient information provided in the disclosure documents, advertising and

seminars relating to over-the-counter contracts for difference (CFD) made it
difficult for retail consumers to make informed investment decisions.
• Some firms distributing hybrid securities included sales information in addition to,
or inconsistent with, the information in the prospectus. This information tended to
emphasise high yield while downplaying risk.
The Inquiry is also concerned that certain less complex add-on insurance products may
not meet the needs of some consumers. For example, an ASIC report revealed
Consumer Credit Insurance (CCI) products being bought by consumers whose
situation made them ineligible to claim under the policy. 8 The Financial Ombudsman
Service (FOS) found that 11 per cent of claims on CCI products were declined,
compared with 3 per cent of all personal general insurance claims. 9
A number of recent high-profile ASIC enforceable undertakings (EUs) demonstrate

some firms had serious compliance issues in providing personal advice and internal
controls. 10 Although these examples raise potential breaches of the personal advice
regime and occurred before the significant FOFA changes, they also demonstrate
weaknesses in processes for, and controls on, product distribution to consumers that
are not limited to the provision of personal advice.
The financial services industry has already attempted to address this problem through
broader risk management processes and specific initiatives. For example, the
6 Commonwealth of Australia 2012, The Treasury, Compensation arrangements for consumers of

financial services, report prepared by R St John, Canberra, pages 149–150.
7 Australian Securities and Investments Commission (ASIC) 2014, Report 384: Regulating
complex products, ASIC, Sydney, page 4.
8 Australian Securities and Investments Commission (ASIC) 2011, Report 256: Consumer credit
insurance: A review of sales practices by authorised deposit taking institutions, ASIC, Sydney,
pages 22–23.
9 Financial Ombudsman Service (FOS) 2014, General Insurance Code of Practice: Overview of the
year 2012/2013, FOS, Melbourne, page 51.
10 For example, Australian Securities and Investments Commission (ASIC) 2011, Enforceable
Undertaking (EU) with Commonwealth Financial Planning Limited, 25 October; ASIC
2011, EU with UBS Wealth Management Australia Ltd, 17 March; ASIC 2013, EU with
Macquarie Equities Ltd, 29 January.
200
Australian Financial Markets Association (AFMA) has developed product approval

principles for retail structured finance products. However, these do not cover all
issuers and distributors, and, in any event, are not enforceable. 11
This recommendation takes into account the Senate Economics References

Committee’s report on ASIC’s performance. The Senate Committee suggested that
urgent attention should be given to providing ASIC with the necessary toolkit to
prevent consumer detriment by subjecting the product issuer to more positive
obligations in regard to the suitability of its product. 12
Rationale
To improve consumer outcomes, the framework should promote the targeting of
products to those consumers who would benefit from them. This would reduce the
incidence of consumers buying products that do not match their needs, building
consumer confidence and trust in the financial system. It would also benefit individual
firms by improving customer relationships.
Options considered
The Inquiry raised two options in its Interim Report to reduce the number of
consumers buying products that do not match their needs:
1. Recommended: Introduce a targeted product design and distribution

obligation.
2. Introduce individual appropriateness test at point of sale for complex

products.
In response to the Interim Report, submissions also suggested the following additional
option:
3. Implement a new obligation through a fully self-regulatory approach by

setting expectations for industry and monitoring their progress, with
regulatory follow-up if progress is not made.

Introduce a targeted product design and distribution obligation
Increasing the accountability of product issuers and distributors in this way would
boost consumer confidence and trust in the system, and is supported in submissions
11 Australian Financial Markets Association (AFMA) 2012, Principles relating to product

approval — retail structured financial products, AFMA, Sydney.
12 The Senate Economics References Committee 2014, Performance of the Australian Securities
and Investments Commission, Commonwealth of Australia, Canberra, pages 442–443.
201
by many consumer groups and financial advice groups. However, industry

submissions note that many firms already have sophisticated controls in place, and
regulatory intervention would increase product costs or decrease product offerings for
consumers. 13 Submissions from issuers, distributors and industry groups also raise
concerns about the difficulty for product issuers in determining the suitability of
products and the additional compliance cost involved with introducing the new
obligation. Firms believe their processes would need to be reviewed even if they
already have controls in place.
However, the Inquiry notes the proposed obligation is likely to have substantial
benefits for consumers. As discussed earlier, in conjunction with other measures, a
product issuer and distributor obligation could reduce the incidence of cases such as:
• Storm Financial, where margin lending products did not suit consumer risk
profiles, such as those approaching retirement who could only cover significant
losses by selling the family home. Close to 2,800 consumers faced around
$500 million net losses. 14
• Opes Prime, where complex securities lending arrangements were not understood
by consumers. As a result, hundreds of clients, many of whom were retail
consumers, faced close to $400 million net losses. 15
The Inquiry considers that industry concerns about implementation costs can be dealt
with by ensuring the obligation builds on good practice, is principles-based and is
applied on a scaled basis, allowing scope for firms to adapt their existing practices.
Thus, the new obligation would impose minimal costs on firms with existing good
practices. Some incremental costs for industry may include client categorisation, record
keeping, updating documentation and staff training, as well as monitoring changes in
the external environment. In addition, the regulator would require additional
resources to establish initial guidance and monitor compliance.
Some stakeholders suggest that a new obligation of this kind should be limited to the
design and distribution of complex products. Although many of the recent cases of
concern involve distribution of complex products to retail clients, examples of concern
have also included distribution of less complex products such as add-on insurance and
debentures. Recent EUs have raised concerns with the quality of distribution plans for
credit cards. 16 The Inquiry’s view is that the obligation should not be restricted. As a
Inquiry, page 50.
14 Australian Securities and Investments Commission 2014, First round submission to the
15 Australian Securities and Investments Commission 2013, Verdict in Opes Prime director
trial, media release, 6 September.
16 Australian Securities and Investments Commission 2012, Enforceable Undertaking with
Commonwealth Bank of Australia, 6 March.
202
matter of principle, the proposed obligation should be universal in its nature and
scalable in line with the nature of the product.
This option would deliver benefits to industry, including strengthening internal risk
management for product design, which may mitigate future problems, as well as
signalling a higher level of customer focus. This approach should also avoid new, more
complex and interventionist regulation in the future, promoting efficiency in the
financial system overall.
This recommendation aligns with policy objectives in peer jurisdictions; however, the
Inquiry has taken a principles-based approach that is less prescriptive. The European
Union and the United Kingdom have introduced regulated product governance
arrangements, and the International Organization of Securities Commissions has
suggested that issuers evaluate whether their general distribution strategy is
appropriate for the target market, particularly for structured products. 17 The United
Kingdom recently assessed compliance with the new product governance obligation,
suggesting that although firms’ processes and procedures are of variable quality, the
obligation is playing a positive role in focusing firms on consumer needs. 18
Introduce individual appropriateness test at point of sale

In the European Union, an individual product appropriateness test is being introduced
for product issuers and distributors at point of sale. 19 An appropriateness test requires
the assessment of some of an individual’s personal circumstances before making the
product available to them. In Japan, Hong Kong and Singapore, intermediaries are
required to assess consumers’ knowledge and experience of certain complex products
before providing services to them. 20 In the United States, the Financial Industry
Regulatory Authority has introduced heightened supervision expectations on issuers
and distributors for complex products. 21
An individual appropriateness test, where no personal advice is provided, would

introduce significant costs for issuers and distributors due to necessary changes to the
sales process. Appropriateness tests are also open to manipulation. The Inquiry
17 European Securities and Markets Authority (ESMA) 2014, Consultation Paper: MIFID/MiFIR,
ESMA, Paris, page 39; Financial Conduct Authority (FCA), Regulatory Guide: The
responsibilities of providers and distributors for the fair treatment of consumers, FCA, London;
International Organization of Securities Commissions (IOSCO) 2013, Report FR 14/13
Regulation of retail structured products, IOSCO, Madrid, pages 43,52.
18 Financial Services Authority (now the Financial Conduct Authority) (FCA) 2012, Retail
product development and governance — structured product review, FCA, London, page 11.
ESMA, Paris, page 136.
20 Australian Securities and Investments Commission (ASIC) 2014, Report 384: Regulating
complex products, ASIC, Sydney, page 41.
21 Financial Industry Regulatory Authority (FINRA) 2012, Regulatory notice 12-03: Heightened
supervision for complex products, FINRA, Washington DC, pages 5–6.
203
believes that the objective can be achieved by taking a principles-based approach to

product design and distribution that is less prescriptive.
Implement new obligation through a fully self-regulatory approach

This option would build on the recent work of AFMA, relying on the financial services
industry to monitor how standards are applied and take relevant disciplinary action if
required. However, recent experience with industry self-regulation in the financial
sector suggests that improving the design and distribution of products for consumers
would not be achieved by self-regulation alone.
The Inquiry considers that past industry-led standards have not been sufficient by
themselves to address serious conduct issues; for example, managing conflicts in
financial advice driven by remuneration. Despite efforts over many years, the financial
advice industry failed to improve financial advisers’ conduct, leaving it unable to
prevent or reduce the effect of recent serious cases of poor advice.
Although AFMA standards on product approval practices are valuable, they do not
cover the whole industry and are not subject to substantive monitoring and
enforcement. Self-regulation alone would also fail to underscore the importance of this
recommendation to improve consumer outcomes.
Conclusion
Product issuers and distributors are best placed to understand the features of a
product and its appropriate target market. Introducing a targeted design and
distribution obligation for all products would decrease the number of consumers
buying products that do not meet their needs, and would make the industry more
customer-focused in product design. Therefore, the Inquiry recommends introducing a
principles-based regulatory obligation that enables industry to develop standards of
practice tailored to product classes.
The Inquiry recognises that some firms have already made significant progress in
designing products for and distributing products to suitable target markets. For firms
that are already designing products and distribution strategies in this way, the new
obligation is not likely to have a significant effect. The Inquiry considers that this
best-practice approach taken by some firms should become standard practice.
This recommendation should not limit the kinds of products that could be developed
and issued. The Inquiry supports the role of innovation and its benefits to consumers.
The new obligation would help target innovative products to consumers whose needs
align with product features. This may mean certain products are not marketed to
certain kinds of retail consumers, or are not marketed to consumers unless certain
conditions are met — an approach consistent with existing good practice.
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This recommendation should also be considered in conjunction with other

recommendations in this report, particularly those in Chapter 5: Regulatory system.
Implementing this recommendation would require adequate regulator capabilities to
review financial firms’ internal controls and to understand the relevant product
markets and consumer behavioural biases.
Circumstances beyond those reasonably foreseeable at the time would not be expected
to be taken into consideration by issuers and distributors.
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Introduce product intervention power
Recommendation 22
Introduce a proactive product intervention power that would enhance the regulatory toolkit
available where there is risk of significant consumer detriment.
Description
Government should amend the law to provide ASIC with a product intervention
power. ASIC should be equipped to take a more proactive approach to reducing the
risk of significant detriment to consumers with a new power to allow for more timely
and targeted intervention. This power should be used as a last resort or pre-emptive
measure where there is risk of significant detriment to a class of consumers. This
power would enable intervention without a demonstrated or suspected breach of the
law. Given the potential significant commercial impact of this power, the regulator
should be held to a high level of accountability for its use.
This power would allow the regulator to intervene to require or impose:
• Amendments to marketing and disclosure materials.
• Warnings to consumers, and labelling or terminology changes.
• Distribution restrictions.
• Product banning.
This power is not intended to address problems with pricing of retail financial
products, where consumers might be paying more than expected for a particular
product or where a large number of consumers have incurred a small detriment.
The power would be limited to temporary intervention for 12 months. The temporary
intervention 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. The power could be used against an individual firm or class of firms in relation
to a product or class of products. The power would be subject to a judicial review
mechanism.
ASIC would be required to consult with the Australian Prudential Regulation

Authority (APRA) prior to using this power when it may affect an APRA-regulated
body. Government should review the use of this power after five years.
206
The Inquiry’s view is that providing ASIC with this new power complements the need
for a proactive market-based regulator. The efficacy of this power depends on a strong,
independent and accountable regulator. As part of its overall assessment of ASIC’s
performance against its mandate, the proposed Financial Regulator Assessment Board
should assess the use of this new power. (See Chapter 5: Regulatory system for a range of
complementary recommendations.)
Objectives
• Reduce significant detriment arising from consumers buying financial products
they do not understand.
• Limit or avoid the future need for more prescriptive regulation.
• Build consumer confidence and trust in the financial system and, in turn, improve
efficiency through increased consumer engagement and participation.
Discussion
Currently, ASIC can only take action to rectify consumer detriment after a breach or
suspected breach of the law by a firm. Further, ASIC can only take enforcement action
against conduct causing consumer detriment on a firm-by-firm basis, even where the
problem is industry-wide.
Australia has had cases of significant consumer detriment where ASIC had exhausted
its current regulatory toolkit and where there was no clear basis to take enforcement
action. These include:
• Mortgage managed investment schemes (MISs), where close to 100 were frozen in
the market downturn during the global financial crisis. More than 4,000 consumers
received hardship relief, indicating that many did not expect an investment of this
type to be illiquid. 22
• Unlisted debenture investments, such as Banksia Securities, where many

consumers thought the products they bought were like bank term deposits. More
than 1,500 consumers have lost more than $100 million after recoveries to date. 23
Prior to the collapses, ASIC took action to stop a number of individual pieces of
22 Parliamentary Joint Committee on Corporations and Financial Services 2011, Statutory

oversight of the Australian Securities and Investments Commission, 28 February,
23 McGrathNicol 2012, Banksia Securities Limited Cherry Fund Limited (Receivers and Managers
appointed to both companies): Receivers and Managers’ Report to debenture holders, Sydney,
page 14; McGrathNicol 2014, Banksia Securities Limited (Receivers and Managers appointed):
Circular to debenture holders, Sydney, page 1.
207
marketing, but that did not correct consumers’ overall impressions about the level
of risk involved.
In both cases, ASIC responded to the emerging risk of significant consumer detriment
by providing guidance on the nature of disclosure that should accompany these
products. However, ASIC did not have power to impose such disclosure requirements,
instead seeking to create an expectation on firms to provide clearer disclosure that
outlined the risk and central features of the products.
There have also been cases where ASIC lacked a broad toolkit to respond effectively
and in a timely way to an emerging risk of significant consumer detriment. For
example, the following cases involving leveraged investment strategies that
exacerbated the loss for many consumers:
• Agribusiness schemes, where the product did not perform in the way that
consumers were led to believe, including schemes relying on ongoing sales to fund
their operations. Many consumers did not understand the potential risk of
borrowing to invest in these products. In total, more than 65,000 consumers
invested and lost close to $3 billion.
• Financial collapses that involved poor distribution practices, such as Storm

Financial and Opes Prime. More than 3,000 consumers lost more than $1.4 billion,
of which around half was recovered. 24
Although these cases have a number of contributing causes, a strong, independent and
accountable ASIC, as recommended in Chapter 5: Regulatory system, in combination
with early intervention using the proposed power, would likely reduce consumer
losses in similar situations.
Changes in technology mean that consumers have increasing access to complex

products, which can involve complicated structures and heightened risk. These
products may be difficult for consumers to understand, testing the limits of the
disclosure-based regulatory regime. For example, some structured products have a
high degree of risk, but are labelled, described and promoted in a way that suggests
they have lower risk. 25 In such cases, consumers may still not understand the
risk/return trade-off or the central features of the financial product or strategy, even
where they are accurately disclosed.
Although complexity does not necessarily correlate to higher risk, complex features
make it particularly difficult for consumers to assess the risk and appropriate pricing
24 Australian Securities and Investments Commission (ASIC) 2014, First round submission to
the Financial System Inquiry, page 191; ASIC 2013, Verdict in Opes Prime director trial,
media release, 6 September.
25 Australian Securities and Investments Commission (ASIC) 2013, Report 340: ‘Capital
protected’ and ‘capital guaranteed’ retail structured products, ASIC, Sydney, page 8.
208
of higher-risk products. ASIC found that 71 per cent of survey respondents, including
industry participants, consumers and financial literacy specialists, believe that
Australian consumers do not understand the risk involved with complex products. 26
Also, complex products are particularly influenced by behavioural biases: people
respond automatically and unconsciously to try to simplify the decision-making
process, leading to poor financial decisions. 27
That said, the risk of consumer confusion about risk and features is not limited to
complex products. Past case studies involving margin loans, mortgage schemes and
debentures indicate consumers may also misunderstand less complex products and
their core features and risk. 28 Many consumers find information imbalances or
behavioural biases hard to overcome. Some current product distribution strategies also
hamper understanding. For example, investors in CFDs may rely disproportionately
on issuer marketing materials, which may not provide a sufficient basis for making an
informed decision. 29 (See Recommendation 21: Strengthen product issuer and distributor
accountability.)
This recommendation takes into account the Senate Economics References

Committee’s report on ASIC’s performance. The Senate Committee suggested that
urgent attention should be given to providing ASIC with the necessary toolkit to
prevent consumer detriment through allowing ASIC to intervene and prohibit the
issue of certain products in retail markets. 30
Rationale
The Inquiry believes that targeted early intervention would be more effective in
reducing harm to consumers than waiting until detriment has occurred. The regulator
should be able to be proactive in its supervision and enforcement. Significant
consumer detriment could be reduced if ASIC had the power to stop a product from
being sold or, where the product had already been sold, to prevent the problem from
affecting a larger group of consumers.
26 Australian Securities and Investments Commission (ASIC) 2013, ASIC Stakeholder survey,
ASIC, Sydney, page 28. Survey conducted by Susan Bell Research, covering 1,468
stakeholders.
27 Kahneman, D 2011, Thinking Fast and Slow, Penguin Books Ltd, London, page 224.
28 For example, Parliamentary Joint Committee on Corporations and Financial Services 2009,
Inquiry into financial products and services in Australia, Canberra, Commonwealth of
Australia, pages 28–30, 56–58; Australian Securities and Investments Commission (ASIC)
2012, Regulation impact statement: Mortgage schemes: Strengthening disclosure under RG 45,
ASIC, Sydney, pages 12–13.
29 Australian Securities and Investments Commission (ASIC) 2010, Report 205: Contracts for
difference and retail investors, ASIC, Sydney, page 8.
30 Senate Economics References Committee 2014, Performance of the Australian Securities and
Investments Commission, Canberra, Commonwealth of Australia, pages 442–443.
209
Options considered
The Inquiry raised two options in its Interim Report to reduce consumer detriment:
1. Recommended: Introduce a product intervention power.
2. Introduce default products for a range of basic financial needs; for example,
deposits, home and contents insurance and basic investments.
In response to the Interim Report, submissions also suggested the following additional
option:
3. Prohibit distribution of certain classes of non-mainstream products to retail

consumers.

Introduce product intervention power
Most consumer group submissions support a broad intervention power. 31 The banking
industry supports the ability to ban products temporarily where detriment to
consumers is significantly likely, but not to prescribe terminology or restrict product
features, due to the potential constraints on product innovation. 32 However, many
industry stakeholders do not support changes of this nature, citing concerns about
misuse of the power obstructing legitimate business opportunities. Others believe such
a power needs court or parliamentary oversight. They question whether ASIC’s
cultural and skills mix is sufficient to carry out the responsibilities associated with such
a power. On the other hand, some believe additional powers “… would allow ASIC to
react quickly to market developments”. 33
Some stakeholders believe the nature of the powers would create uncertainty,
constrain innovation, detract from consumer accountability and introduce costs that
may be borne by consumers. They are also concerned about the reputational cost if the
new power is used. The Inquiry considers these concerns can be addressed by the
design and implementation of the power. Specifically:
• If the power is used effectively, it should not significantly affect innovation. The
power is expected to be used infrequently and as a last resort or pre-emptive
measure. In addition, this power is not intended to be used for pre-approval of
31 For example, Superannuation Consumers’ Centre 2014, Second round submission to the
Financial System Inquiry, pages 14–15.
Inquiry, page 51.
33 Deloitte Access Economics 2014, Second round submission to the Financial System Inquiry,
page 58.
210
products as this is likely to result in moral hazard: the perception that no regulator
intervention implies a low-risk product.
• This power is not intended to alleviate consumers from bearing responsibility for
their financial decisions. This would be made clear when the power is
implemented.
• Firms with robust product design and distribution practices should not face
additional regulatory costs as the focus would be on products being distributed to
consumers who do not understand the central features of the products, such as risk.
ASIC engagement with potentially affected firms would allow these firms to
change their practices before any use of the power, thereby limiting public
reputational damage.
• The regulator would be accountable for the use of its power, and it would be
subject to post-implementation review. ASIC would be expected to engage with
potentially affected firms and to consult with Council of Financial Regulators
colleagues before any use of the power, including consulting with APRA where
prudentially regulated firms may be affected.
This recommendation would be consistent with policy responses in most peer

jurisdictions, which have taken an increasingly proactive regulatory stance. In 2012,
the United Kingdom introduced product intervention rules, and since then it has used
them to restrict the distribution of contingent convertible instruments. 34 Similar
changes have been reflected in Europe through amendments to the Markets in
Financial Instruments Directive, with a view to increasing consumer protection. 35 The
US Consumer Financial Protection Bureau has the power to declare certain practices
unfair, deceptive or abusive. 36 However, the Inquiry believes that the same outcome
can be achieved in Australia with a less extensive power than is in place in these
jurisdictions.
Many cases of financial firm failure include situations where consumers have failed to
understand the risk/return trade-off involved in a product, even if disclosure and
advice were compliant. Examples of cases discussed earlier have affected a significant
number of Australians, and involved large uncompensated losses. Although it is hard
to quantify the dollar value of the consumer detriment the power might prevent, the
Inquiry believes that the benefits to consumers would be substantial.
34 Financial Conduct Authority (FCA) 2014, Restrictions in relation to the retail distribution of
contingent convertible instruments, FCA, London.
ESMA, Paris, page 166.
36 Dodd-Frank Wall Street Reform and Consumer Protection Act 2010, USA, s1031.
211
In addition, as discussed in Recommendation 21: Strengthen product issuer and distributor

accountability in this chapter, consumer confidence and trust in the financial system can
be improved by shifting to a more proactive regulator.
Introduce default products

Introducing default products would involve significant new powers and require
considerable resources and skilled personnel. Although some areas may need default
products, such as superannuation, where consumers are compelled to participate, the
Inquiry does not believe this rationale extends to other product types. Widening the
pool of default products may risk significantly limiting innovation and reducing
competition.
Prohibit distribution of products

Some international jurisdictions have prohibited the distribution of certain classes of
product to retail consumers. For example, in the United Kingdom, non-mainstream
investment products are prohibited from being distributed to retail consumers. 37
Although such measures may reduce the risk of detriment, they take a broad approach
and remove choice across a range of products for consumers who may understand the
risk involved. For this reason, the Inquiry does not recommend them.
Conclusion
The Inquiry believes it is important to reduce consumer detriment and rebuild
consumer confidence and trust in the financial system in the longer term. A more
proactive approach to improving retail consumer outcomes underscores the
importance of financial firms treating consumers fairly. This is a significant new power
that is consistent with having a proactive regulator. The power should be used
carefully, and ASIC should be accountable for its use as discussed in Chapter 5:
Regulatory system.
Accountability would be an important part of the application of this new power. ASIC
would be expected to issue general policy (after public consultation) describing when
the power may be used, the process of engagement with affected parties, consultation
with other regulators before the use of the power, transparency in its use and public
reporting of the review of each use of this power. An affected product issuer or
distributor, or class of affected firms, should be able to seek judicial review on the use
of the power.
Given the significance of this new kind of power, Government should review its use
after five years.
37 Financial Conduct Authority (FCA) 2013, PS13/3: Restrictions on the retail distribution of
unregulated collective investment schemes and close substitutes, FCA, London.
212
Facilitate innovative disclosure
Recommendation 23
Remove regulatory impediments to innovative product disclosure and communication with

consumers, and improve the way risk and fees are communicated to consumers.
Description
Government should amend the law to remove regulatory impediments to innovative
communication of product disclosure information, such as the use of online
communication tools, new media, self-assessment tools and videos. This change
should occur in two phases:
1. By ASIC giving individual exemptions from the law through its current pilot
project to allow innovative communication of mandated product disclosure
information.
2. By implementing a broader exemption through legislation, taking into account

the effectiveness of innovative disclosure under ASIC’s pilot project.
Industry should develop standards for disclosing risk and fees, and, if significant
progress is not made within a short time frame, Government should consider a
regulatory approach.
Objectives
• Promote more engaging and effective communication with consumers to increase
consumer understanding and facilitate better decision making.
• Reduce the number of consumers buying products that do not match their needs.
• Promote efficiency, including competition, by better informing consumers.
213
Discussion
Product disclosure
Mandated product disclosure requirements, which set form and content requirements,
are impeding issuers from developing innovative approaches to communicating
disclosure information. 38 With technological developments, such as those enabling
online financial services, consumer expectations have changed, but the current regime
inhibits the ability of firms to meet these expectations.
The Inquiry supports the need for mandated product disclosure, which is necessary to
inform the market and to support issuers and consumers in setting out the terms of
their contract. However, the Inquiry sees scope to provide issuers with more flexibility
to communicate mandated disclosure to better engage and inform consumers.
Consumers can more effectively use information that is accessible, engaging and
understandable. Research shows that presenting financial product information in
shorter disclosure documents that are better signposted, and using plain English and
graphics, can improve consumer understanding. 39 Although there has been limited
research on the benefits of new media compared with paper-based disclosure, new
media offers opportunities for more engaging communication.
An ASIC pilot project is underway to test innovative approaches to disclosure. Issuers

in this pilot will provide consumers with a key facts sheet and a self-assessment tool
using a variety of electronic media, including video, audio and interactive
presentations. ASIC will provide individual relief necessary to facilitate the pilot.
Risk and fee disclosure

With the exception of the new standard risk measure in the MySuper product
dashboard, the law generally does not provide detailed requirements on how to
disclose risk. Yet evidence shows that consumers frequently misunderstand risk
relating to financial products. ASIC found that 45 per cent of survey respondents,
including industry participants, consumers and financial literacy specialists, believe
consumers do not understand that higher reward often means higher risk, and
71 per cent believe that consumers fail to fully understand the risk involved in complex
38 A number of legislative provisions require issuers to provide documents and in some cases
prescribe the format; for example, the Corporations Regulations 2001 for superannuation and
simple managed investment products, the Corporations Act 2001 for prospectus
requirements, and the National Consumer Credit Protection Act 2009 and the National
Consumer Credit Protection Regulations 2010 for credit contracts and consumer leases.
39 For example, Susan Bell Research 2008, The provision of consumer research regarding financial
product disclosure documents: Research report for the Financial Services Working Group, Susan
Bell Research, Sydney.
214
products. 40 Behavioural economists highlight that individuals are prone to making

systematic errors in decisions that involve assessing risk and uncertainty, such as
when making insurance or investment decisions. 41
The law mandates standardised communication of fees for superannuation and simple
MISs. Despite these more prescriptive fee disclosure provisions, ASIC has recently
reported varied compliance practices and is consulting on clarifications to the law.
However, even after these clarifications of current law, aspects of fee disclosure would
remain open to industry to standardise further where the law does not set specific
requirements. These areas include:
• Improving treatment of buy–sell spreads in unit prices.
• Reducing differences in fee disclosure between superannuation and simple MISs.
• Improving the provision of fee information by issuers of underlying investment

entities.
Conclusion
The Inquiry considers that innovative disclosure can improve consumer engagement
and understanding, and that industry should pursue innovative disclosure and
alternative forms of communication. The Inquiry endorses the ASIC pilot project and
encourages industry to continue to engage with ASIC about forms of innovative
disclosure.
The Inquiry is aware that commercial factors can work against creating more
innovative disclosure. Although removing impediments may or may not provide
sufficient incentive for industry incumbents to innovate, it may allow new entrants to
drive different forms of disclosure.
The results from ASIC’s pilot should be considered when drafting new laws to
facilitate innovative disclosure, including the findings from consumer testing within
the pilot. Consideration should also be given to domestic and international research on
the presentation of mandated information.
The Inquiry also considers improved disclosure of risk would assist consumers to
make more informed decisions about financial products. Improving consistency of fee
presentation would enhance allocative efficiency; for example, by promoting fee-based
competition in superannuation.
40 Australian Securities and Investments Commission (ASIC) 2013, ASIC Stakeholder Survey,
stakeholders.
41 Financial Conduct Authority (FCA) 2013, Occasional Paper No.1, Applying behavioural
economics at the Financial Conduct Authority, FCA, London, page 5.
215
The Inquiry recommends a self-regulatory, flexible approach to improving

communication of risk and fees, allowing tailoring for different classes of products and
avoiding prescriptive regulation, which would involve higher compliance costs.
Industry should build on existing measures to improve consumer understanding of
risk by including risk measures for investment products; for example, simple and
non-simple MISs, securities and structured products. Industry should also consider
examples of risk measures used in Europe and Canada. In developing risk measures,
industry should consider:
• Whether a risk measure should be applied broadly across all classes of product.
• Whether there are more effective alternatives to risk measures, such as:
– Disclosure on relative expected or promised return against a well-regarded

benchmark like the official cash rate.
– Tools that assist consumers to understand how products would be likely to

perform in different market conditions.
– Prominent warnings about whether a product is leveraged and what this means
for consumers if there is a serious market downturn.
Proposed measures should be consumer-tested to maximise their effectiveness.
216
Align the interests of financial firms and consumers
Recommendation 24
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.
Description
Better align the interests of financial firms with those of consumers by:
• Industry raising standards of conduct and levels of professionalism to build

confidence and trust in the financial system.
• Government amending the law to provide ASIC with an enhanced power to ban
individuals, including officers and those involved in managing financial firms,
from managing a financial firm. This would enhance adviser and management
accountability.
• Government amending the law to require that an upfront commission for life
insurance advice is not greater than ongoing commissions. This would reduce
incentives for churning and improve the quality of advice on life insurance.
• ASIC reviewing the effect of current stockbroking remuneration structures on the

quality of consumer outcomes. If this review raises significant concerns, ASIC
should advise Government on the need to remove the sector’s exemption from the
ban on conflicted remuneration.
Objectives
• Improve the culture of financial firms and build consumer trust in those firms.
• Align remuneration structures with a customer-focused culture.
• Promote efficiency in the financial advice sector through increased consumer

participation and engagement.
217
Discussion
Poor standards of conduct and professionalism
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. 42 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. 43 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. 44 In addition, ASIC found only 33 per cent of
stakeholders agreed that financial firms operate with integrity. 45
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. 46 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.
Life insurance
In light of recent evidence, the Inquiry is concerned about high upfront commissions
for life insurance advisers. This has been a longstanding industry practice reflecting
42 Smith, J 2009, Professionalism and Ethics in Financial Planning, Victoria University,

Melbourne, page 347.
43 Deloitte 2012, FOFA Perspective: Advice delivery, Financial Services Risk and Regulatory Review,
Deloitte, Sydney, page 19.
44 Roy Morgan Research 2014, Data provided to the Financial System Inquiry,
5 November 2014, Australians aged 14+.
45 Australian Securities and Investments Commission (ASIC) 2013, ASIC Stakeholder survey,
stakeholders.
46 Australian Securities and Investments Commission 2014, Second round submission to the
218
that life insurance has higher arranging costs, such as managing the underwriting
process, and that consumers are often not independently motivated to purchase life
insurance. With the exception of group life insurance policies inside superannuation
and an individual life insurance policy for a member of a default fund, life insurance
products are exempt from the FOFA ban on commissions. This allows individual life
policies to be sold with high upfront commissions, creating an incentive for advisers to
make a sale, rather than provide strategic advice. For example, these policies can have
100–130 per cent of the first year’s premium payable as upfront commissions, with an
ongoing trail commission of around 10 per cent. A recent ASIC report on life insurance
revealed significant problems with both compliance and the consequences for
consumers. 47 More than a third of the personal advice reviewed failed to comply with
the laws relating to appropriate advice and prioritising the needs of the consumer.
Upfront commissions can affect the quality of advice. ASIC found that 96 per cent of
advice rated as a ‘fail’ was given by advisers paid under an upfront commission
model. ASIC also found high upfront commissions encourage advisers to replace a
consumer’s policy rather than retain it. 48 In some cases, this may result in inferior
policy terms. To date, industry approaches to address the issues in life insurance have
not worked. 49
Stockbrokers
In recent years, ASIC has identified compliance issues in the stockbroking industry. 50
The Inquiry is aware of concerns with the prevalence of ‘grid’ commissions for
advisers, where commission-based remuneration is received soon after advice is given,
with the potential to create a conflict of interest between the adviser and the consumer.
Australia and the United States are the only jurisdictions that use a grid commission
structure. In most other major financial centres, stockbrokers are paid a salary and
discretionary bonus. The Inquiry recognises it may be difficult for individual firms to
change remuneration models without policy intervention because stockbrokers would
move firms.
47 Australian Securities and Investments Commission (ASIC) 2014, Report 413: Review of retail
life insurance advice, ASIC, Sydney, page 6.
48 Australian Securities and Investments Commission (ASIC) 2014, Report 413: Review of retail
life insurance advice, ASIC, Sydney, page 5, 42.
49 However, note that the Financial Services Council and Association of Financial Advisers
have now established a working group to address the issues raised by the ASIC report;
Financial Services Council 2014, John Trowbridge to chair FSC-AFA life insurance working
group, media release, 17 October.
50 Australian Securities and Investments Commission (ASIC) 2013, ASIC accepts enforceable
undertaking from Macquarie Equities Ltd, media release, 29 January; ASIC 2011, ASIC
accepts legally enforceable undertaking from UBS Wealth Management Australia, media
release, 17 March.
219
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.
For life insurance, the Inquiry recommends a level commission structure implemented
through legislation requiring that an upfront commission is not greater than the
ongoing commission. This would provide a balanced and cost effective approach to
better align the interests of advisers and consumers. The remuneration model needs to
be sustainable; otherwise there is a risk that providers may exit the market, making it
more difficult for consumers to obtain life insurance advice. The findings of the
Financial Services Council and the Association of Financial Advisers working group
should also be considered during the development and implementation phases.
Alternative models of remuneration, such as delayed vesting of commissions and

clawback arrangements, may simply delay the issue of churn and are complex. At this
stage, the Inquiry does not recommend removing all commissions, as some consumers
may not purchase life insurance if the advice involves an upfront fee. However, if level
commission structures do not address the issues in life insurance, Government should
revisit banning commissions.
The Inquiry has not determined the percentage amount of the level commissions that
should apply in the life insurance sector. This should be left to the market and
industry.
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
220
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.
221
Raise the competency of advisers
Recommendation 25
Raise the competency of financial advice providers and introduce an enhanced register of
advisers.
Description
Government should continue the current process to raise the minimum competency
standards for financial advisers. 51
In the Inquiry’s view, the minimum standards for those advising on Tier 1 products
should include:
• A relevant tertiary degree.
• Competence in specialised areas, such as superannuation, where relevant.
• Ongoing professional development — including technical skills, relationship skills,

compliance and ethical requirements — to complement the increased focus on
standards of conduct and professionalism in Recommendation 24: Align the interests of
financial firms and consumers in this chapter.
The standards should be reviewed regularly to ensure they take into account
developments in the financial sector. In addition, compliance with the standards needs
to be actively monitored. Transitional arrangements should be made to allow
opportunity for advisers to upskill, and include recognition of professional experience.
In addition, ASIC should complete the establishment of an enhanced public register of

all financial advisers, which includes those who are employees. The Inquiry considers
that the register should include licence status, work history, education, qualifications
and credentials, areas of advice, employer, business structure and years of
experience. 52
51 Government is currently considering mechanisms to raise minimum education

requirements.
52 Government has recently announced an enhanced register: Cormann, M (Minister for
Finance and Acting Assistant Treasurer) 2014, An enhanced public register of financial
advisers, media release, 24 October, Canberra.
222
Objectives
• Increase the likelihood of consumers receiving customer-focused quality advice.
• Promote confident and informed consumer use of financial advisory services.
• Facilitate consumer access to information about financial advisers’ experience and

qualifications to improve transparency and competition.
Discussion
Competency standards
The Interim Report observed that affordable, quality financial advice can bring
significant benefits for consumers. 53 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”. 54 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’. 55 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. 56

page 3-63.
54 Parliamentary Joint Committee on Corporations and Financial Services 2009, Inquiry into
financial products and services in Australia, Canberra, page 87.
55 Australian Securities and Investments Commission (ASIC) 2012, Report 279: Shadow
shopping study of retirement advice, ASIC, Sydney, page 8.
56 Australian Securities and Investments Commission (ASIC) 2013, Report 377: Review of advice
on retail structured products, ASIC, Sydney, page 12.
223
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. 57 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”. 58 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. 59 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.
57 Tier 2 products are generally simpler and better understood than Tier 1 products and are
therefore subject to lighter training standards, including a lower educational level. Tier 2
includes basic banking products and general insurance products. Tier 1 covers the
remainder, including superannuation, managed investment schemes, life insurance,
securities and derivatives.
58 Parliamentary Joint Committee on Corporations and Financial Services 2009, Inquiry into
financial products and services in Australia, Commonwealth of Australia, Canberra, page 90.
224
Internationally, Singapore and the United Kingdom are seeking to raise minimum
competency standards. 60 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
60 Monetary Authority of Singapore (MAS) 2013, MAS issues response to consultation on

recommendations of Financial Advisory Industry Review, media release, 30 September,
Singapore. In the United Kingdom, the Retail Distribution Review increased the minimum
education standards for advisers to the equivalent of the first year of tertiary education:
Financial Conduct Authority 2014, Data provided to the Financial System Inquiry,
24 October 2014.
61 Investment Trends data shows that 85 per cent of planners say they currently provide
scaled advice to new clients. Around half (46 per cent) of these planners say they intend to
provide even more single-issue advice (either scaled and/or transactional) over the next
12 months. While new advice and advice reviews over web chat is currently a niche, many
advisers are interested in utilising this technology to engage with clients: Investment
Trends 2014, May 2014 Planner Business Model Report, Investment Trends, Sydney. Based on
a survey of 1,038 financial planners.
225
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.
62 Issues that would have to be addressed in achieving this include that determinations are
currently made only against licence holders.
226
Improve guidance and disclosure in general insurance
Recommendation 26
Improve guidance (including tools and calculators) and disclosure for general insurance,
especially in relation to home insurance.
Description
The general insurance industry should guide consumers as to the likely replacement
value for home building and contents for the purpose of insurance. If significant
progress is not made by industry within a short time frame, Government should
consider introducing a regulatory requirement to provide this guidance at the point of
renewal or on entering into a contract with a new insurer.
The general insurance industry should enhance existing tools and calculators for home
insurance, including providing up-to-date information about building costs and
building code changes.
The general insurance industry should complete its work on improving disclosure in
insurance product disclosure documents, including consumer testing, and providing
information at the appropriate point in the sales process.
Objectives
• Reduce the incidence of inadvertent underinsurance by assisting consumers to
make an informed decision about the sum insured.
• Increase the ability of consumers to make informed decisions when taking out
insurance.
• Enhance consumer understanding of insurance policies, especially key features,

caps and limits, and exclusions.
Discussion
Many stakeholders are concerned about underinsurance flowing from natural disasters
and high premiums, especially in disaster-prone areas. The cost of insurance can be
high, especially for coverage in higher-risk areas such as flood plains and
cyclone-prone areas, leading to non-insurance and underinsurance. The Inquiry
believes this issue should be primarily handled by risk mitigation efforts rather than
direct government intervention, which risks distorting price signals. (For more
discussion on relevant issues, see Box 12: General insurance and natural disasters).
227
Studies after natural disasters reveal inadequate levels of insurance. 63 After the
Canberra bushfires in 2003, ASIC found affected consumers were underinsured by
27 per cent on average. Research undertaken by Legal Aid NSW in relation to the Blue
Mountains bushfires of 2013 found, “of the 68 survey participants who were insured
and had suffered a total loss of their home at the Blue Mountains, a total of 82 per cent
experienced some level of underinsurance for their home building policy and/or home
contents policy”. 64
Replacement value
The current regulatory settings allow insurers to provide guidance on the replacement
value of home building or contents without needing to comply with the personal
advice rules. 65 At present, this is not working and insurers are not typically providing
guidance on replacement value. The Inquiry believes that commercial disincentives
mean insurers are reluctant to provide this type of guidance. Although many insurers
provide online calculators to estimate replacement value, insurers typically refrain
from giving guidance on the replacement value either over the phone or on a renewal
notice. A recent ASIC report identified that most insurers operate on a ‘no advice’ or
factual information model. 66
The draft Productivity Commission (PC) report on natural disaster funding

arrangements commented on a number of important issues consumers face during
natural disasters, including a lack of consumer understanding about risk and
insurance leading to non-insurance and underinsurance. 67 Underinsurance often
occurs because most standard home building and contents insurance policies require
the consumer to decide on the amount of insurance. One of the causes of
underinsurance includes consumers setting their replacement value amounts too low,
due to a lack of knowledge and the specialist skills required to more accurately
estimate the cost of rebuilding a home and replacing home contents. 68
The ASIC report found that “consumers frequently sought assistance from insurers
about how best to decide a sum insured amount”. However, in many instances, sales
staff advised they were not able to assist. Insurers have access to information that
allows them to assess replacement value better than consumers. However, insurers
typically do not give phone-based guidance or refer consumers to existing online tools
63 Australian Securities and Investments Commission (ASIC) 2005, Report 54: Getting home
insurance right, ASIC, Sydney; ASIC 2007, Report 89: Making home insurance better, ASIC,
Sydney.
64 Legal Aid NSW 2014, Second round submission to the Financial System Inquiry, page 5.
65 Corporations Act 2001, s766B(6).
66 Australian Securities and Investments Commission (ASIC) 2014, Report 415: A review of the
sale of home insurance, ASIC, Sydney, pages 9, 10, 47.
67 Productivity Commission 2014, Draft Report: Natural disaster funding arrangements,
Volume 1, Commonwealth of Australia, Canberra, page 31.
68 Australian Securities and Investments Commission (ASIC) 2005, Report 54: Getting home
insurance right, ASIC, Sydney, page 5.
228
and calculators, which would help with these replacement estimates. 69 Renewal
notices also typically do not include this information. The Inquiry believes that it is
important for insurers to provide guidance on replacement value to consumers to
lessen the risk of underinsurance.
Tools and calculators

Tools and calculators can be updated to help consumers estimate replacement costs
more accurately. The Inquiry acknowledges that the insurance market has developed
some tools to address ‘estimation risk’; for instance, providing ‘uplift’ factors to sums
insured, indexation or inflation adjustments to sums insured, and technological tools
designed to assist consumers. However, the Inquiry sees further scope to address this
issue, including the industry improving tools and calculators by referencing up-to-date
building costs and changes in building codes that may affect rebuild cost. The draft PC
report discussed how information imbalances may increase underinsurance due to
consumers being unable to access relevant information, such as changes to building
codes that may increase the cost of building a home. 70
Disclosure
Although general insurance has a specific product disclosure regime, the industry
lacks standard practice in describing a policy’s key features and exclusions. The PC
also commented on the difficulties consumers face in understanding the information
they receive about their insurance policy. 71
Survey results highlight that even when consumers take the time to read insurance
documentation including the product disclosure statement, many misunderstand it,
scan it briefly due to over-reliance on sales staff or fail to understand it due to its
complexity. 72 For example, as a consequence of recent natural disasters, it became clear
many consumers did not understand whether they were covered for flood. A survey
by the Caxton Legal Centre after the Queensland floods of 2011 found that of
participating consumers:
• 51 per cent read the policy but misunderstood important exclusions or limitations.
• 12 per cent received the policy but never read it.
• 4 per cent tried to read the policy but gave up as they could not understand it.
69 Australian Securities and Investments Commission (ASIC) 2014, Report 415: A review of the
sale of home insurance, ASIC, Sydney, page 10.
72 Caxton Legal Centre Inc 2011, Submission to the Standing Committee on Social Policy and
Legal Affairs: Inquiry into the operation of the insurance industry during disaster events,
page 16.
229
Conclusion
The Inquiry believes that underinsurance would reduce if, as standard practice,
insurers gave consumers relevant information, guidance and advice on home building
and contents insurance. Some stakeholders argue that total replacement policies would
be the best solution to the issue of underinsurance. However, this may increase risk for
insurers, which may exacerbate affordability issues. The Inquiry considered whether
introducing standardised or default insurance products would reduce the risk of
consumers failing to understand policies’ key features and exclusions. On balance, the
Inquiry considers the consequent reduction in competition and potential disincentive
for innovation does not warrant this kind of response.
The Inquiry encourages insurers to provide consumers with enhanced guidance about
likely replacement values, and to develop further and make consumers aware of tools
that can help them to purchase adequate insurance cover. Industry should standardise
the way replacement costs are estimated. To the extent this is limited by the existing
regulatory regime, industry should work with Government to resolve. Such estimates
should be given at the time of purchase, and changes to replacement costs should be
communicated to consumers at each renewal.
Insurers providing consumers with enhanced guidance on replacement values would

lessen the risk of underinsurance and increase confidence and trust in the sector. This
may also reduce the need for governments to provide assistance after natural disasters.
If, within the short term, industry has not made significant progress in providing this
guidance to consumers, the Inquiry considers that Government should require
industry to provide it.
The Inquiry believes the general insurance industry should complete its recent work
on reducing complexity and facilitating consumer understanding of key features and
exclusions, including relevant consumer testing. This work can be a useful supplement
to the key facts sheet for home building insurance, which was introduced in
November 2014. 73 Insurers could also incorporate elements of the key facts sheet when
giving information, guidance and advice over the phone and online.
The Inquiry believes that the recommendations build on existing industry work and
practices, and should have lower implementation costs than compliance with a
prescriptive regulatory regime.
73 Insurance Contracts Regulations 1985, Part 4, Division 4.
230
Box 12: General insurance and natural disasters

Many stakeholders raised concerns in relation to general insurance. The Interim
Report highlighted two issues on general insurance and natural disasters:
1. The costs of insurance, especially for coverage in higher-risk areas, such as
flood plains and cyclone-prone areas. It observed that increased use of
risk-based pricing is likely to increase premiums in these areas.
2. The incidence of underinsurance following a natural disaster, especially

inadvertent underinsurance, where homeowners underestimate the cost of
rebuilding.
Cost of insurance
High premiums can lead to calls for government intervention; for example, in
relation to the cost of home and strata title insurance in North Queensland. The
Australian Government Actuary, which has completed two reports on the issue,
attributed recent price increases to historic underpricing of coverage, higher
reinsurance costs and the cost of natural disasters. It also found that insurers were
providing appropriate risk-based products and pricing. 74
The Inquiry recognises a few areas where the absence of private sector providers
creates a need for governments to provide insurance; for example, for terrorism
insurance or cover for catastrophic personal injuries. However, in most cases, the
Inquiry considers the main role of government is to support the market in working
as effectively as possible rather than subsidising prices. The costs of natural disaster
insurance can be reduced through improved data, further mitigation efforts — such
as building flood levies, and in the case of states and territories, by reducing the tax
burden on insurance contracts (see Appendix 2: Tax summary). The Inquiry notes
Government has recently decided to provide a comparison website for home
insurance in North Queensland and has clarified that unauthorised foreign insurers
may provide some competition and offer lower prices in targeted areas prone to
natural disaster. 75
74 Australian Government Actuary (AGA) 2014, Second report on investigation into strata title
insurance price rises in North Queensland, Commonwealth of Australia, Canberra,
pages 19–20; AGA 2012, Report on investigation into strata title insurance price rises in North
Queensland, Commonwealth of Australia, Canberra, pages 7, 16–17.
75 Cormann, M (Minister for Finance and Acting Assistant Treasurer) 2014, Initiatives to help
address insurance affordability in North Queensland, media release, 23 October, Canberra;
Senate Economics Legislation Committee 2014, Hansard transcript, 31 October,
Commonwealth of Australia, Canberra, pages 13–25.
231
Box 12: General insurance and natural disasters (cont.)
Insurance coverage and underinsurance

Price competition can also help to address underinsurance. For mass-marketed
insurance products, governments can play a role in encouraging comparison
websites. In Chapter 3: Innovation, the Inquiry recommends the PC review how data
can be used more effectively to enhance consumer outcomes, better inform decision
making, and facilitate greater efficiency and innovation in the financial system.
Statutory insurance is insurance that is mandatory; for example, compulsory
third-party motor vehicle insurance, workers’ compensation insurance and
professional indemnity insurance. While there are strong justifications for making
some insurance cover mandatory (especially liability insurance) where the
detriment is to third parties, governments imposing this requirement should take
steps to encourage an adequate market (where they do not provide the cover
themselves). Where governments provide insurance in competition with the private
sector, this should be done on the basis of competitive neutrality.
232
Australia needs strong, independent and accountable regulators to help maintain trust
and confidence in the financial system. This is critically important for attracting
investment and supporting growth. The quality of oversight and supervision is vital in
maintaining financial stability and achieving positive consumer outcomes.
Appropriate firm culture is critical, but needs to be supported by proactive regulators
with the right skills, culture, powers and funding.
Australia’s regulatory system, as described in the Interim Report, is a legacy of the

Wallis Inquiry’s functional approach to regulation. 1 This means regulators generally
focus on particular outcomes across the system, rather than particular sectors. 2 The
Australian Prudential Regulation Authority (APRA) specialises in prudential
regulation of banking, insurance and superannuation, while the Australian Securities
and Investments Commission (ASIC) has a broader conduct and market integrity
mandate. 3
Since the Wallis Inquiry, Australia’s regulatory system has undergone significant
change. The overall approach to prudential regulation changed significantly in the
wake of the collapse of HIH Insurance Limited (HIH) in 2001. There has been a
stronger focus on developing tools for crisis management and resolution. APRA also
acquired a more active role in the superannuation sector. 4 In addition, ASIC’s mandate
expanded significantly, assuming responsibility for regulating credit as well as
financial market supervision.
The global financial crisis (GFC) prompted policy makers and regulators around the
world to reconsider their approach to maintaining financial stability. Some countries at
the epicentre of the crisis have since expanded their prudential perimeters and
adopted more formal and centralised institutional arrangements. This includes
establishing single entities with responsibility for macro-prudential regulation.
Australia has long adopted what could be called a ‘macro-prudential’ approach to

supervision under the rubric of financial stability. Yet, Australia’s institutional
structure is relatively informal and decentralised. The Reserve Bank of Australia (RBA)
and APRA each have responsibility for financial stability. However, most
macro-prudential tools can only be deployed by APRA. This places a strong premium
on cooperation between the two agencies.

page 3–90.
2 The exception is the Payments System Board, which focuses on the payments industry.
3 This is described as the ‘twin peaks’ model.
4 This includes trustee licensing, the capacity to make prudential standards and authorisation
of MySuper products.
233
Against the background of developments overseas, the Inquiry has considered

whether Australia should change its institutional arrangements for making and
implementing financial stability policy.
However, the Inquiry does not see a strong case for change in this area. Although
Australia’s approach has advantages and disadvantages, alternative institutional
approaches are yet to be tested — as indeed is the effectiveness of many
macro-prudential tools. For this reason, the Inquiry recommends no fundamental
change to the current institutional arrangements for financial stability policy and no
change to the prudential perimeter at this time. 5 However, it believes that the RBA
should continue to monitor risks in the non-prudentially regulated sector, and the
Council of Financial Regulators (CFR) should periodically consider whether change is
required. 6
The Inquiry does not see a need to expand the permanent membership of the CFR to
include the Australian Competition and Consumer Commission (ACCC), the
Australian Transaction Reports and Analysis Centre (AUSTRAC) or the Australian
Taxation Office (ATO), as these agencies can already attend meetings as necessary.
However, there would be benefit in increasing the transparency of the CFR’s
deliberations, including its assessment of financial stability risks and how these are
being addressed.
The Inquiry also considered whether superannuation outside self-managed

superannuation funds (SMSFs) should still be subject to prudential regulation by
APRA and whether to narrow ASIC’s responsibilities.
The Interim Report identified that defined contribution superannuation is different to

banking and insurance and therefore needs to be regulated differently. Unlike deposit
accounts, defined contribution superannuation balances are intended to be exposed to
market risk, and do not guarantee a particular return. However, the Inquiry believes
the compulsory nature of superannuation justifies ongoing prudential regulation by
APRA, including the availability of compensation in the event of fraud or theft.
Some submissions suggest that SMSFs might be prudentially regulated by APRA. 7 The
Inquiry does not support this. The defining characteristic of the SMSF sector is that
trustee members are directly responsible for each fund and must take responsibility for
their own decisions.
5 The section on graduated payments regulation in Chapter 3: Innovation recommends making

some changes to the current authorisation regime that applies to purchased payment
facilities. It recommends that the current arrangements should be replaced with a two-tiered
authorisation regime.
6 The Financial Stability Board produces an annual survey of the global shadow banking
sector, including that in Australia.
7 Financial Services Council 2014, Second round submission to the Financial System Inquiry,
Chapter 3, page 89; Actuaries Institute 2014, Second round submission to the Financial
234
The Inquiry agrees there is scope to separate ASIC’s registry business from the rest of
its functions, but is not persuaded that there is a strong case for removing other
functions. Neither has it recommended any additions to ASIC’s responsibilities. 8 The
Inquiry accepts the view that there are synergies between functions—such as market
supervision, insolvency and consumer protection—that would be lost if these
functions were moved to other agencies. The Inquiry has not recommended giving the
ACCC sole responsibility for consumer protection because these powers are an
important part of ASIC’s enforcement toolkit. The Inquiry sees value in an integrated
consumer regulator for financial services. 9
Although there is no need for major change to the responsibilities of the regulators, the
Inquiry has identified some weaknesses in how financial regulation is implemented
and believes there is scope to improve regulatory processes. It notes: Government
lacks a process for holding regulators accountable for their overall performance; some
significant weaknesses exist in regulator funding arrangements and enforcement tools,
particularly for ASIC; and competition and efficiency in designing and applying
regulation may not be adequately considered.
Recommended actions
While the Inquiry does not recommend major changes to the overall regulatory
system, it believes action should be taken in the following five areas to improve the
current arrangements and ensure regulatory settings remain fit for purpose in the
years ahead:
• Improve the regulator accountability framework: Australia needs a better

mechanism to allow Government to assess the performance of financial regulators.
The Inquiry recommends establishing a new Financial Regulator Assessment Board
(Assessment Board) to undertake annual ex post reviews of overall regulator
performance against their mandates. It also recommends that Government should
provide more clarity around its expectations of regulators, including its appetite for
risk in the financial system, while regulators should develop better performance
indicators. These new arrangements should ensure, among other things, regulators
give stronger and more transparent consideration to competition and compliance
cost issues.
• Improve the effectiveness of our regulators: Australia’s regulatory system will

continue to be challenged by the pace of technological change. Especially in
payments and financial markets, new business models are challenging existing
8 The Interim Report asked whether ASIC should regulate technology providers and
superannuation administrators of scale, and whether securities dealers who are not direct
market participants should be regulated as market participants: Commonwealth of
Australia 2014, Financial System Inquiry Interim Report, Canberra, pages 3-106 to 3-108.
9 ASIC currently has exclusive responsibility for consumer protection in relation to financial
services and credit, while the ACCC has these powers in relation to the rest of the economy.
235
regulatory frameworks. The emergence of new technology is placing demands on

regulators to be more flexible, and raising issues relating to identity, privacy and
cyber security. Australia’s regulators need the funding and skills to meet these
challenges into the future, including encouraging innovation through appropriately
graduated approaches.
The Inquiry recommends that ASIC and APRA should both be strengthened
through increased budget stability built on periodic funding reviews, and greater
operational flexibility. ASIC, APRA and the payment systems function of the RBA
should also commit to six-yearly capability reviews. These exercises should ensure
they have the required skills and culture to maintain effectiveness in an
environment of rapid change, as will the recommendation in Chapter 3: Innovation
that Government create a new public-private collaboration mechanism to facilitate
regulatory change in response to innovation.
• Strengthen ASIC: Instances of misconduct and consumer loss in the financial

system have prompted questions about the effectiveness of consumer protection, as
well as the adequacy of ASIC’s resources and the design of the regulatory
framework in which it operates. The public expectation is that ASIC will act as a
pro-active watchdog in supervising all financial services providers. However, in
practice, ASIC has a very wide remit but limited powers and resources.
The Senate Economics References Committee’s report on ASIC’s performance was

released just before the publication of the Interim Report. The Interim Report
indicated that the Inquiry would consider the Senate Committee’s
recommendations in the lead-up to its Final Report. 10
Several of the recommendations in this Final Report are consistent with those of the
Senate Committee. The Inquiry has recommended some fundamental changes to
the regulatory framework governing the financial services industry (see Chapter 4:
Consumer outcomes). These measures are part of a broad shift in Australia’s
approach to consumer protection in the financial sector — away from primarily
relying on disclosure and financial literacy.
The Inquiry has also recommended changes in how ASIC approaches its consumer
protection role. In particular, the Inquiry considers that ASIC should devote more
attention to industry supervision, including more proactively identifying and
weeding-out misconduct. It has also recommended several measures to strengthen
ASIC, including better funding, enhanced regulatory tools (including the proposed
product intervention powers discussed in Chapter 4: Consumer outcomes), stronger
licensing powers to address misconduct, and substantially higher criminal and civil
penalties.

page 3-89.
236
In light of the significance of these changes, the Inquiry recommends that ASIC
should be the first regulator to undergo a capability review, along with the funding
review that would take place under the recommendation for increased budget
stability. This would help to ensure ASIC has the appropriate skills and culture to
adopt a flexible risk-based approach to its future role. Its overall performance
would also be subject to annual review by the proposed new Assessment Board.
• Rebalance the regulatory focus towards competition: Not surprisingly, regulators

have increased their focus on resilience in the wake of the GFC. However, the
Inquiry believes there is complacency about competition, and that the current
framework does not systematically identify and address competition trade-offs in
regulatory settings.
Although the ACCC is responsible for competition policy in the financial sector,
this is part of its broader economy-wide responsibilities. Furthermore, the ACCC is
not responsible for reviewing how decisions by other regulators affect competition.
It is not always clear how APRA and ASIC balance their core regulatory objectives
against the need to maintain competition. Policy makers and regulators need to
take increased account of competition when making regulatory decisions, while
ASIC should be given an explicit competition mandate. Periodic external reviews of
the state of competition should be conducted, including assessing whether
Australia can reduce barriers to market entry for new domestic and international
competitors.
• Improve the process of implementing new financial regulations: Since the GFC,
Australia’s financial system has been influenced by new global standards and the
increasing scope and complexity of cross-border financial regulation. Substantial
regulatory change has resulted from international developments and decisions
made in major offshore financial centres, concurrent with a large number of
domestically driven changes, especially in financial advice and superannuation.
Although there is no evidence to suggest Australia’s compliance burden is

substantially larger than in jurisdictions overseas, work commissioned by the
Inquiry suggests that improved regulatory processes could reduce industry costs
and lead to better outcomes. Specifically, the Inquiry recommends that Government
and regulators adhere to minimum implementation lead times and monitor impacts
more thoroughly post-implementation.
237
Principles
In making recommendations in this chapter, the Inquiry has been guided by the
following principles: 11
• The system must have highly skilled, effective regulators that are both independent
and accountable for discharging their mandates.
• Competition is the cornerstone of a well-functioning financial system and is

generally preferred to Government intervention as the mechanism for efficient,
resilient and fair outcomes. Policy makers and regulators should minimise barriers
to domestic and international competition and seek to encourage competition.
• Regulators and regulation must be forward looking, with the flexibility and
capability to cope with a changing environment. Effective regulators need to be
able to offer competitive salaries.
• Regulation and regulators should be cost effective, and the benefits of regulation
should outweigh the cost. Costs should be allocated to those who create the need
for regulation.
• The culture of firms is important and will affect the need for regulation.
Conclusion
Adopting the recommendations in this chapter will make Australia’s regulators more
effective, more adaptable and more accountable, with greater independence in some
areas, such as funding. It will also increase the focus on competition and improve how
regulations are made and reviewed.
11 Drawing on the principles set out in Commonwealth of Australia 2014, Financial System
Inquiry Interim Report, Canberra, pages 1–7.
238
Regulator accountability
Recommendation 27
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.
Description
Government should create a new Assessment Board to provide it with ex post, annual
reports on the performance of APRA, ASIC and the payment systems regulation
function of the RBA. They would be assessed against their statutory mandates as well
as against the priorities identified in Statements of Intent (SOIs). 12
The reports would consider how the regulators have balanced the different
components of their mandates as well as how they are allocating resources and
responding to strategic challenges. Reports should include the views of regulators and
be made public once Government has had the opportunity to consider a response. The
Assessment Board need not be established as a separate agency and could be
supported by a separate secretariat housed in Treasury. This would separate the
provision of support to the Assessment Board from Treasury’s ongoing policy role as a
CFR agency.
It is not intended that the Assessment Board should direct the regulators — it would
report to Government. It would also be precluded from examining individual
complaints against regulators or the merits of particular regulatory or enforcement
decisions. However, it would be asked to assess how regulators have used the powers
and discretions available to them. In the case of ASIC, a significant issue would be its
use of the temporary product intervention power recommended in Chapter 4: Consumer
outcomes.
The Assessment Board would replace the current Financial Sector Advisory Council
(FSAC). It would consist of between five and seven part-time members with industry
and regulatory expertise. It would not include current employees of regulated entities.
However, members would be expected to consult extensively with industry and
consumer stakeholders. Diversity of membership should act as a safeguard against the
12 The Assessment Board would not review the mandates of regulators or the frameworks they
administer.
239
Assessment Board being unduly influenced by the views of one particular group or
industry sector. 13
Government should also set out more clearly how regulators should interpret their
mandates in Statements of Expectation (SOEs). SOEs should also set out:
• A statement of the strategic direction Government expects regulators to take,

including in response to changing circumstances.
• A broad outline of Government’s tolerance for financial sector risk.
Regulators should increase their use of outcomes-focused performance indicators.

These could be included in SOIs, as per the practice of New Zealand regulators, or in
annual reports. 14,15 Performance indicators should cover core regulatory objectives as
well as competition and compliance cost objectives.
Regulators should more clearly explain in their annual reports how they have balanced
the different parts of their mandates, particularly the effect of their decisions on
competition and compliance costs. This information would be an important input into
the Assessment Board’s annual reviews, along with other relevant reports produced by
regulators. 16
These recommendations are intended to be consistent with, and not duplicate,

Government’s Regulator Performance Framework (see Implementation considerations).
Objectives
• Create a formal mechanism for Government to receive annual independent advice
on regulator performance.
• Strengthen the accountability framework governing Australia’s financial sector

regulators.
13 A code of conduct for members could also be used to address this issue.
14 See, for example, Reserve Bank of New Zealand (RBNZ), 2014, Statement of Intent, RBNZ,
Wellington, page 11.
15 Increased use of performance indicators in annual reports is likely to be consistent with the
new performance reporting requirements that will apply under the Public Governance,
Performance and Accountability Act 2013, these requirements would be broader than the
Regulator Performance Framework that Government has already announced.
16 For example, ASIC publishes a Strategic Outlook as well as periodic reports on relief
decisions and enforcement outcomes. APRA and ASIC both publish periodic stakeholder
surveys.
240
Discussion
Australia’s financial regulators operate within complex accountability frameworks. A
range of bodies carry out narrow rather than overall performance assessments. For
example, the Australian National Audit Office (ANAO) conducts performance audits
in relation to particular programs or activities, and the Office of Best Practice
Regulation reviews Regulation Impact Statements (RISs) on proposed regulatory
changes, while the courts and other quasi-judicial bodies review specific decisions.
The main problem with the current arrangements is Government lacks a regular
mechanism to assess the overall performance of its financial regulators. Parliament has
mechanisms to do this, including review of annual reports. However, parliamentary
scrutiny tends to be episodic and focus on particular issues or decisions. The
complexity of regulator mandates presents a challenge to effective monitoring,
especially as Parliament is not supported in this role through regular independent
assessments of annual reports.
The core mandates of the regulators are generally clear. APRA is responsible for
maintaining financial stability; protecting the claims of authorised deposit-taking
institution depositors and insurance policy-holders; and promoting prudent
management of non-SMSF superannuation funds. ASIC is responsible for consumer
protection and market integrity. The RBA and Payments System Board (PSB) are
responsible for financial stability and controlling risk in the financial system. Each
regulator is required to balance these core responsibilities against other objectives,
including promoting competition and efficiency, maximising business certainty and
minimising compliance costs. However, there is some inconsistency in how these other
objectives are framed in relation to APRA and ASIC, including whether or not they
apply at all. 17
Regulators currently receive little guidance about how they should balance the
different objectives in their respective mandates. At present, SOEs typically list each
regulator’s objectives, without guidance from Government on its tolerance for risk, or
how it expects the regulators to balance the different components of their mandates,
17 The Australian Prudential Regulation Authority Act 1998 requires APRA to consider efficiency,
competition, contestability and competitive neutrality alongside financial safety and stability.
The objects clauses in the Banking Act 1959 and Superannuation (Industry) Supervision Act 1993
do not mention competition or efficiency. The objects clauses in the Insurance Act 1973 and
Life Insurance Act 1995 identify competition and innovation as objectives (subject to industry
viability). There is no reference to reducing compliance costs. The Australian Securities and
Investments Commission Act 2001 (ASIC Act) requires ASIC to promote commercial certainty
and economic development and efficiency while reducing business costs. However, there is
no explicit reference to competition in the ASIC Act (or the objects clause for Chapter 7 of the
Corporations Act 2001).
241
especially where there may be a trade-off between objectives. 18 Similarly, annual

reports by regulators provide scant information on how they have balanced their
different objectives. As the Inquiry noted in its Interim Report, regulators’ annual
reports lack performance indicators.
The FSAC, created as a recommendation of the Wallis Inquiry, is currently the main
formal mechanism for industry stakeholders to provide advice to Government.
Although FSAC has attracted high-calibre members, and has performed a useful role
in relation to some issues, it has been hampered by the lack of a clear mandate and
regular work program. This means that its influence has varied over time.
Rationale
A more effective review mechanism that provides Government with regular formal
advice on the overall performance of regulators will improve regulator accountability.
Options considered
The Interim Report proposed improving SOEs, SOIs and annual reports. It identified
two options to strengthen external oversight of financial regulators: an
Inspector-General of Regulation and a ‘unified oversight authority’. Second round
submissions also suggest the CFR could play a larger role in monitoring the
performance of regulators.
1. Recommended: Create a new Assessment Board to advise Government

annually on how regulators have implemented their mandates, based on
regulator self-assessments, periodic capability reviews and industry
consultation.
2. Recommended: Provide clearer guidance to regulators in SOEs, and increase

the use of performance indicators to strengthen regulator reporting.
3. Appoint an Inspector-General of Regulation or unified oversight authority for

financial system regulators.
4. Formalise the CFR and task it to hold regulators accountable for performance
against their mandates.
5. Place APRA and ASIC under the control of boards comprising executive and
non-executive directors.
Options costs and benefits

Submissions generally support improved accountability mechanisms for regulators.
18 For example, lowering barriers to entry may benefit consumers by strengthening competition
but also increase risks for end-users. Likewise, higher barriers to entry can have the opposite
effect.
242
Annual reviews of performance by a new Assessment Board

Establishing a new Assessment Board has the potential to provide more focused
oversight of regulator performance. However, the success of the Assessment Board
will depend on how it approaches its task. Some of the risks associated with this
recommendation are that the Board simply becomes another accountability process
that adds to costs without adding value, or that it attempts to intervene directly in the
work of the regulators. Another risk is that it undermines Treasury’s relationship with
the other CFR agencies.
The Inquiry has sought to address these risks by making it clear that the Assessment
Board should have a diverse membership to avoid being unduly influenced by a
particular group; limiting the Board’s mandate to ex post overall assessments of
regulator performance; ensuring the Board bases its assessments on existing outputs
where possible; and suggesting that the Board be supported by a separate secretariat
within Treasury. A diverse membership would also help ensure a balance of views and
deal with potential conflicts involving individual members.
Improve SOEs and increase use of performance indicators

There appears to be widespread support for improving SOEs and SOIs, and increasing
the use of performance indicators as a means of enhancing regulator accountability.
The main issues are the extent to which Government is willing to be more explicit
about trade-offs in regulatory policy (especially its risk appetite) and the capacity of
regulators to devise performance indicators that adequately capture the complexity of
their work. While Government may be reluctant to set out views, and developing
performance indicators is a difficult exercise, the Inquiry believes that increased efforts
in these areas would enhance regulator accountability.
Inspector-General of Regulation or unified oversight authority

The Inquiry does not support the Inspector-General model because it would involve
creating a new agency. The Assessment Board would replace the existing FSAC. The
Inspector-General model would place considerable reliance on a single person, while
the Assessment Board can include members with expertise across the regulators.
Finally, the Inquiry considers an Assessment Board is more suited to undertaking an
overall review of regulator performance, while the Inspector-General model is better
suited to undertaking more detailed assessments of administrative processes of the
type currently performed by the ANAO and the Inspector-General of Taxation (in
relation to the ATO).
Formalise the CFR as oversight body

The Inquiry does not support creating a separate body with an overarching oversight
or review role because it would fundamentally change the current regulatory system.
If the CFR was to perform this role, as some submissions suggest, it would be
transformed from a mechanism to facilitate cooperation between regulators into a
243
separate agency in its own right. This would result in overlapping responsibilities and
weaken accountability.
Place APRA and ASIC under the control of boards

This option was raised by the Senate Economics References Committee in its report on
the performance of ASIC. 19 It has also been identified as an option for the ACCC in the
Draft Report of the Competition Policy Review. 20
The non-executive board model was used by APRA when it was established.
However, the Royal Commission into the collapse of HIH concluded that this
arrangement had blurred accountability for regulatory outcomes between the board
and the chief executive officer, and that APRA would be better headed by a small
full-time executive, with the capacity to establish an advisory board if necessary. 21
Conclusion
The Inquiry believes that creating a new Assessment Board to review regulator
performance is the best way to address the gap it has identified in the current
accountability framework. This option would facilitate improved scrutiny of regulator
performance without creating new agencies or compromising existing accountability
relationships. This recommendation is not intended to reduce the independence of
regulators in executing their statutory mandates.
Interaction with Government’s new Regulator Performance Framework
Under the new Regulator Performance Framework, regulators will have to undertake
an annual externally-validated self-assessment of their performance to minimise the
burden on their regulated populations. Selected regulators will also have their
performance assessed externally by a review panel every three years, with the option
of an annual review for major regulators.
Annual reviews by the Assessment Board would be broader than the process
envisaged under the Regulator Performance Framework. Although they would
encompass compliance cost issues, this would be only one element of overall
performance. To avoid duplication, the Assessment Board could act as the validation
body for each regulator’s annual self-assessment, and this assessment could be used in
the Board’s deliberations. This would remove the need for two separate processes.
19 Senate Economics References Committee 2014, Performance of the Australian Securities and
Investments Commission, Commonwealth of Australia, Canberra, Recommendation 55,
page 433.
20 Commonwealth of Australia 2014, Competition Policy Review, Draft Report, Canberra, Draft
Recommendation 47, page 63.
21 HIH Royal Commission 2003, The Failure of HIH Insurance Volume 1 of 3, Part Three,
Commonwealth of Australia, Canberra, Recommendations 18 and 19.
244
Other issues
Government should consider whether agencies outside the Treasury portfolio that
have a significant effect on the financial system, such as AUSTRAC, should be assessed
by the Assessment Board.
The remit of the Assessment Board should be narrow and specifically exclude:
• Assessments of the merits of relief for particular transactions, enforcement actions

and individual complaints against the regulators.
• Matters of financial system regulation policy, such as whether the mandates of

regulators are appropriate.
245
Execution of mandate
Recommendation 28
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.
Description
Government should continue to determine the level of funding for APRA and ASIC.
However, APRA and ASIC should be given greater year-to-year certainty in their
funding profiles as well as more flexibility in how they spend their budgets, including
their remuneration policies. Adopting a more rigorous funding model would provide
the regulators with more certainty, while enhancing transparency and efficiency. As
part of this model:
• Regulator funding should be set by Government based on the recommendation of

three-yearly funding reviews. These reviews should include consultation with
industry and consumer stakeholders.
• Once determined, funding would remain stable between reviews, subject to

appropriate indexation and efficiency arrangements. 22 Changes would only be
made if there were a significant change in the scope of a regulator’s mandate, or an
emergency event such as a financial crisis.
Regulators should be funded at a level that enables them to offer remuneration that is
competitive with the private sector. Effective regulation depends on effective human
capital, and more effective regulators are likely to require higher salaries. Regulators
currently target average remuneration at the 25th percentile of the market rate for like
work in the financial sector; however, the Inquiry is concerned they currently find it
difficult to meet this target.
The Inquiry is also concerned this target may be too low, preventing regulators from
offering market-median or higher remuneration to attract more specialised and senior
staff with strong market experience without median pay for other staff falling well
below the 25th percentile.
22 The efficiency measure may be a fixed efficiency dividend, or some other tailored efficiency
measure. It should be applied upfront as part of the funding review process to ensure
regulator funding remains stable over the estimates period.
246
ASIC staff should be removed from coverage by the Public Service Act 1999 (Public
Service Act) to bring it into line with APRA and the RBA. APRA and ASIC should be
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.
APRA, ASIC and the payments system regulation function of the RBA should each
conduct six-yearly forward-looking capability reviews to ensure they remain fit for
purpose and have the capabilities to address future regulatory challenges.
Objective
• Ensure Australia’s regulators are fit for purpose and have the funding, staff and
regulatory tools to deliver effectively on their mandates.
Discussion
Funding for APRA and ASIC
The Interim Report set out the following principles for funding the regulators: 23
• Funding should have a high degree of stability and certainty.
• Total funding should be proportionate to the task.
• Regulatory costs should be borne by those contributing to the need for regulation.
• Funding should promote the independence and accountability of the regulators.
The funding arrangements currently applying to APRA and ASIC do not reflect these
principles. Regulators lack stable funding. They are subject to unpredictable budget
reductions and unexpected efficiency dividends that limit their capacity to plan how
they will dedicate resources beyond the short term. ASIC funding was reduced in the
2014–15 Budget. At the same time, APRA and ASIC were subject to additional
whole-of-Government efficiency dividends in the 2014–15 Budget, the 2013–14
Economic Statement and the 2011–12 Budget. Submissions support the view that
financial regulator funding should have a high degree of stability and certainty.
The Inquiry has not carried out its own assessment of the adequacy of regulator
funding. However, submissions from both industry and consumer stakeholders argue
that ASIC is not adequately funded to carry out its current consumer protection
mandate in relation to the financial services industry, let alone the more proactive role

pages 3-110 to 3-111.
247
the Inquiry recommends ASIC should adopt in the future. 24 ASIC has also relied
heavily on specific-purpose funding. Periodic funding reviews would allow
Government to determine whether the regulators have sufficient funding to execute
their mandates. The Inquiry recognises that funding reviews are not simple tasks.
However, it believes there should be more consideration of the resources that
regulators require to deliver effectively on their mandates.
APRA’s industry funding arrangements mean its costs are generally borne by
prudentially regulated entities. This is not currently the case with ASIC. The next
recommendation in this chapter—that industry funding should also be adopted for
ASIC—will address this issue.
Current funding arrangements do not promote regulator independence and

accountability. These would improve if funding levels were based on periodic funding
reviews rather than annual Government decisions, and if regulators had more
discretion in determining how funding is used. Funding reviews would ensure
sufficient resources to support other recommendations in this report, such as ensuring
regulators can offer remuneration that allows them to compete effectively with the
private sector for talent.
Operational flexibility
APRA and ASIC are both subject to policies that limit their capacity to attract and
retain staff from the private sector. In particular, public sector–wide industrial
relations policies are a poor fit for APRA and ASIC, whose employees are typically
recruited from the private sector. 25 Second round submissions agree with the
proposition that APRA and ASIC should have more flexibility over staffing and be
able to offer competitive remuneration. Indeed, industry participants recognise the
value of competent and experienced regulators. 26
Unlike APRA and the RBA, ASIC is subject to the Public Service Act. Yet there is no
clear rationale for which agencies are included in the Act and which are not. ASIC
notes in its submission that the application of the Public Service Act has unnecessarily
limited ASIC’s ability to recruit and utilise external staff. 27 Although the Inquiry
recognises the need for regulators to maintain a culture of ‘public service’, this does
not depend on coverage by the Public Service Act and can be achieved through
tailored codes of conduct and statements of values. Removing ASIC from coverage by
24 See also: Senate Economics References Committee 2014, , Report on the Performance of the
Australian Securities and Investments Commission, Commonwealth of Australia, Canberra,
pages 407–415; International Monetary Fund (IMF) 2012, Australia: Financial System Stability
Assessment, IMF Country Report No.12/308, IMF, Washington, DC, page 26.
25 Over the last five years, less than 5 per cent of APRA staff members were recruited from the
public service. APRA, Second round submission to the Financial System Inquiry, page 78.
26 Australian Financial Markets Association 2014, Second round submission to the Financial
Financial System Inquiry, pages 75–77.
248
the Public Service Act would allow it to tailor management and staffing arrangements
to suit its needs.
Capability
There is no formal process for keeping regulators fit for purpose by ensuring they have
the skills, resources and powers to meet future challenges. At present, regulators are
subject to regular review through the five-yearly International Monetary Fund
Financial Sector Assessment Program. However, this has a strong focus on compliance
with international standards and codes. Capability reviews are only undertaken on an
ad hoc basis; for example, the Palmer Review into the role of APRA in the collapse of
HIH. This is in contrast to the recent requirement for major Government agencies,
including the ATO and the Australian Bureau of Statistics, to undertake periodic
capability reviews. For APRA and ASIC, a six-yearly cycle would allow capability
reviews to be aligned with every second funding review, allowing the two to take
place concurrently.
Conclusion
Moving ASIC and APRA to a three-year budget model, giving them more operational
autonomy and introducing six-yearly capability reviews would enhance the operation
of the current regulatory framework. This is a particularly important issue for ASIC
given the breadth of its responsibilities.
Given the extent of the changes the Inquiry has proposed for ASIC in this report, ASIC
should be the first to undergo a capability review in 2015. This would help to ensure it
has the skills and culture to carry out its enhanced role effectively.
249
Strengthening Australian Securities and Investments

Commission’s funding and powers
Recommendation 29
Introduce an industry funding model for Australian Securities and Investments

Commission (ASIC) and provide ASIC with stronger regulatory tools.
Description
Government should recover the cost of ASIC’s regulatory activities directly from
industry participants through fees and levies calibrated to reflect the cost of regulating
different industry sectors. Government would continue to set ASIC’s overall funding
needs. However, this would be done through three-yearly funding reviews.
Government should strengthen the Australian Credit Licence and Australian Financial
Services Licence (AFSL) regimes so ASIC can deal more effectively with poor
behaviour and misconduct. ASIC should be able to consider all relevant factors in
determining whether or not a licence should be granted. ASIC approval should be
required for material changes in the ownership or control of a licensee. Finally, ASIC
should have more capacity to impose conditions requiring licensees to address
concerns about serious or systemic non-compliance with licence obligations (including
expert reviews).
The maximum civil and criminal penalties for contravening ASIC legislation should be
substantially increased to act as a credible deterrent for large firms. ASIC should also
be able to seek disgorgement of profits earned as a result of contravening conduct.
Objective
• Ensure ASIC has adequate funding and regulatory tools to deliver effectively on its
mandate.
Discussion
Industry funding
At present, Government only recovers a small proportion of ASIC’s costs directly from
industry participants, through the Financial Institutions Supervisory Levies,
application fees and fees for market supervision. The absence of industry funding
means ASIC costs are not transparent to regulated industry participants. It also
exposes ASIC to an increased risk of funding cuts that are unrelated to changes in the
cost of delivering on its mandate. The Senate Economics References Committee report
250
on ASIC’s performance highlighted that resource constraints affect ASIC’s capacity to

conduct surveillance across regulated entities. 28
Most of the revenue collected by ASIC on behalf of Government comes from annual
fees paid by small proprietary companies as part of ASIC’s registry business. These
entities pay more than the cost of supervision. By contrast, the fees collected from large
corporations, auditors, liquidators and financial institutions amount to less than the
cost of regulating them, although some of this shortfall is offset by the money
Government collects through the Financial Institutions Supervisory Levies
administered by APRA.
The Wallis Inquiry recommended that both APRA and ASIC should be industry
funded. 29 However, this recommendation was only adopted in relation to APRA. At
that time, the revenue collected by ASIC on behalf of the Australian Government was
required to be shared with the states.
Enforcement tools
Although ASIC’s AFSL licensing powers were significantly strengthened in 2012, as
part of the Future of Financial Advice law reforms, ASIC’s submission notes that some
gaps remain in its capacity to exclude persons who are not fit and proper from the
industry: 30
• Ownership or control of licensees can change without the need to obtain approval
from ASIC — or APRA, in the case of prudentially regulated entities. This problem
was identified in relation to the collapse of Trio Capital. While the previous
Government agreed to a recommendation by the Parliamentary Joint Committee on
Corporations and Financial Services to address this issue, the law has not been
changed. 31
• The extent to which ASIC can consider previous conduct in other businesses in
determining whether an applicant will satisfy the ‘fit and proper’ test is uncertain.
This can limit its capacity to refuse a licence to applicants who have played a
material role in businesses previously subject to enforcement action. This issue was
28 Senate Economics References Committee 2014, Report on the Performance of the Australian
Securities and Investments Commission, Commonwealth of Australia, Canberra, pages 23–24.
29 Commonwealth of Australia 1997, Financial System Inquiry Final Report,
Recommendation 107, Canberra, page 535.
Financial System Inquiry, page 46. This issue is also covered in Chapter 4: Consumer outcomes.
31 Parliamentary Joint Committee on Corporations and Financial Services 2012, Inquiry into the
Collapse of Trio Capital, Commonwealth of Australia, Canberra, pages 127–128;
Commonwealth of Australia 2013, Government Response to the Parliamentary Joint Committee on
Corporations and Financial Services, Inquiry into the Collapse of Trio Capital, Canberra, page 2.
251
identified in the Senate Economics References Committee’s report on ASIC’s

performance. 32
• ASIC is limited in its capacity to use the licensing regime to impose conditions on
firms to address concerns about internal systems relating to serious or systemic
misconduct. At present, these can often only be imposed through enforceable
undertakings with the agreement of the licensee.
As the Inquiry noted in its Interim Report, the maximum penalties in Australia for
contravening laws governing financial sector conduct are low by international
standards. For example, ASIC cannot seek disgorgement of profits in relation to civil
contraventions. 33 As such, current penalties are unlikely to act as a credible deterrent
against misconduct by large firms. While the Inquiry recommends substantially higher
penalties, it does not believe that Australia should introduce the extremely high
penalties for financial firms recently seen in some overseas jurisdictions. This practice
risks creating inappropriate incentives for government and regulators unless revenue
is separated and used for social or public purposes.
Conclusion
Few submissions comment on ASIC enforcement powers or the adequacy of the
current penalty regime. Most discussion of ASIC enforcement powers focused on
whether or not ASIC should regulate product manufacture and distribution, although
there was some discussion of the balance between administrative remedies on the one
hand, and enforceable undertakings and judicial remedies, such as civil and criminal
penalties, on the other. 34 Some submissions specifically support substantially
increasing maximum penalties. 35
Stronger enforcement of the current framework can reduce demands for new rules and
regulations. This is a particularly important issue for ASIC given the breadth of its
responsibilities. The main risk of the new arrangements is that they may impinge
unfairly on the rights of industry participants. However, ASIC decisions in this area
would continue to be subject to merits review.
Second round submissions are divided on the issue of whether Government should
charge fees and levies that reflect the cost of ASIC’s regulatory functions. Several
32 Senate Economics References Committee 2014, Report on the Performance of the Australian
Securities and Investments Commission, Commonwealth of Australia, Canberra, pages 387–388.
33 Commonwealth of Australia 2014, Financial System Inquiry Interim Report, pages 3-124 to
3-125.
34 Minter Ellison 2014, Second round submission to the Financial System Inquiry, page 9.
35 Law Council of Australia 2014, Second round submission to the Financial System Inquiry,
Business Law Section, pages 7–8 and 10–12; Australian Shareholders’ Association 2014,
252
submissions support industry funding, while others were opposed to this option. 36
Remaining submissions that dealt with the issue support the concept of industry
funding provided it is accompanied by stronger transparency and accountability
mechanisms. 37 Others emphasise that Government, rather than regulators, should
determine the overall quantum of funding. 38 One issue is whether ASIC’s regulatory
functions are ‘public goods’ that should be funded through general taxation. Although
ASIC’s regulatory functions reflect public policy objectives, the Inquiry does not
believe this should prevent the introduction of industry funding. However, it may be
inappropriate for particular functions, such as financial literacy. Industry funding is
already used by APRA as well as many similar regulators overseas. 39
The main benefit of industry funding is its potential to give ASIC more predictable
funding as well as strengthen engagement between ASIC and industry on the costs of
conduct and market regulation. It would also have some potential costs. Depending on
how they are designed, fees and levies have the potential to increase barriers to entry
and potentially limit competition. One submission raises this concern in relation to
existing cost recovery arrangements for market supervision. 40
To maximise its benefit, the funding model should be structured to create a close
relationship between the incidence of fees and levies and the cost of regulating the
relevant activity. Costs must also be attributed fairly across different firms and
industry segments. The way in which industry funding is implemented may need to
be tailored to different industry sectors.
The Inquiry expects the benefits of industry funding to exceed the costs, subject to
careful implementation and inclusion of an appropriate transparency and
accountability framework. 41 It has sought to address stakeholder concerns about
industry funding by ensuring Government would continue to set ASIC’s budget.
Recommended three-yearly reviews would bring additional rigour to the budget
process, and improve the efficiency of the regulators.
36 Choice 2014, Second round submission to the Financial System Inquiry, page 25; EY 2014,
Second round submission to the Financial System Inquiry, page 16; Stockbrokers Association
of Australia 2014, Second round submission to the Financial System Inquiry, pages 13–15;
SMSF Professionals Association of Australia 2014, Second round submission to the Financial
37 For example, Australian Financial Markets Association 2014, Second round submission to the
Financial System Inquiry, page 46; Insurance Council of Australia 2014, Second round
submission to the Financial System Inquiry, page 15; Westpac Group 2014, Second round
38 Herbert Smith Freehills 2014, Second round submission to the Financial System Inquiry,
ASIC Funding, supplementary submission; National Insurance Brokers Association 2014,
page 3-112.
40 Chi-X Australia 2014, Second round submission to the Financial System Inquiry, pages 2-6.
41 Basic requirements are set out in Department of Finance 2014, Australian Government Cost
Recovery Guidelines, Resource Management Guide No. 304, Commonwealth of Australia,
Canberra.
253
Strengthening the focus on competition in the financial

system
Recommendation 30
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.
Description
Through their annual reports, regulators should demonstrate that they have given
explicit consideration to trade-offs between competition and other regulatory
objectives when designing regulations. The effect of regulatory proposals on
competition should be explained explicitly in consultation documents and annual
reports, which would then feed into Assessment Board examination of overall
regulator performance.
Government should commission periodic external reviews of the state of competition

in the financial system every three years, including regulatory barriers to foreign and
domestic entrants.
As an immediate first step, regulators should examine their rules and procedures to
assess whether those that create inappropriate barriers to competition can be modified
or removed, or whether alternative and more pro-competitive approaches can be
identified. 42 Each regulator should report back to Government prior to the first
external review of the state of competition.
Government should update ASIC’s mandate to include a specific requirement to take

competition issues into account as part of its core regulatory role. 43
These proposals are in addition to the recommendations in this report addressing

sectoral issues in banking, payments and financial markets.
42 Some of this is underway. Australian Prudential Regulation Authority (APRA) stated in its
second round submission that it is considering whether a more graduated approach to
authorisation may be warranted for established foreign institutions. APRA 2014, Second
43 The Australian Securities and Investments Commission Act 2001 (ASIC Act) requires ASIC to
promote commercial certainty and economic development and efficiency while reducing
business costs. However, there is no explicit reference to competition in the ASIC Act (or the
objects clause for Chapter 7 of the Corporations Act 2001).
254
Objectives
• Increase the focus on competition in the financial sector.
• Deliver more explicit reporting about the competition implications of regulatory

decisions.
• Highlight areas where there may be opportunities to strengthen competition.
Discussion
The benefits of competition are central to the Inquiry’s philosophy. While competition
is generally adequate in the financial system at present, the high concentration and
steadily increasing vertical integration in some sectors has the potential to limit the
benefits of competition in the future. Licensing provisions and regulatory frameworks
can impose significant barriers to the entry and growth of new players, especially
those with business models that do not fit well within existing regulatory frameworks.
Financial services businesses competing across national borders can find themselves
subject to duplicated and sometimes conflicting obligations. In some cases, these rules
reflect different local circumstances. However, they can limit competition in Australia
as well as impede Australian-domiciled firms’ ability to participate in global financial
markets.
Australian Competition Law provides an economy-wide framework for promoting

competition and addressing anti-competitive behaviour. However, the effectiveness of
the framework depends on the ACCC’s capacity to enforce its provisions — and the
ACCC must prioritise its work across the entire economy. Also, Australian
Competition Law does not provide a framework for removing regulatory barriers to
competition through improved regulatory practices and rules.
At present, regulator mandates adopt an inconsistent approach to competition. The

PSB has a clear competition objective. APRA is required to consider competition and
contestability in its decisions, although the industry frameworks do not adopt a
consistent approach to this issue. ASIC lacks an explicit competition mandate.
Furthermore, there is no current requirement for regulators to explain how they
balance competition considerations with other regulatory objectives in reaching
decisions. 44
Finally, there is currently no process for regularly assessing the state of competition in
the financial system, as there is for assessing stability in the form of the Financial
Stability Review. This creates the risk that broader competition issues will ‘fall between
the cracks’ as regulators focus on their specific mandates for stability or consumer
44 The Interim Report noted this is currently done on an ad hoc basis: Commonwealth of
Australia 2014, Financial System Inquiry Interim Report, Canberra, page 3-122.
255
protection. For example, no regulator has direct responsibility for removing barriers to
consumers switching products.
Conclusion
The recommendation would deliver a stronger focus on competition in the financial
system. In the absence of change, there is a risk that regulators and policy makers will
not place sufficient emphasis on competition when making decisions. This is a
significant issue given the:
• Extent of market concentration in some parts of the system, and its potential to limit
competition in the future.
• Disproportionate effect that regulation can have on smaller firms.
• Potential benefits to the Australian economy of disruptive innovation from new

market entrants in the financial system, and improved depth and international
connectivity of financial markets from cross-border competition.
The Inquiry considered two alternative options for strengthening the focus on
competition: appoint an additional APRA member to focus on competition, or give the
ACCC exclusive responsibility for competition matters (that is, remove it from the
mandates of APRA and ASIC). In relation to the first option, the Inquiry concluded
that strengthening consideration of competition issues as part of ordinary regulatory
processes was likely to have more effect than appointing a separate competition
member.
In relation to the second, the Inquiry considered it would be counterproductive to

remove competition and efficiency considerations from the mandates of APRA and
ASIC because this would reduce pressure on them to consider these issues. The ACCC
also lacks the power to intervene in regulation making by APRA or ASIC. Its focus is
on enforcing the prohibitions against anti-competitive conduct by businesses in
Australian Competition Law.
256
Compliance costs and policy processes
Recommendation 31
Increase the time available for industry to implement complex regulatory change.
Conduct post-implementation reviews of major regulatory changes more frequently.
Description
Except in exceptional circumstances, Government and regulators should give industry
participants at least six months to begin implementing regulatory changes once they
are finalised. Additional transitional periods of 12–24 months will also generally be
appropriate. Grouping commencements at fixed dates during the year — for example,
1 July and 1 January — would help industry participants to accommodate overlaps
between related changes, rather than having to make multiple system changes.
Government and regulators should also carry out more post-implementation reviews
of major changes to analyse their cost effectiveness and help develop better processes
for future interventions.
This proposal is consistent with Government’s recently announced Regulator

Performance Framework, which requires post-implementation reviews for regulatory
changes that have a major economic effect. The Inquiry’s recommendations on
accountability and competition are also expected to improve policy processes and
focus policy makers and regulators on considering compliance costs and efficiency
implications.
Objective
• Reduce costs, complexity and unanticipated negative implications associated with
implementing regulatory change.
Discussion
Most industry submissions identified the scope and pace of domestic regulatory
change in the post-GFC environment as a major issue. This is partly due to factors
beyond Australia’s direct control, including the proliferation of global standard-setting
under the auspices of the Financial Stability Board in the wake of the crisis. Another
factor is the wave of domestic regulatory change in countries that were at the epicentre
of the crisis, substantially affecting Australian firms with an international presence.
However, these developments have occurred at the same time as major domestically
257
driven changes to the regulation of credit, financial advice, general and life insurance,
and superannuation.
The Inquiry has not sought to examine all regulation with a view to identifying
deregulation opportunities. However, the Inquiry commissioned Ernst & Young (EY)
to assess the cost effectiveness of regulatory processes for three initiatives: changes to
the presentation of credit card terms and conditions; the ‘know your customer’ (KYC)
requirements of Australia’s anti-money laundering (AML) framework; and the
three-day balance transfer requirement for superannuation funds included in the
SuperStream reforms.
EY’s conclusion was that Government can, “… improve medium-term outcomes of

regulatory intervention through incremental changes in how it designs and
implements additional measures and how it monitors the impact (including
unintended effects) of regulation that has been implemented”. 45 Although overall
policy settings may be appropriate, the report identified some shortcomings in how
policies are operationalised, including:
• In some cases, it is not clear that detailed costs and benefits of changes have been
considered.
• There are gaps in industry consultation processes; for example, they may occur too
late to allow for efficient planning.
• Implementation deadlines can be optimistic.
The EY report highlighted the difficulties associated with undertaking cost-benefit

analysis of regulatory interventions. In particular, it noted that governments undertake
interventions for a mix of short- and long-term objectives and that assessing benefits is
more difficult than assessing direct costs. Timing issues are also relevant in that costs
may be readily apparent in the short-term, yet benefits may only emerge over a longer
period. For this reason, EY suggested that better upfront cost effectiveness analysis
would be an appropriate alternative to a full cost-benefit analysis, particularly where
timeframes are short.
Improved cost effectiveness analysis could include up-front projections of the expected
effects, early consultation on costs, and then post-implementation monitoring of actual
effect and costs, with review points triggered where changes have materially lower
effects or materially higher costs. Specific findings related to the three initiatives
studied by EY are set out in Box 13: EY cost effectiveness analysis of regulatory
interventions.
45 EY 2014, Financial System Regulation, data provided to the Financial System Inquiry,
October 2014, page 2.
258
Box 13: EY cost effectiveness analysis of regulatory interventions

Reforms to the presentation of credit card terms and conditions are estimated to
have involved total implementation costs of between $40 million and $120 million
across the industry. EY found some changes to consumer behaviour and associated
savings did follow the reforms; however, it could not conclude with certainty that
the changed behaviour was the result of the reforms. EY noted it was not clear
whether the Commonwealth had undertaken detailed consideration “… of how to
best target different consumer segments through the overall dispersion of additional
information on credit card terms”. 46 This example highlights the importance of a
transparent cost-benefit or cost effectiveness process.
KYC requirements are estimated to have cost between $647 million and $1 billion to
implement, with ongoing annual costs of between $299 million and $435 million. The
changes are driven by the need to comply with international regulatory standards.
Although participants agreed AML legislation is essential, consultations
highlighted, “… earlier consultation on coverage and structure would have
produced more efficient regulation”. 47
The three-day balance transfer requirement introduced as part of SuperStream was
estimated to have cost industry between $560 million and $1.2 billion. EY noted that
regulation in this area was a response to industry’s failure to adopt effective
electronic payment protocols. However, the industry view was that Government’s
approach generated some additional costs. In particular, consultation did not start
early enough and implementation deadlines were optimistic. Tight deadlines meant
that solutions were implemented in a less than optimal way to ensure timelines were
met. A more risk-based approach from the Commonwealth, with more time for
industry to develop data requirements and format standards, would have produced
a more efficient outcome.
The EY work reinforced some of the main points in industry submissions, where
industry participants asked for better regulatory design and more realistic
implementation time frames. 48 In general, better processes for the future are a higher
priority in the short term than efforts to reduce the current stock of regulation.
Despite concerns related to processes arising from this work, the Inquiry has found
limited evidence to suggest the compliance burden is higher in Australia than in
comparable peer countries. The Australian Bankers’ Association submission
highlighted that, according to the World Economic Forum’s Global Competitiveness
Report 2013–14, Australia ranks 128th out of 148 countries for “Burden of government
Inquiry, pages 63–68, ANZ 2014, Second round submission to the Financial System Inquiry,
page 28.
259
regulation”. 49 However, in addition to the evidence set out in the Interim Report, cost
of compliance survey data provided by Thomson Reuters Accelus suggests that,
although compliance costs for the financial sector have risen in Australia recently,
Australia is not out of step with other jurisdictions.
Chart 7: Financial services firm compliance teams spending more than

10 hours per week tracking finance sector regulatory developments
Per cent Per cent
35 35
31
29
30 30
25
25 25
21 21
20
20 20
18 17
15 13 13
15
11
10 10
8
5 5
0 0
United North Asia Middle East Australia Rest of world
Kingdom & America (excluding
European Australia)
Union
2013 2014
50
Source: Thomson Reuters Accelus.
Conclusion
Regardless of Australia’s relative position, unnecessary compliance costs and poor
policy processes are a concern. The Inquiry notes that Government has already
implemented a range of initiatives in this area, including more stringent requirements
relating to RISs, sunsetting provisions for existing regulations, portfolio targets for
reducing compliance costs and the Regulator Performance Framework.
Combined with Government’s existing initiatives to reduce ‘red tape’ and a slowing in
the pace of international regulation, the Inquiry’s recommendations should address
many of the concerns raised in industry submissions.
Inquiry, page 63.
50 Thomson Reuters Accelus 2014, data provided to the Financial System Inquiry,
7 October 2014.
260
The Inquiry has recommendations on a number of additional significant matters.
Funding
Impact investment
Recommendation 32
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.
Impact investing allows investors to pursue opportunities that provide both social and
financial returns. This innovative form of funding is growing globally as a valuable
mechanism to support social service delivery. Changing community expectations
about the role of government and the financial sector in funding social service delivery
highlight a need for this funding mechanism in Australia.
Impact investment can occur through direct investment in not-for-profit or social

enterprises. Alternatively, it can be intermediated by community development
financial institutions, social banks and impact investment fund managers. These
intermediaries play a valuable role in channelling impact investment funds as well as
building capacity in not-for-profit and social enterprises to attract impact investment
funds.
Importantly, impact investing has the potential to benefit government and taxpayers
by reducing costs and improving social policy outcomes. It can change the role of
Government from paying for inputs to paying for outcomes. It can also benefit
not-for-profits by diversifying their funding sources and helping them to develop
technical expertise in benchmarking and measuring outcomes, as well as improving
governance and accountability.
261
Financial System Inquiry — Final Report
Given the potential benefits of social impact investment and its current limited use in
Australia, the Interim Report sought feedback on market impediments. The Inquiry
agrees with stakeholders who suggest that clarifying some aspects of regulation would
facilitate market development, including:
• Clearer guidance from the Australian Prudential Regulation Authority (APRA) on

the appropriateness of impact investment for superannuation trustees. Currently,
guidance is limited.
• Government should amend the law to facilitate private ancillary funds established
and controlled by ‘sophisticated’ or ‘professional’ investors accessing wholesale
offerings for social impact bonds. 1
Many stakeholders argue that Government should play a more active role to facilitate
the social impact investment market in Australia, although views vary on the nature of
this role. 2 The Inquiry agrees “Government intervention can play a catalytic role both
in facilitating the functioning of the ecosystem and targeting actions to trigger its
further development. However, these actions should provide incentives for the
engagement, not the replacement of the private sector and should be conducted in a
manner conducive of the market”. 3
The Inquiry sees merit in Government facilitating the impact investment market.
Government’s involvement should include coordinating interested private sector
parties, providing expertise on social service delivery and performance measurement,
and offering explicit public endorsement for the significant private sector interest in
this emerging market.
1 Impact Investment Group 2014, Second round submission to the Financial System Inquiry,
pages 6–7.
2 Westpac 2014, Second round submission to the Financial System Inquiry, page 50; Impact
Investing Australia 2014, Second round submission to the Financial System Inquiry, page 5;
Impact Investment Group 2014, Second round submission to the Financial System Inquiry,
page 9.
3 Impact Investing Australia 2014, Second round submission to the Financial System Inquiry,
page 10 citing: Organisation for Economic Co-operation and Development (OECD) 2011,
Financing high-growth firms: the role of angel investors, OECD, Paris, page 124.
262
Retail corporate bond market
Recommendation 33
Reduce disclosure requirements for large listed corporates issuing ‘simple’ bonds and
encourage industry to develop standard terms for ‘simple’ bonds.
Australia has an established domestic bond market. However, a range of constraints,

including tax and regulatory settings, have limited the market’s development — in
particular, the retail corporate bond market. The Interim Report discusses these issues
further. 4
For corporates, the disclosure requirements for a retail corporate bond issue are more
onerous and costly than for domestic wholesale issuance. Although the new ‘simple’
corporate bonds legislation reduces the cost of disclosure documentation, it is still
greater than for a domestic wholesale issue. 5 Less onerous disclosure requirements for
listed securities would make retail issuance simpler and more cost effective.
The Inquiry considers that Government should amend the law to reduce disclosure
requirements for large listed corporate issuers of ‘simple’ bonds. The disclosure regime
should comprise a term sheet for a standardised product and a cleansing notice. In
addition, industry — assisted by the Australian Financial Markets Association —
should develop standard terms and conditions for ‘simple’ bonds, which would also
help reduce disclosure costs. The Inquiry believes that the proposed regime would
strike the right balance between reducing issuance costs and providing potential
investors with sufficient information to make a considered investment decision.
Stakeholders generally agree, and suggest that the documentation costs would be
broadly aligned with those for domestic wholesale issuance. 6 Given the proposed
disclosure regime is similar to current requirements for a domestic wholesale issue, it
would also reduce the administrative burden of a retail offer associated with a
wholesale issue.
Broadly, submissions and stakeholders agree that, at least initially, the new disclosure
regime should not be available to smaller corporates on the listed equity market. In

pages 2-86 to 2-87.
5 The Corporations Amendment (Simple Corporate Bonds and Other Measures) Bill 2014 became law
on 11 September 2014. The regime is not fully implemented, as much of the structure and
content of disclosure requirements are to be set by regulation and have only recently been
released for public consultation.
6 Based on an industry survey conducted by the Australian Financial Markets Association
(AFMA). AFMA 2014, Data provided to the Financial System Inquiry, 1 October 2014.
263
general, investors have the benefit of more market research and publicly available
information for larger corporates. Larger corporates are also more likely to be repeat
issuers and thus be subject to market discipline regarding the quality of their
disclosures.
The Inquiry considers that the new regime should only be available to the top 150
companies by market capitalisation on the Australian Securities Exchange (ASX). This
is broadly consistent with the views of stakeholders. Government should review this
limit after two years to determine whether the regime should be extended to smaller
corporates.
Unfair contract term provisions
Recommendation 34
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.
Protections from unfair contract term (UCT) provisions under the Australian Securities
and Investments Commission Act 2001 currently do not apply to small business loans or
business-to-business lending. The UCT provisions are limited to consumer contracts:
those in which at least one party is an individual acquiring goods or services wholly or
predominantly for personal, domestic or household use or consumption.
Several submissions suggest that some non-monetary loan covenants are unfair and
lenders could be more transparent when exercising them.
The Inquiry supports Government’s public consultation and policy development

process for extending the coverage of UCT protections under standard form 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 and the fair exercise of rights pursuant to non-monetary default
covenants. The Australian Securities and Investments Commission (ASIC) could also
make protections more effective by clarifying its intent to enforce UCT provisions.
More broadly, the Inquiry encourages the banking industry to adjust its code of
practice to address non-monetary default covenants. The Code of Banking Practice and
the Customer Owned Banking Code of Practice could require banks to give borrowers
sufficient notice of changes to covenants and of an intention to enforce —which could
give a borrower reasonable time to obtain alternative financing. Such adjustments to
industry practice would also provide greater scope and guidance for the Code
Compliance Monitoring Committee and the Financial Ombudsman Service to deal
with relevant complaints.
264
Finance companies
Recommendation 35
Clearly differentiate the investment products that finance companies and similar entities
offer retail consumers from authorised deposit-taking institution deposits.
Finance companies operate under an exemption from the Banking Act 1959. They differ
from authorised deposit-taking institutions (ADIs) because they raise funds by issuing
debt securities rather than by accepting deposits. Although most Australian finance
companies source their funding from wholesale investors, some smaller entities target
consumers. The period since the global financial crisis has seen numerous failures of
finance companies, resulting in significant losses. In the wake of these failures, it has
become apparent that some consumers did not appreciate the difference between
finance companies and ADIs. 7 This problem was exacerbated by finance companies
using bank account–like terminology and allowing consumers to access funds at call.
The Inquiry considered whether to ban finance companies from accepting retail funds
from consumers. However, it recognises that well-run finance companies can play a
useful role in the market. It also considered whether they should be prudentially
regulated by ASIC — an approach considered by the former Government following
the collapse of Banksia Securities. However, the Inquiry does not recommend that
ASIC’s mandate be extended in this way. The Inquiry considers that the best approach
would be to differentiate the products of finance companies from accounts offered by
ADIs. The Inquiry therefore recommends APRA ban finance companies from offering
at-call products to retail consumers and from using bank account–like terminology.
Corporate administration and bankruptcy
Recommendation 36
Consult on possible amendments to the external administration regime to provide additional

flexibility for businesses in financial difficulty.
The Interim Report asked stakeholders about the efficiency of Australia’s external
administration regime. 8 Submissions indicate that Australia’s external administration
provisions are generally working well and do not require wholesale revision.
7 Australian Prudential Regulation Authority 2014, First round submission to the Financial
8 Commonwealth of Australia 2014, Financial System Inquiry Interim Report,
Canberra, page 2-69.
265
Stakeholders present little evidence to suggest the Australian regime causes otherwise
viable businesses to fail. However, submissions highlight that a few elements of the
United States Bankruptcy Code’s Chapter 11 insolvency framework merit
consideration. 9
Submissions argue that directors should be protected by ‘safe harbour’ provisions that
permit restructuring efforts for firms in financial difficulty without invoking external
administration processes. These protections would only apply where directors seek
expert assistance. Stakeholders also suggest extending the safe harbour protection to
the expert restructuring advisers to prevent them from being considered de facto
directors. Further, stakeholders suggest that ipso facto clauses be suspended from
operating during the restructuring efforts. 10
The Inquiry recognises more work needs to be done to assess the potential value of
these proposals and recommends Government conducts stakeholder consultation on
these matters.
The current Australian external administration regime has other complexities:
• In some cases, external administration and bankruptcy processes overlap, causing

disproportionate complexity and cost. This particularly affects small and
medium-sized enterprises, where the owner faces personal bankruptcy if their
incorporated business fails.
• Complaints and dispute resolution processes relating to the external administration

regime could be improved. ASIC is currently implementing measures to enhance
existing processes.
• Elements of external administration and bankruptcy regulation are not technology

neutral and efficiencies available from digital processes are not being used.
Government consultation has commenced on measures to address elements of the first

two of these issues. Recommendation 39: Technology neutrality in this appendix addresses
the third.
9 Chapter 11 refers to “… the chapter of the US Bankruptcy Code providing (generally) for
reorganisation, usually involving a corporation or partnership”. United States Courts,
Reorganization under the Bankruptcy Code, United States Courts, Washington, DC, viewed
23 October 2014,
<http://www.uscourts.gov/FederalCourts/Bankruptcy/BankruptcyBasics/Chapter11.aspx>.
10 Ipso facto clauses deem a company to be in default in circumstances approaching insolvency;
for instance, where there has been a ‘material adverse change’ in a company’s financial
circumstances. Corporations and Markets Advisory Committee (CAMAC) 2003,
Rehabilitating large and complex enterprises in financial difficulties, CAMAC, Sydney,
paragraph 1.44, page 9.
266
Superannuation and retirement incomes

Superannuation member engagement
Recommendation 37
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.
Research indicates that giving consumers retirement income projections improves their
engagement with saving for retirement. 11 However, many superannuation funds do
not provide retirement income projections on member statements. All members need
to understand their projected retirement income to make informed decisions about
their retirement savings. Where possible, all funds should provide meaningful
retirement income projections on member statements, including scenarios to alert
members to sequencing risk, based on the standard assumptions described in ASIC’s
requirements for superannuation forecasts. 12 This would benefit members at a
relatively small cost to superannuation funds.
Superannuation funds can only provide a partial perspective of retirement incomes for
members who have multiple accounts and wealth accumulated outside of
superannuation. Online calculators enable individuals to enter all their information —
superannuation fund and asset balances—to obtain a more accurate retirement income
projection, including any income from the Age Pension. The Australian Taxation
Office (ATO), which holds consolidated superannuation information across multiple
accounts, could provide that information for use in calculators, which could initially be
accessed from the ATO’s myGov superannuation portal. This would assist funds to
design calculators that provide retirement income projections based on the
comprehensive income product for retirement they offer members
(see Recommendation 11: The retirement phase of superannuation in Chapter 2).
11 Goda, G, Manchester, C, Sojourner, A 2012, What’s my account really worth? The effect of
lifetime income disclosure on retirement savings, National Bureau of Economic Research,
Working Paper No. 17927.
12 Australian Securities and Investments Commission (ASIC) 2014, Regulatory Guide 229:
Superannuation forecasts, ASIC, Sydney.
267
There would be small implementation costs for the ATO to link its existing myGov
superannuation portal to retirement income calculators.
Innovation
Cyber security
Recommendation 38
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.
As observed in the Interim Report, cyber attacks are increasing in frequency and
sophistication. 13 The financial industry is a major target of cyber crime and is under
increasing threat as the number of high-value targets in the sector grows. Major
industry participants raise cyber security as a significant risk to their viability and to
the financial system. A financial sector cyber crisis could result in system-wide impacts
and significant consumer detriment.
The growth in interconnectivity, increasing network speeds and broad distribution of

technology mean that responses to cyber threats by individual institutions are
necessary but, in some cases, insufficient. Many industry participants suggest the
cyber security of the financial system is only as strong as its ‘weakest link’, requiring
efforts by both Government and industry to strengthen capacity to respond in an
effective and coordinated way.
Australia has a Cyber Security Strategy (CSS) in place, released in 2009, that outlines a
whole-of-Government cyber security policy. Submissions indicate the CSS is out of
date and not suited to today’s threat environment. Given the rapidly changing nature
of cyber space and the threat environment, Government should act to ensure Australia
has an updated and cohesive CSS.
Industry participants indicate that, although they already actively monitor the threat
environment and are well placed to identify vulnerabilities, the most effective
responses come from combining the intelligence they hold with timely threat

page 4-55.
268
information held by Government. Consequently, policy and regulatory frameworks

need to support effective and timely public–private sector information sharing.
Given the constant and rapid evolution of cyber threats, public–private sector
coordination of cyber crisis planning — including across sectors (for example, with the
telecommunications sector) — is becoming increasingly important. Industry
participants in particular highlight a need to clarify the roles of the public and private
sectors in a cyber crisis event to ensure a rapid, coordinated and effective response.
Updating the CSS, developing formal mechanisms for public–private sector

information sharing and clarifying public and private sector roles in a cyber crisis
would help to improve the resilience of the financial system. It would better prepare
the financial sector, Government and other industry sectors to respond in a timely and
coordinated manner to evolving cyber threats.
Technology neutrality
Recommendation 39
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.
Some regulation assumes or requires the use of certain forms of technology. For
example, regulation may specify certain delivery mechanisms for products, or use
terminology that assumes a paper-based environment. In other cases, new
technologies put the operation of certain provisions in doubt. These circumstances can
impede innovation and efficiency by preventing the uptake of new technologies that
could provide better outcomes for users, businesses and government. They can also
prevent government and regulators from managing risks appropriately.
Stakeholders have identified a range of priority areas for amendment, including

regulation relating to financial products and services disclosure, customer consent and
authorisation, payments and cheques, external administration processes, conveyancing
and identity verification. 14
14 Including: Mercer 2014, Second round submission to the Financial System Inquiry,
pages 57-58; King & Wood Mallesons 2014, Second round submission to the Financial System
269
Government should establish an industry working group to identify the priority areas
of regulation to be amended for technology neutrality. A number of stakeholders have
indicated their support for and willingness to be involved in such an initiative. 15
Technology-neutral regulation enables any mode of technology to be used and tends to

be competitively neutral. Generally, regulation should be principles-based and
functional in design, focusing on outcomes rather than prescribing the method by
which it should be achieved. However, the Inquiry recognises that technology specific
regulation may continue to be required and be beneficial in cases where adopting a
common technology standard would improve overall system efficiency. In these cases,
future review mechanisms should be established to ensure technology-specific
regulation does not impede innovation.
The principle of technology neutrality should be incorporated into government

policy-making guides, and processes for developing future regulation. The guidance
should allow for technology-specific regulation on an exceptions basis.
A technology-neutral approach to regulation enables regulators and government to

adapt to innovative developments and manage risks. It can also reduce compliance
costs by removing unnecessary regulatory impediments and improving the stability
and longevity of regulation. It can also give financial product providers greater
flexibility to innovate to meet changing consumer expectations.
Stakeholders note a potential consequence of technology-neutral regulation is that it

risks excluding some community segments from the financial system. 16 For example,
by enabling businesses to shift to electronic service delivery as a default, older
Australians or others with limited internet access may become excluded. As a result, it
is important that regulation accommodates the ability of consumers to select
alternative methods to access services, such as paper-based delivery.
In implementation, a phased approach may be required to manage transitional costs to

industry. However, the Inquiry believes these costs would be outweighed by the
longer-term efficiency benefits to industry and improved consumer outcomes.
Inquiry, pages 33–34; PEXA (Property Exchange Australia) 2014, Second round submission
to the Financial System Inquiry, pages 7–9; Australian Restructuring Insolvency and
Turnaround Association 2014, Second round submission to the Financial System Inquiry
(main document), page 3.
15 Commonwealth Bank 2014, Second round submission to the Financial System Inquiry,
page 60.
16 Refer, for example, to National Seniors Australia 2014, Second round submission to the
270
Consumer outcomes
Provision of financial advice and mortgage broking
Recommendation 40
Rename ‘general advice’ and require advisers and mortgage brokers to disclose ownership
structures.
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. 17
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. 18 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. 19
17 Australian Securities and Investments Commission (ASIC) 2013, Report 378: Consumer testing
of the MySuper product dashboard, ASIC, Sydney, page 22; ASIC 2013, Report 341: Retail investor
research into structured capital protected and capital guaranteed investments, ASIC, Sydney;
Susan Bell Research 2008, The provision of consumer research regarding financial product
disclosure documents, Financial Services Working Group, Sydney.
18 ASIC’s review of Future of Financial Advice reform implementation observed that
approximately 63 per cent of licensees in the sample tested were affiliated with financial
product issuers. Australian Securities and Investments Commission (ASIC) 2014, Report 407:
Review of the financial advice industry’s implementation of the FOFA reforms, ASIC, Sydney,
page 19.
19 In contrast, only 14 per cent of consumers considered financial planners working under the
brand of the same financial institution to be independent. Roy Morgan Research 2014, data
provided to the Financial System Inquiry, 7 November 2014.
271
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.
Unclaimed monies
Recommendation 41
Define bank accounts and life insurance policies as unclaimed monies only if they are
inactive for seven years.
At present, bank accounts and life insurance policies are deemed to be unclaimed
monies and transferred to Government if they are inactive for three years. The present
position was changed in 2012, from a longstanding arrangement that required an
inactive period of seven years.
The Australian Bankers’ Association estimates that reverting to seven years would
halve the number of claims. 20 The Inquiry believes Government should act to ensure
bank accounts and life insurance policies are deemed unclaimed after seven years of
inactivity and that these monies should be held in a separate trust account.
20 Australian Banker’s Association 2014, Submission in response to the Treasury discussion

paper: Options for Improving the Unclaimed Bank Account and Life Insurance Money Provisions,
page 2.
272
Regulatory system
Managed investment scheme regulation
Recommendation 42
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
The Inquiry received relatively few submissions on managed investment scheme (MIS)
matters, possibly due to other related and concurrent Government consultations.
In 2012, following a series of high-profile scheme collapses, the Corporations and

Markets Advisory Committee (CAMAC) released a report into MISs that identified
problems in a range of areas, including arrangements for restructuring or winding up
failed schemes. 21,22 The report also highlighted more fundamental concerns about
schemes being used as vehicles for entrepreneurial activities rather than as passive
investment vehicles. It found that most problems with the sector had arisen due to
stress in ‘common enterprise’ schemes, where the MIS structure is favoured over the
corporate structure for tax reasons. This in turn led to a number of difficulties in
managing the financial distress of those schemes and consequent consumer detriment.
In 2014, CAMAC released a broad-ranging discussion paper that, among other issues,
identified MIS regulatory architecture characteristics that impede other jurisdictions
from recognising the equivalence of the Australian regulatory regime. Without
equivalence, companies find it harder to conduct cross-border business. 23
Submissions received were largely about these issues. Accordingly, the Inquiry
believes these should be priority areas for Government action arising from CAMAC’s
work.
21 Collapses were experienced primarily in the agribusiness sector.

22 Corporations and Markets Advisory Committee (CAMAC) 2012, Managed investment schemes,
CAMAC, Sydney.
23 Corporations and Markets Advisory Committee (CAMAC) 2014, The establishment of managed
investment schemes, CAMAC, Sydney.
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In addition to this recommendation, the Inquiry is making several other

recommendations affecting the MIS sector, including:
• Strengthening regulators’ focus on competition in the financial system, including
identifying barriers to cross-border provision of financial services.
• Prioritising the rationalisation of MIS legacy products (see below).
• Removing regulatory impediments to innovative product disclosure and

communication with consumers.
The Inquiry also identifies a number of taxes for consideration as part of the Tax White
Paper process, such as the tax treatment of funds management vehicles (for further
detail, see Appendix 2: Tax summary).
Legacy products
Recommendation 43
Introduce a mechanism to facilitate the rationalisation of legacy products in the life insurance
and managed investments sectors.
Industry estimates suggest that approximately 25 per cent of all funds under
management are in legacy products. 24 These are products that are closed to new
investors and have become uneconomic or rendered out of date by changes to market
structure, Government policy or legislation. Legacy products increase costs to fund
managers and life insurers. They can also prevent consumers from accessing better
features in newer products.
Between 2007 and 2010, Government worked with industry to develop a mechanism to
facilitate product rationalisation, focusing on the managed investments and life
insurance sectors — superannuation was considered less problematic as there was
already a successor fund transfer mechanism in relevant legislation. However,
Government did not finalise or implement the mechanism.
The mechanism would have facilitated rationalisation of genuine legacy products —

that is, not simply those that are performing poorly — subject to a ‘no disadvantage
test’ for relevant consumers. It would also have provided tax relief to ensure
consumers were not disadvantaged as a result of triggering an early capital gains tax
event.
24 Financial Services Council (formerly Investment and Financial Services

Association Ltd) 2009, Second round submission to Australia’s Future Tax System Review,
page 5.
274
The Inquiry sees benefit in such a mechanism for product rationalisation that treats
consumers fairly. Given the cost of implementing the mechanism, the Inquiry
considers it should initially be limited to managed investments and life insurance, and
that it should be subject to a cost recovery mechanism, such as an application fee. The
application fee could be designed to offset process administration costs and
incorporate economic incentives to ensure rationalisation targets the most problematic
areas.
Corporations Act 2001 ownership restrictions
Recommendation 44
Remove market ownership restrictions from the Corporations Act 2001 once the current
reforms to cross-border regulation of financial market infrastructure are complete.
An additional restriction on the ASX’s ownership, over and above the Foreign
Investment Review Board national interest test, was introduced on the exchange’s
demutualisation in 1998. The rationale for this restriction was concern about a possible
conflict of interest in the ASX’s role as a market co-regulator. However, responsibility
for market supervision has now been transferred to ASIC, and proposals are underway
to allow for stronger cross-border regulation. 25
Government should act to remove market ownership restrictions for the ASX to make
it subject to the same ownership restrictions as other entities in the financial sector.
25 Council of Financial Regulators (CFR) 2014, Application of the Regulatory Influence Framework
for Cross-border Central Counterparties, CFR, Sydney; Reserve Bank of Australia (RBA) and
Australian Securities and Investments Commission 2012, Implementing the CPSS-IOSCO
Principles for financial market infrastructures in Australia, RBA, Sydney; Stevens, G 2012, Review
of Financial Market Infrastructure Regulation, letter to the Hon. Wayne Swan, MP (Deputy
Prime Minister and Treasurer), 10 February.
275
The Inquiry has identified a number of taxes that distort the allocation of funding and
risk in the economy. The Inquiry also identified other tax issues that may adversely
affect outcomes in the financial system. Unless they are already under active
Government consideration, the tax issues listed below should be considered as part of
the Tax White Paper process.
277
Issue
Differentiated tax The tax system treats returns from some forms of saving more favourably than others. For example, interest income from bank deposits
treatment of savings and fixed-income securities are taxed relatively heavily. This distorts the asset composition of household balance sheets and the broader
flow of funds in the economy.
To the extent that tax distortions direct savings to less productive investment opportunities, a more neutral tax treatment would likely
increase productivity.
The relatively unfavourable tax treatment of deposits and fixed-income securities makes them less attractive as forms of saving and
increases the cost of this type of funding.
Negative gearing and Capital gains tax concessions for assets held longer than a year provide incentives to invest in assets for which anticipated capital gains
capital gains tax are a larger component of returns. Reducing these concessions would lead to a more efficient allocation of funding in the economy.
For leveraged investments, the asymmetric tax treatment of borrowing costs incurred in purchasing assets (and other expenses) and
capital gains, can result in a tax subsidy by raising the after-tax return above the pre-tax return. Investors can deduct expenses against
total income at the individual’s full marginal tax rate. However, for assets held longer than a year, nominal capital gains, when realised,
are effectively taxed at half the marginal rate. All else being equal, the increase in the after-tax return is larger for individuals on higher
marginal tax rates.
The tax treatment of investor housing, in particular, tends to encourage leveraged and speculative investment. Since the Wallis Inquiry,
278
higher housing debt has been accompanied by lenders having a greater exposure to mortgages. Housing is a potential source of
systemic risk for the financial system and the economy.
Dividend imputation The case for retaining dividend imputation is less clear than in the past. To the extent that dividend imputation distorts the allocation of
funding, a lower company tax rate would likely reduce such distortions.
By removing the double taxation of corporate earnings, the introduction of dividend imputation (in 1987) reduced the cost of equity and
the bias towards debt funding. This contributed to the general decline in leverage among non-financial corporates.
However, the benefits of dividend imputation, particularly in lowering the cost of capital, may have declined as Australia’s economy has
become more open and connected to global capital markets. If global capital markets set the (risk-adjusted) cost of funding, then
dividend imputation acts as a subsidy to domestic equity holders. That would create a bias for domestic investors, including
superannuation funds, to invest in domestic equities. Imputation provides little benefit to non-residents that invest in Australian
corporates.
For investors (including superannuation funds) subject to low tax rates, the value of imputation credits received may exceed tax payable.
Unused credits are fully refundable to these investors, with negative consequences for Government revenue.
Mutuals cannot distribute franking credits, unlike institutions with more traditional company structures. This may adversely affect mutuals’
cost of capital, with implications for competition in banking.
Issue
Interest withholding tax For non-residents, repatriated income from Australian investments is, in some cases, subject to withholding tax. The unequal tax
(IWT) treatment of repatriated income may affect the funding decisions of Australian entities and place Australia at a competitive disadvantage
internationally.
Lower, more uniform withholding tax rates would unwind these distortions; however, since withholding taxes help protect the integrity of
the tax system, reforms should consider the potential implications for tax avoidance.
Withholding tax varies depending on a range of factors, including the type of funding, the country of the non-resident and the relationship
between the non-resident and the domestic recipient of the funding.
Withholding taxes generally increase the required rate of return for foreign investors, which reduces the relative attractiveness of
Australia as an investment destination. Where foreign investors can pass on the cost to domestic recipients of funds, this raises the cost
of capital in Australia.
For financial institutions, different funding mechanisms are subject to different rates of IWT. Reducing IWT (for the relevant funding
mechanisms) would reduce funding distortions, provide a more diversified funding base and, more broadly, reduce impediments to
cross-border capital flows.
For foreign bank branches in Australia, interest paid on funds borrowed from the offshore parent is deductable, limited to the London
Interbank Offered Rate (LIBOR) cap. This can prevent the branch from claiming the full interest cost of borrowing.
Australia’s IWT regime also applies to derivative transactions. Under G20 commitments, certain standardised over-the-counter
279
derivatives need to be collateralised and cleared through a regulated central counterparty (CCP). In Australia, outbound interest
payments on collateralised positions may be subject to IWT (flows from Australian participants to offshore CCPs, or flows from Australian
CCPs to offshore participants). This may increase costs for Australian participants and adversely affect liquidity in Australian derivatives
markets.
Development of new financial markets that trade non–AUD denominated financial products (for example, RMB-denominated products)
requires making markets across borders. Greater certainty regarding how withholding taxes are applied in these markets, and better
alignment of the regime with regional trading partners, would aid market development.
The Research and The R&D Tax Incentive provides businesses with annual tax offsets for eligible R&D costs.

Development (R&D) Tax Submissions broadly support the regime, although some argue that more frequent access to tax offsets would help alleviate firms’ cash
Incentive flow constraints, particularly for new ventures.
Tax treatment of Simplifying the tax rules for VCLPs and streamlining Government administration of the regime would reduce barriers to fundraising. A
Venture Capital Limited 2011 Board of Taxation review (Review of taxation arrangements under the Venture Capital Limited Partnership regime) made
Partnerships (VCLPs) recommendations to simplify the regime. In 2013, Government provided in-principle support for the recommendations.
Issue
Tax treatment of funds In 2009, the Johnson Review (Australia as a financial centre: Building on our strengths) recommended changes to the tax treatment of
management vehicles funds management. Government has implemented some of the proposed changes but is still considering others, including expanding the
range of collective investment vehicles (CIVs).
Typically, offshore investors require an investment vehicle that allows flow-through of any tax liabilities from the vehicle to the end
investor. However, Australian tax law does not allow for the types of vehicles that both provide for flow-through and are familiar to
offshore clients (particularly in Asia). A broader set of appropriate vehicles would better facilitate the management of foreign funds.
The Board of Taxation reviewed tax arrangements applying to CIVs in 2011. Government is yet to release the report.
Tax treatment of Tax concessions in the superannuation system are not well targeted to achieve provision of retirement incomes. This increases the cost
superannuation: Tax of the superannuation system to taxpayers and increases inefficiencies arising from higher taxation elsewhere in the economy, and the
concessions distortions arising from the differences in the tax treatment of savings. It also contributes to the broader problem of policy instability,
which imposes unnecessary costs on superannuation funds and their members and undermines long-term confidence in the system (see
Chapter 2: Superannuation and retirement incomes).
Tax treatment of Earnings are taxed at 15 per cent in the accumulation phase, but are untaxed in the retirement phase. This can act as a barrier to funds
superannuation: offering ‘whole-of-life’ superannuation products and increases costs in the superannuation system.
Differentiated tax rates Aligning the earnings tax rate between accumulation and retirement would reduce costs for funds, help to foster innovation in whole-of-
on earnings life superannuation products, facilitate a seamless transition to retirement and reduce opportunities for tax arbitrage (see Chapter 2:
280
Superannuation and retirement incomes).

Tax treatment of legacy Legacy products are financial products that are outdated and closed. These include some life insurance policies and interests in
products managed investment schemes.
Legacy products are a drag on the efficiency of product providers, which ultimately may lead to higher costs for consumers. In 2009,
Government proposed a framework for rationalising legacy products; however, this has not yet led to an implemented solution. One
significant issue is the tax treatment of underlying assets when legacy products are converted or consolidated into products with
equivalent features or benefits (see Recommendation 43: Legacy products in Appendix 1: Significant matters).
Duties on insurance Insurance taxes are levied by the states and territories. All states impose stamp duties on general insurance premiums, while some
states impose additional levies—for example, fire service levies.
Insurance taxes mean that individuals and businesses must pay more to achieve the same risk reduction. Reducing duties on insurance
would assist in dealing with underinsurance.
Tax treatment of With regard to corporate groups that include regulated entities, a group headed by a NOHC may give legal and operational separation to
non-operating holding the group’s regulated and non-regulated activities. In Australia, few financial groups are headed by NOHCs, and none of the four major
companies (NOHCs) banks operate under this structure.
A NOHC structure may provide financial institutions with greater flexibility in their activities. For regulators, a NOHC structure may
facilitate supervision and resolution. However, restructuring carries significant costs for corporate groups, including tax implications.
Making a move to a NOHC structure tax neutral would reduce disincentives to adopt this corporate structure.
Issue
Goods and services tax GST is not levied on most financial services. This may contribute to the financial system being larger than it otherwise would be.
(GST) Financial service providers that do not charge GST still must pay GST on inputs, but cannot claim input tax credits. Providers pass this
cost on to consumers in the form of higher prices.
As a result, households could be over-consuming financial services compared to what they would consume if GST was applied to these
services. Because the GST is embedded in prices charged to businesses, but not charged explicitly, businesses cannot claim input tax
credits. This could result in businesses consuming fewer financial services than otherwise would be the case.
281

Appendix 3: Small and medium-sized
enterprises (SMEs)
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 (see Recommendation 20: Comprehensive
credit reporting in the Chapter 3: Innovation). 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 (see Recommendation 18: Crowdfunding in Chapter 3). 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 (see Recommendation 34: Unfair contract term provisions in
Appendix 1: Significant matters). 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 (see

Recommendation 17: Interchange fees and customer surcharging and Recommendation 16:
Clearer graduated payments regulation in Chapter 3). 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.
283
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
(see Recommendation 19: Data access and use in Chapter 3).
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 (see Recommendation 14: Collaboration to enable innovation in Chapter 3).
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 (see Appendix 2: Tax summary).
284
Appendix 4: Consultation
Approach to the Inquiry
The Inquiry has taken a consultative approach to its task.
The Committee invited public submissions by 31 March, based on the terms of

reference. The Inquiry received more than 280 submissions as part of this process.
The Inquiry invited a second round of submissions in response to the Interim Report,
released on 15 July 2014, which made 28 observations and posed a series of questions
seeking further information from stakeholders. The Inquiry received more than 6,500
submissions as part of this process.
In addition to formal submissions, Committee members have held bilateral meetings,

roundtables and public forums in Australia over the course of the Inquiry. The
Committee also met with the International Panel and undertook two international trips
to meet with international regulators and financial intermediaries.
Consultation
Committee and Panel meetings
No. Event City
31 Financial System Inquiry Committee meetings Sydney (1 meeting held in Canberra)
1 International Advisory Panel meeting (with Committee) Sydney
2 International Advisory Panel meeting (with Committee) Teleconference
1 International Advisory Panel meeting (with Committee) Hong Kong
Public Forums
Location Date Committee Members attending
Perth 13 August 2014 David Murray, Craig Dunn
Melbourne 14 August 2014 David Murray, Kevin Davis, Brian McNamee
Brisbane 19 August 2014 David Murray, Carolyn Hewson, Brian McNamee
Sydney 20 August 2014 David Murray, Carolyn Hewson, Craig Dunn
285
Roundtables
Location Date Event
Melbourne 9 May 2014 Industry Roundtable – Small Business
Sydney 16 July 2014 Post-Interim Report sector de-brief — Payments sector
Sydney 16 July 2014 Post-Interim Report sector de-brief — Financial Markets sector
Sydney 16 July 2014 Post-Interim Report sector de-brief — Banking sector
Sydney 17 July 2014 Post-Interim Report sector de-brief — General Insurance sector
Sydney 17 July 2014 Post-Interim Report sector de-brief — Superannuation and Life
Insurance sector
Sydney 7 May 2014 Academic roundtable — Centre for International Financial

Regulation
Melbourne 6 August 2014 Academic roundtable — Australian Centre for Financial Studies
Sydney 15 August 2014 Industry roundtable – Consumer outcomes
Sydney 18 August 2014 Post-Interim Report sector de-brief – Consumer organisations
Sydney 18 August 2014 Industry Roundtable – Small Business
Sydney 19 August 2014 Industry roundtable — Banking
Sydney 19 August 2014 Industry roundtable — Superannuation
Sydney 19 August 2014 Industry roundtable — Retirement Incomes
Sydney 21 August 2014 Academic roundtable — Centre for International Financial

Regulation
Speeches
14 February 2014
Conduct of the Financial System Inquiry
Address to the Economic and Political Overview Conference, Sydney, Committee for Economic
Development of Australia
David Murray AO, Chair, Financial System Inquiry
1 May 2014
Financial System Inquiry: An Update on Progress
Address to the Australian Business Economists, Sydney
15 July 2014
Sustaining Confidence in the Australian Financial System — Launch of the Interim Report
Address to the National Press Club, Canberra
Note: These speeches are available on the Financial System Inquiry website (see http://fsi.gov.au).
286
Stakeholder meetings
The Inquiry also participated in several hundred meetings with stakeholders. The table
below summarises the stakeholder meetings attended by Committee members. It does
not include the numerous stakeholder meetings conducted by the Secretariat.
Meetings in Australia
Pre-Interim Report Post-Interim Report
No. Stakeholder category No. Stakeholder category
11 Government 13 Government
20 Financial Institutions 34 Financial Institutions
6 Consultants 1 Consultant
5 International 5 International
1 Service provider 2 Service providers
21 Peak bodies 16 Peak bodies
- - 1 Individual (small business owner)
64 Total 72 Total
International Trips
Date No. of meetings Location
26 March 2014 5 meetings Hong Kong
20–24 July 2014 17 meetings Europe — Frankfurt ,Basel, London
24–30 July 2014 14 meetings United States — New York, Washington DC
7–11 September 2014 10 meetings Asia — Singapore, Beijing, Hong Kong
Submissions to the Inquiry

First round submissions (lodged up until 2 May 2014) are available on the Financial
System Inquiry website (www.fsi.gov.au), except where authors requested
confidentiality. A list of people and organisations that made non- confidential
submissions is available at Appendix 3 of the Financial System Inquiry Interim Report.
The second round of submissions closed on 26 August 2014. Of the more than 6,500
submissions the Inquiry received in response to the issues set out in the Interim
Report, more than 5,000 campaign submissions were received on the issue of ‘credit
card surcharges’ — these are not listed below. Second round submissions are also
available on the Inquiry’s website.
287
Analysis of submissions
Chart 8: Second round submitters to the Inquiry shows the composition of parties that
made second round submissions to the Inquiry.
Chart 8: Second round submitters to the Inquiry

Per cent Per cent
35 35
30 30
25 25
20 20
15 15
10 10
5 5
0 0
Source: Centre for International Financial Regulation. Excludes campaigns such as credit card surcharges
and too-big-to-fail. Also excludes appendices, attachments, supplementary materials and confidential
submissions.
Chart 9 (page 289) shows the frequency that Interim Report observations were raised
in second round submissions.
Chart 10 (page 290) shows the three observations that each category of stakeholder
raised most frequently in the second round of submissions. The darker shade
represents a heavier focus on that observation.
288
Chart 9: Frequency that Interim Report observations were raised in second round submissions
289
Source: Centre for International Financial Regulation and Centre for Law, Markets and Regulation. Excludes campaigns such as credit card surcharges and too-big-to-
fail. Also excludes confidential appendices, attachments, supplementary materials confidential submissions.
Chart 10: Top 3 observations in second round submissions from each category of stakeholder
290
List of submitters
The following people and organisations made non-confidential second round
submissions. The Interim Report lists the people and organisations that made
non-confidential first round submissions.
ACTU AMP Atkinson, Graham
Aarsten, Xavier Anderson, R Atkinson, Pamela
Aceti Anfruns, Michael Atkinson, Thomas
Actuaries Institute ANZ Attiwill, Ian
Adams, G ANZ and the Aussie

Consumer Action Law
Adams, Helen Centre AUSTRAC
Adams, Nora Apps, Terry Australian APEC

Study Centre
Adams, Thomas Apswoude, David
Australian Bankers’
Adams, W Arnhem Investment Association (ABA)
Management
Adkins, John Australian Business
Arnold, James Register (ABR)
Aebi, Bruno
Ashby, Damien Australian Centre for
Ainslie, Frank Financial Studies
Ashby, Leon (ACFS)
Aldridge, Les
Asia Pacific Stock Australian Council of
Alfonso, Alfredo Exchange Limited Social Service (ACOSS)
Alford, M & J Association of Australian Council of

Financial Advisers Superannuation
Alifrangis, Philip (AFA) Investors (ACSI)
Allens Linklater Association of Australian Digital

Superannuation Funds Currency Commerce
Allianz Australia (ASFA) Association
Allison, Anthony ASX Ltd Australian Finance

Group
American Express Atchison Consultants
291
Australian Financial Australian Retailers’ Banking and Finance

Markets Association Association Consumer Support
Association
Australian Financial Australian Securities
Security Authority and Investments Bankmecu
(AFSA) Commission (ASIC)
Bardon, Richard
Australian Foundation Australian
Investment Company Securitisation Forum Barlow, Rita
Australian Industry Australian Barry, Annie

Group Shareholders
Association Barry, Ernie
Australian Institute of
Company Directors Australian Super Barry, Michael
Australian Institute of Ayling, Michael Bartlett, Donald

Superannuation
Trustees (AIST) Back, Deborah Bartlett, Gerald
Australian Listed Badcock, Paul Barton Consultancy

Investment Companies
Association Baddeley, Margaret Bartosch, Klaus
Australian Bain, John Bartron, Clive

Newsagents’
Baines, Ron Barwick, Elisa
Federation Ltd
Australian Payments Baker & McKenzie Bateman, Alan & Claire

Clearing Association
Baker, Bruce Bauer, David
(APCA)
Baker, Caroline Baum, RL

Australian Private
Equity & Venture
Baker, Lynn Beaton, Ashley
Capital Association
Baker, Ross Beck, Cameron

Australian Prudential
Regulation Authority Beck, Jeremy
Ballistic Eng
(APRA)
Bamfield, Michael Beecroft, Theresa
Australian
Restructuring Bell, Peter
Bank Doctor, The
Insolvency &
Turnaround Belmont Business
Bank Reform Now
Association (ARITA) Enterprise Centre
Banki Haddock Fiora
292
Belonogff, Michael Boyd, Alisa Bruce Mulvaney & Co
Bernal, Ivo Boyd, Keith Buckland, Dianne &

Ray
Best, Kris BPAY
Buckley, Ross and Ooi,
Biddulph, Noel Bradford, Don Ken
Bingley, Rhys Bradford, Kael Bunning, Scott
Bird, Steve Brandson, Peter Burgess, Steven
Blacktown City Breckenridge, Alistair Burke, AJ

Council
Breustedt, Francis Burnett, Geoffrey
Blake, Jason
Breward, Alun Burro, Guido
Blake, Stephen
Britten, Jamie Business Council of
Blasen, Christian Australia
Britten, RJ
Block, Milton Bussenscheet, Val
Broadbent, Betty
Boardman, Warwick Busuttil, Paul
Broadbent, Henry
Bodey, James Butler, Greg
Broadbent, Keith
Bone, David Butler, Robert
Broadridge Financial
Bonham, James Solutions Button, Jennifer
Booby, Maxine Broff, Roy Byrne, Richard
Booth, Don Brooks, Jason Caiani & Company
Bourke, Bernie Brotherhood of St Campbell, A

Laurence
Bourne, Duncan Campbell, Bruce
Brown, Gregory
Bourne, Glenyss Campbell, John
Brown, Neville
Boutique Financial Campbell, Sandy
Planners Brown, Peter
Campbell, Trudy
Bower, D Brown, Robert
Campbell, W
Boxall, Malcolm Brownlie, Peter
293
Cantarella, John Chamber of Commerce Clanchy, Michael

and Industry
Capone, Malcolm Queensland Clarity Advisory
and Training
Carnegie, Les Chan & Naylor Solutions Pty Ltd
Carnellor, Amanda Chant West Clark, Allan
Carter, John Chapman, Graeme Clark, Ian
Carters Chapman, Janet and Clark, Judith

David
Cash, Brett Clarke, Elizabeth
Chapman, Peter
Cash, Clinton Clarke, Frank
Chartered Accountants
Cash, Glennis Australia and New Clarke, Terry
Zealand
Cash, Nathan Clayton Utz
Chatzitaskas, Nick
Catrevena Clifford, Richard
Cheever, Paul
Cavendish Clyde, Barry
Superannuation Chegwyn, John
Coburn, Niall
Centre for Commercial Chessell, Leo
and Property Law — Coles
Queensland University Chin, Debbie
of Technology Collingwood, Bevan
Chi-X Australia Pty Ltd
Centre for Digital Combined Pensioners
Business Chizhov, Mikhail and Superannuants
Association of NSW
Centre for International Chizhova, Tatyana Inc (CPSA)
Finance and Regulation
(CIFR) CHOICE Comiskey, D
Centre of Excellence in Christensen, Kay Commercial Asset

Population Ageing Finance Brokers
Research (CEPAR) Chung, Lisa Association of
Australia (CAFBA)
CFA Societies Australia Citizen Freeman Pty
Ltd Commins, Darren
Challenger
Citizens Electoral Committee for Sydney
Council
Commonwealth Bank
294
Concannon, Edward Council of Social CV Solutions

Service of NSW
Conners, Robert (NCOSS) Czajka, Micahel
Connors, Ron Cousins, Paul Dagger, William
Consumer Action Law Cowling, Nan Dahlsen, John

Centre
CPA Australia Dale, Bernard
Convenience and
Mixed Business Crerar, Amanda Dalug, John
Association (CAMBA)
Cross, Phillip Daly, Gary
Cooke, Heather
Crossing, Margot Daniels, Ian
Cooke, Lynda
Crowder, Colleen Davey, Danielle
Cooper, J
Crowe, Mary Davey, Shaun
Copas, Murray
Crowther, Charles Davies, Matthew
Corbin, Michael
Crowther, Sonya Davies, Rodney
Corin Jacka Financial
Solutions CSR Limited Davis, Lindsay
Cornell, Geoff CUA Davis, Peter
Corporate Cullen, Jill Davis, Stephen

Superannuation
Association Cullen, Patrick Davy, Jeffrey
Cosgrove, Lindsay Cullen, WB Daw, John
COTA Culling, Nick Dawborn, Anne
Cotter, Patrick Culverwell, John de la Motte, Rolfe
Cotterell, Lilias Cummings, Trevor Dean, Geoffrey
Cottrell, M Curtis, Bob Della Gatta, Norma
Coué, PL Customer Owned Deloitte

Banking Association
Council of Small (COBA) Deloli, Kent
Business Australia
(COSBOA) Cuticone, Vince Denise, Michelle
295
Desreaux, Barry Eberle, R & D EY
Detjen, Henry Economic Reform Fadden, Vicki

Australia
Dewis, David Faddoul, Charles
Edam, N
Dibbs Barker Fallon, Frances
Edmunds, Roy
Dickson, Gillian Farraher, P
Edstein, John
Dignam, Adrian Farrington, G
Edwards, Dale
Dilley, Allen Feltham, Gregory
Edwards, Josie
Dillon, Craig Fernandes, Pearl
Edwards, Peter
Dimensional Ferrall, David
Edwards, Thelma
Dixon Advisory Ferriday, D
Edwards, Walter
Djerriwarrh Ferrier Hodgson
Investments Limited Eedy, Peter
Ferrier, Peter
Doherty, William eftpos
Ferriggi, Francis
DomaCom Eggins, Christine
Ficken, John
Donaldson, Bill Eldridge, Janice
Field, Allen
Donaldson, David Eley, Steven
Financial Institutions &
Dooley, Clint Elliott, Elizabeth Management Advisory
(FIMA)
Downey, Tony Ellis, Shane
Financial Ombudsman
Downham, M Empirical Capital Service
Drake, Tony Equip Financial Planning

Association of
Dudley, Berice Erikson, Peter Australia Limited
Dunn, Gavin Erskine, Alex Financial Rights Legal

Centre
Dziadosz, Lucas Eva, Keith & Gail
Financial Services
East, Deb Evans, Stacie Council (FSC)
296
Financial Services Game, Bill Grant, David

Institute of Australasia
Gapes, Gordon Gray, Allan
Fisher, Julie
Gaskell, Robin Greening, Peter
Fleet, Ray
Gay, Norman Grenfell, Colin
Fleming, Donna
Geissman, Mark Greville, Mark
Fletcher, George
Genworth Group of 100
flongle
Geritz, Elise Grubb, Mark
Flood, Francis
Geritz, Tony Guley, Gordon
Flory, Paul
Gerrish, Robert Gulf Elect
Forbes, Alistair
Gibb, BJ Hadfield, James
Forbes, Peter
Gillard, Amber Hall, Simon
Force, Rod
Ginidis, Peter Hallam, K
Foresters Community
Finance Gleeson, Lynne Halstead, Brian
Forrest, Frederick Goldsmith, Don Hamblion, Robert
Forrest, John Goldthorpe, Aileen Hamilton, Christine
Forrest, Tim Good Shepherd Hamilton, G

Microfinance
Forster, Russell Hamilton, Greg
Gordon, Andrew
Fosters, Rolf Hand, Graham
Gordon, Ian
Fox, Andrew Hansman, AP
Gors, Beryl
Fraser, Roderick Harden, Stewart
Gough, Michael
Fraser, the Right Harding, Stephen
Honourable Malcolm Goulter, Max
Harfouche, Gabriel
Freedman, Ben Goumas, Costas
Harris, Andrew
Friendly Societies of Graham, the
Australia Honourable Peter QC Harry, Paul
297
Hart, Stuart Herrmann, Teresa Hornsby, Chris
Harvey, AE Hetherington, Maurice Houghton, James
Harvey, Helen Heugh, John Housing Industry

Association (HIA)
Harvey, Mr & Mrs L Heyward, Rick
Howard, Scott
Harvey, Steven Hill, MW
Howarth, James
Haw, William Hilton, Roger
Howell, Michael
Hazel, Gary Hingston, Philip
Hu, Ling-chia and
Hazzard, James Hirsch, Siegfried Lyons, Mark
Healy, Pat Hoar, Peter Hubbard, Carole
Heazlett, William Hobbs, Beverley Hull, Brian
Hedditch, Robert Hoffman, Peter Humar, Leopold
Hegglun, Ian Hogan, Greg Hunneman, Jack
Henderson, Gail Hogan, Margaret Hunt, Howard
Henderson, Michael Holding, Rod Hunt, Warwick
Heng, Adriel Holiday Coast Credit Hunter, Gordon

Union
Henke, Grant Hunter, Steven
Hollingworth, Annette
Henson, Fiona Hurley, Stan
Holloway, Llewellyn
Henzell, Leonard & Hutchinson, Gerard
Gail Homesafe Solutions
Hydrargyros Pty Ltd
Herbert Smith Freehills Homolka, Paul
(ASIC Funding) Ibrahim, Ali
Honeyman, Greg
Herbert, Greg Ifield, David
Hope, Daniel
Herman, Paul Ifield, Kerrie
Hopkins, Raymond
Herman, Rudolf Ifield, William
Horne, Colin
Hermann, Margaret IFM Investors
298
Impact Investing Jackson, Anne Kasupene, Morgan

Australia
Jacobs, Richard and Kavanagh, Bryan
Impact Investment Jacqueline
Group Kay, Jacqueline
James, Philip & Ewa
Income is the Goal Kealley, Dave
Jamieson, John
Independent Fund Kean, Michael
Administrators & Jans, Ray
Advisers (IFAA) Kearnan, R
Jans, Sarah
Industry Group, The Keenan, Peter
Jans, Sheryn
Infrastructure Keizer, Dirk
Australia Jelleff, John
Kelly, Bernard
ING Bank Australia Jenatsch, R
Kelly, Derek
Ingrey, William Jeray, Eva
Kelly, Gilbert
Innovation Australia Johnson, Anthony
Kelmar, John
Insurance Australia Johnston, Brian
Group (IAG) Kemp, Raelene
Jones, Evan
Insurance Council of Kennedy, Rosanna
Australia Jones, Kaye
Kennelly, Peter
International Swaps Jones, Leon
and Derivatives Kettlewell, Michael
Association (ISDA) Jordan, David
Kinderis, Stan &
Isherwood, Aaron Jordan, Tom Stephanie
Isherwood, Craig Jorgensen, Erik King & Wood

Mallesons
Isherwood, Glen Joyce, DE
King, Anthony
Isherwood, Katherine Juhasz, Stephen
King, Roselyn
Italiano, Pietro K&L Gates
King, Steve
Ivanov, George Kanavas, Tania
Kingsford Smith,
Izzett, Guy Karg, Frank Dimity
299
Kirov, Kris Law Council of LM Investor Victim

Australia (Business Centre (LMIVC)
Kitto, Ernest Law Section)
Lock, Diane & Max
Klein, Stephen Law Council of
Australia LokalITy Pty Ltd
Klein, SW (Superannuation
Committee, Legal Lovell, Dean
Kloas, Ewen Practice Section)
Lovett, Peter
Klose, Werner Lawler, Krista
Lowe, Neville
Kobold, Alex Lawler, Peter
Loyall, Ken
Kociemski, Chris Laws, Daniel
Lyell, Charles
Koenders, Olaf Lazarenko, M &
Marcussen, D Lynch, Troy
Koops, Jim
LCH.Clearnet Lyons, Jill
KordaMentha
Legal Aid NSW Macdonald, Diana
Kosmas, Jim
LeGarde-Glasko, Inez Mace, Lincoln
KPMG
Leikov, Joreje Mackenzie, Alan
Kucina, SJ
Lekakis, G, Rogers, I MacPherson, Ron
Kylstra, Wytze and Manning, P
Macquarie Group
Lacey, Nigel Lele, Stephen
Macqueen, Angus
Lahy, Colleen Lemon, Robert
Maddock, Rodney
Lahy, Michael Lenane, A & P
Madonald, Ian
Lane, Alan Lenoese, N
Madsen, John
Lange, Jonathan Lepse, Traudi
Maher, Mike
Lanzi, D Lewis, Kevin
Mair, Peter
Larsen, Ben Liebmann, George
Malfiore, S & G & L
Latimer, Paul Lipman, Julian
Manadavadi, Pravin
Laverty, Dorothy
300
Manestar, Ivan McCallum, Graham Mercer
Marks, Danny McCarthy, Jonathan Mesch, Monica
Marks, David McCormick, Rob & Meyers, Peter

Lesley
Maroun, Paul Meyers, Rod
McCosker, Richard
Martin, Colin Micah, Jim
McCullagh, James
Martin, Gordon Michaelisks, Con
McDermott, Chris
Martin, John Microsoft
McDonald, Chris
Martin, Ken Migga, Jenyce
McDonald, Danielle
Marx, Tony Milborrow, John
McEwan, Marcus
Master Builders Minter Ellison
Australia McFee, Claire
Minter, Steven
Master Grocers’ McGing Advisory &
Australia Actuarial Mistry, Cyrus
MasterCard McGrathNicol Mitchell, Doug
Mate, Joseph McKay, Ralph Mitchell, Tara
Mathews, Rose McKinnon, Lorne Modra, John
Matoga, L McNally, Kerry Moffat, Gordon
Matoga, W McNally, Noel Moir, Margaret
Maurice Blackburn McNamara, Glen Mollison, Charles

Lawyers
McNess, John Money Farms
Maxwell, Robert
McPherson, M Monkey Mia
Mayman, Wendy Wildsights
McQueen, Colin
McAuley, JP Moran, Janice
ME Bank
McAvoy, John Morehead, Basil
Medibank
McCahon, Dale Moreton, Barry
Meggitt, Cathleen
301
Morgij Analytics Investments Inc Noonan, Jim

(NICRI)
Mori, Don Norton, Tom
National Insurance
Morningstar Brokers Association of NSW Small Business
Australia Commissioner
Mortgage and Finance
Association of National Seniors O’Connor, Akiko
Australia (MFAA) Australia
O’Niell, Kevin
Motive Power Neal, Sandra
Oakes, Rick
Mowe, Jeremy Neave, Barbara
Oakes, Robert
Moxham, Brian New Zealand Council
of Financial Regulators O’Brien, Benjamin
Muir, Barry
Newcombe, Ray O’Brien, John
Muldoon, MH
Newling, Valerie O’Brien, Justin and
Muller, R Gilligan, George
Newnham, Gary
Murphy, Philip O’Brien, Timothy
Nguyen, Khoa
Murrell, Anthony Ockerby, James
Nichols, Adam
Musumweci, Cecily O’Connell, R
Nichols, Bevlee
Myers, Peter Office of the Australian
Nichols, Damon Information
NAB Commissioner
Nichols, Inez
Name Withheld 1 Ogden, Dereka
Nichols, Keverne
Name Withheld 2 O’Keefe, Dan
Nichols, Lauren
Name Withheld 3 Olimpio, Domenic
Nichols, Lorna
Name Withheld 4 Olman, Lindsay
Nichols, S
Name withheld 5 O’Shea, Andrew
Nilov, Alexei
Narrow Road Capitial Ottrey, Philip
Nilov, Marina
National Information Owen, Greg
Centre on Retirement Nolan, Pauline
Ozich, Jim
302
P&N Bank Phair, Richard & Property Council of

Margaret Australia
Papadimitriou, Stan
Phelps, John Property Funds
Papazoglov, Dimitrios Association
Philanthropy Australia
Paradisis Family Provic Group Inc
Group, The Phillips, Rhandall
Providence Wealth
Parkes, Brian Phillips, WJ Advisory Group
Parry, Alan Piesse, John Pukallus, Dennis
PayPal Pilkington, Merridee Pukallus, Jan
Pearce, Benjamin Pitabh, Roland Purvis, Russell
Pearce, Matthew PlayfairTan QBE
Pearson, Faye Plumecocq, Michael QIC Limited
Pelekani, Con Poett, Jenny QSuper
Peltpnen, Tuija Pohl, Nerida Quicke, Allan
Penberthy, Paul Polymath Investors Quilter, Lorna

Proprietary Limited
Pensions Institute R, Ronald
(London) Portelli, Steven
Radford, Edwin
Pepper, Chris Portelli, William
Rainmaker Information
Perrot, Chris Potter, David
Ralfs, Keith
Perry, John Potticary, J
Ray, John
Peters, Greg Power, Colin
Rayner, Frank
Peterson, Monique Praporski, Alex
Rea, Pauline
Petterson, David Presnell, Adam
Read, Arnold
Pettett, Geoff Preston, Laurie
Real Estate Institute of
PEXA Priestly, Claire Australia
Pfeiffer, Neville Pronczak, Peter Real, Roger
303
Reed, Andrew Rourke, Philip Schmidt, Kunobert
Regional Banks (on Rowe, Peter Schmulow, Andy

behalf of BoQ, Bendigo
and Adelaide Bank, Rowlands, Ronald Schorel-Hlavka, GH
ME Bank and Suncorp
Bank) Rowles, Kerry Schreurs, Martin
Regional Policy Roysland, Peter Schroder Investment

Advisory Committee Management Australia
Rubina, Carlos Limited
Research Australia
Rumble, Dr Tony Schutz, Maurice
Reserve Bank of
Australia (RBA) Rumble, Lee Scroop, Eric
REST Industry Super Runcie, Neil Searton, R & A
Reti, Daniel Russo, Mario See, Alexandra
Rhines, Eleanor Rutherford, James Seed, Jeff
Rice Warner Ruyg, Michael Seriya, Mel
Rickard, Neil Ryan, Gerard Seymour, Michael
Rider, Alan Sage, Graham Shaw, R
Ritchies Stores Sallwan, Garette Shields, Geoff
Roan, Bruce & Lorna Salt, Philip Shields, Simon
Roberts, Ben Sambastian, Pierre Shire of Beverley
Robinson, Jean Scallan, Bronwyn Shus, Ed
Robinson, Wayne Scalzi, Robert Siddall, Clytie
Rodgers, John Scarfone, Frank Siebert, Lisa
Rogan, William Schiemer, Donald Siebert, Paul
Rolfe, Brendan Schippl, Helmut Simkiss, John
Rollond, Ken Schlusser, William Simpson, Campbell
Roubicek, Roger Schmetzer, Errol Sims, Daniel
304
Sincock, Philip Soos, Richard Strahan, Colin
Sjogren, Karl Soulos, Andrew Strategies Plus
Slattery, Pat Spain, David Stratford, Narelle
Sledge, RA Spajic, Paul Stratford, Noel
Small, Garrick Spijer, Daan Strathfield Council
Smith, Derek Spinks, June Street, Peter
Smith, G Spyker, Len Sturgiss, Denzil
Smith, Luke St George Community Styles, Carol

Housing Limited
Smith, Mark (SGCH) Styles, Wayne
Smith, P Staehr, Jeanette Sudholz, Judith
Smith, Ray Stallard, Geoff Sullivan, Kerry
Smith, Rick Standard & Poor’s Suncorp Bank
Smith, Rod Stanton, Heather Suncorp General

Insurance
Smith, Russell Steel, Stephen
Suncorp Life
Smith, Sharon Stevens, Renae
Super Innovations
Smith, Sidney Stevenson, Derek
Superannuation
SMSF Owners’ Alliance Stevenson, Richard Consumers Centre
(SMSFOA)
Stockbrokers SuperEd
SMSF Professionals Association of
Association of Australia SuperGuardian/Xpress
Australia (SPAA) Super
Stone, RG
Smyth, John SuperRatings
Storey, Dianne
Social Enterprise Supported Residents &
Finance Australia Ltd Storm, PA Carers Action Group
(SEFA)
Stott, Chris Swan, Graham
Solaiman, Sheikh
Stow, David Swiggs, David
305
Sy, Wilson Tonkin, Tommy van Schaik, Heidi
Syme, Graham Townsend, Kendall Vasanji, Suzann
Synchron Townsend, Norm Veda
TAL Dai-chi Life Treagar, Robert Veit, Christian

Australia Pty Limited
Trent, Kevin Venkatramani, Ramani
Tannberg, Carsen
Triple W Farms Pty Ltd VentureCrowd
Tasmanian Small
Business Council Trouncer, Jody Verheyen, Gerry
Tate, Sue Tucci, Michael Veronika
Taxpayers Party, The Tuffnell, Ian Victorian Teachers

Mutual Bank
Telford, John Turnaround
Management Vincent, Neill
Tesconi, Ernie Association of
Australia Ltd VISA
Tew, Danny
Turner, Les Vogel, Luke
Thies, Dick
Turner, Mark Wall, Terry
Thomas, Brian
Turvey, Claire Walsh, Alexander
Thomas, Peter &
Margaret Turvey, R Walsh, Paul
Thompson, Bruce Turvey, Wener Walters, Eric
Thompson, Martin Twelftree, Matthew Wansbrough, Gary
Thornton Tucker Tyas, Brian Warriner, William
Thornton, Margaret Tyro Payments Watkins, Richard
Thurlow, Kimball UniSuper Management Watson, Barry

Pty Ltd
Thystrup, Lars Watson, John
Utber, Dororhy
Tkacz, Henrik Weigang, Michael
van Roosendael,
Tom Lawler Transport Edmund Welch, AJ
306
Wells, Kath Williams, Barry Yohanna, Sleiman
Wells, NW Williams, Benjamin Yong, Leonard
West, Matthew Williams, Cholm YPINH National

Alliance
Westley, Mark Williams, Gillian
Zell, Max
Westpac Williams, Kevin
Zimmermann,
Weymouth, John Williams, Michael Michaela
Wheeler, Bill Williams, Paul Zumbo, Vincenzo
White Label Personal Williams, Ray

Clouds
Willsher, Trevor
White, Colin
Wilson Asset
White, Mary Management
White, Patricia Wilson, Gilbert
White, Robert Wiltshire, Diana
Whitehead, Bruce Winniak, Daniel
Whitehead, Gareth Witten, Richard
Whitehead, Shae Wizard, Paul
Whitelaw, Wilma Wizner, Ross
Whitney, Ani Woldt, Lee
Whythom, Ben Wood, Don & Anita
Wilde, Milton Wood, Ian

(Submission 1)
Wrae, Louisa
Wildwood, Wolf
Wraith, Pauline &
Wilkie, Ken Barry
Wilkinson, Mark Yabsley, Bob
Williams, Alfred Yaretsky, Ian
307
Appendix 5: Glossary, acronyms and
abbreviations
Acronyms and abbreviations

ABA — Australian Bankers’ Association
ABN — Australian Business Number
ABP — account-based pension
ACCC — Australian Competition and Consumer Commission
ACSC — Australian Cyber Security Centre
ACTU — Australian Council of Trade Unions
ADI — authorised deposit-taking institution
AFA — Association of Financial Advisers
AFMA — Australian Financial Markets Association
AFSA — Association of Superannuation Funds of Australia
AFSL — Australian Financial Services Licence
AFTS — Australia’s Future Taxation System
AGD — Attorney-General’s Department
AGIMO — Australian Government Information Management Office
AIST — Australian Institute of Superannuation Trustees
AML — anti-money laundering
ANAO — Australian National Audit Office
309
APCA — Australian Payments Clearing Association Limited
APRA — Australian Prudential Regulation Authority
ARCA — Australian Retail Credit Association
ASC — Australian Securities Commission
ASIC — Australian Securities and Investments Commission
ASFA — Association of Superannuation Funds of Australia
ASSOB — Australian Small Scale Offerings Board
ASX — ASX Limited or the exchange operated by ASX Limited
AT1 — Additional Tier 1
ATM — automated teller machine
ATO — Australian Taxation Office
AUSTRAC — Australian Transaction Reports and Analysis Centre
AVCAL — Australian Private Equity and Venture Capital Association Limited
BCBS — Basel Committee on Banking Supervision
BIS — Bank for International Settlements
bps — basis points
CAMAC — Corporations and Markets Advisory Committee
CCP — central counterparty
CCR — comprehensive credit reporting
CEO — Chief Executive Officer
CET1 — Common Equity Tier 1
CDFI — community development financial institution
310
Appendix 5: Glossary, acronyms and abbreviations
CDI — CHESS depositary interest
CFR — Council of Financial Regulators
CIPR — comprehensive income product for retirement
CSEF — crowd-sourced equity funding
CSS — Cyber Security Strategy
CTF — counter-terrorism financing
D-SIB — domestic systemically important banks
DC — defined contribution
DHS — Department of Human Services
DLA — deferred lifetime annuity
DVS — document verification service
EFT — electronic funds transfer
ESMA — European Securities and Markets Authority
FATCA — Foreign Account Tax Compliance Act (US based legislation)
FCA — UK Financial Conduct Authority
FCA Act — Financial Corporations Act 1974
FCS — Financial Claims Scheme
FIDO — Fast Identity Online alliance
FINRA — Financial Industry Regulatory Authority
FIRB — Foreign Investment Review Board
FMI — financial market infrastructure
FOFA — Future of Financial Advice law reform
311
FSAC — Financial Sector Advisory Council
FSAP — Financial Sector Assessment Program
FSB — Financial Stability Board, formerly the Financial Stability Forum.
FSG — Financial Services Guide
FWC — Fair Work Commission
G-SIB — global systemically important bank
G20 — Group of Twenty Finance Ministers and Central Bank Governors from 20 major
economies
GDP — gross domestic product
GFC — global financial crisis
GSA — group self-annuitisation
GST — goods and services tax
HQLA — high-quality liquid assets
IADI — International Association of Deposit Insurers
IC — Innovation Collaboration
IMF — International Monetary Fund
IOSCO — International Organisation of Securities Commissions
IRB — internal ratings-based
IWT — interest withholding tax
KYC — know your client/customer
LEI — legal entity identifier
LEIROC — Legal Entity Identifier Regulatory Oversight Committee
312
LIBOR — London Interbank Offered Rate
LRBA — limited recourse borrowing arrangement
MIS — managed investment scheme
NGO — non-government organisation
NOHC — non-operating holding company
NPV — net present value
OBPR — Office of Best Practice Regulation
OECD — Organisation for Economic Co-operation and Development
OIX — Open Identity Exchange
OSC — Ontario Securities Commission
OTC — over-the-counter trading
P2P — peer to peer
PAYE — Pay As You Earn
PAYG — Pay As You Go
PC — Productivity Commission
PDS — product disclosure statement
PJCCFS — Parliamentary Joint Committee on Corporations and Financial Services
PPF — purchased payment facility
PSB — Payments System Board
R&D — research and development
RBA — Reserve Bank of Australia
RCAP — Regulatory Consistency Assessment Programme
313
RIS — Regulation Impact Statement
RMB — Reminbi, the official currency of the People’s Republic of China
RMBS — residential mortgage-backed securities
ROE — return on equity
SG — superannuation guarantee
SIS Act — Superannuation Industry (Supervision) Act 1993
SIS Regulations — Superannuation Industry (Supervision) Regulations 1994
SME — small and medium-sized enterprises
SMSF — self-managed superannuation fund
SOA — Statement of Advice
SOE — Statement of Expectations
SOI — Statement of Intent
UCT — unfair contract term
UFI — Unauthorised Financial Insurer
VCLP — Venture Capital Limited Partnerships
314
Glossary
accumulation phase — the period of time over which an individual builds the value of
their superannuation benefits before retirement.
account-based pension — an individual investment account set up with superannuation

benefits from which a retiree draws a regular income.
annuity — an investment that pays a guaranteed regular income stream.
Australian Payments Clearing Association Limited (APCA) — a public company owned

by banks, building societies and credit unions with specific accountability for key parts of
the Australian payments system, particularly payments clearing operations.
Australian Prudential Regulation Authority (APRA) — the prudential regulator of the

Australian financial services industry that oversees banks, credit unions, building societies,
general insurance and reinsurance companies, life insurance companies, friendly societies,
and most members of the superannuation industry.
Australian Securities and Investments Commission (ASIC) — the national regulator of

corporate entities, with responsibility for market protection and consumer integrity issues
across the financial system.
Australian Competition and Consumer Commission (ACCC) — a national statutory

authority responsible for ensuring compliance with the Competition and Consumer Act 2010
(formerly the Trade Practices Act 1974) and the provisions of the Conduct Code. ACCC’s
consumer protection work complements that of State and Territory consumer affairs
agencies.
Australian Financial Markets Association (AFMA) — an industry body representing

about 200 organisations that participate in Australian over-the-counter wholesale financial
markets such as those for foreign exchange, interest rate products, financial derivatives,
repurchase agreements, commodities, equity and electricity derivatives.
Australia’s Future Tax System (AFTS) — Australia’s future tax system, Report to the
Treasurer, December 2009, Australian Government, Canberra.
authorised deposit-taking institution (ADI) — an institution authorised by APRA to carry

on banking business such as a bank, credit union or building society.
315
Basel I, II, III standards — the Basel Committee on Banking Supervision standards
governing internationally active banks.
Basel Committee on Banking Supervision (BCBS) — provides a forum for regular

cooperation on banking supervisory matters. Its objective is to enhance understanding of
key supervisory issues and improve the quality of banking supervision worldwide.
Bitcoin — a type of digital currency.
BPAY — a payments clearing organisation owned by a group of retail banks. Individuals

who hold accounts with a BPAY participating financial institution can pay billing
organisations that participate in BPAY, using account transfers initiated by phone or
internet. The transfers may be from savings, cheque or credit card accounts.
basis points (bps) — a basis point is 1/100th of 1 per cent or 0.01 per cent. The term is
used in money and securities markets to define differences in interest or yield.
borrower — a person or entity that incurs a debt to a lender on agreed terms.
capital market — a market for medium to long-term financial instruments. Financial

instruments traded in the capital market include shares, and bonds issued by the
Australian Government, State governments, corporate borrowers and financial
institutions.
CHESS depositary interest (CDI) — a financial product that is a unit of beneficial

ownership in an underlying financial product quoted on the ASX.
Common Equity Tier 1 (CET1) capital — comprises ‘tangible’ equity such as

shareholders’ common equity.
Comprehensive Credit Reporting (CCR) — a change in credit reporting legislation

introduced in March 2014. The change will mean lenders must report positive information
about how well consumers meet their repayments, not just negative events, such as
defaults.
Comprehensive product for retirement (CIPR) — a combination of products that is

designed for retirement that, at a minimum, provides individuals with income, flexibility
and risk management (particularly for longevity risk).
Consumers — ‘retail clients’ as defined in the Corporations Act 2001.
316
Council of Financial Regulators (CFR) — the coordinating body for Australia’s main
financial regulatory agencies — RBA, APRA, ASIC and Treasury. CFR’s role is to contribute
to the efficiency and effectiveness of financial regulation and to promote stability of the
Australian financial system.
Cyber Security Strategy (CSS) — Australian Government’s 2009 Cyber Security Strategy.
deferred lifetime annuity (DLA) — a form of lifetime annuity for which income payments
are delayed for a set amount of time.
defined benefit (DB) superannuation — a superannuation scheme where contributions are

pooled. Benefits are calculated using a predetermined formula, and depend on an
individual’s salary or wage and length of service.
defined contribution (DC) superannuation — a superannuation scheme where

contributions are made, and investment earnings accrue, in an individual’s account over
their working life. Benefits in retirement are the balance of the account.
derivative — a financial contract whose value is based on, or derived from, another
financial instrument (such as a bond or share) or a market index (such as the Share Price
Index). Examples of derivatives include futures, forwards, swaps and options.
ePayments code — an update and replacement of the Electronic Funds Transfer Code of
Conduct.
Financial Claims Scheme (FCS) — a guarantee on retail deposits of up to $250,000 per

depositor per ADI.
Foreign Investment Review Board (FIRB) — a non-statutory body established in 1976 to

advise the Treasurer and the Government on Australia’s foreign investment policy and its
administration.
financial markets — a generic term for markets in which financial instruments are traded.
The four main financial markets trade in foreign exchange, fixed interest or bonds, shares or
equities, and derivatives.
Financial Sector Assessment Program (FSAP) — a joint International Monetary Fund

(IMF) and World Bank program, seeking to identify the strengths and vulnerabilities of
countries’ financial systems, and to determine how key sources of risks are being managed.
Financial Stability Board (FSB) — formerly the Financial Stability Forum. The FSB was
formed in April 2009 as the re-establishment of the Financial Stability Forum, which had
317
existed since 1999. The FSB has a mandate to assess the vulnerabilities affecting the financial
system, identify and oversee action to address them, and promote cooperation and
information sharing among authorities responsible for financial stability. Its membership
comprises the G20 countries such as Australia.
financial market infrastructure (FMI) — the channels through which financial transactions
are cleared, settled and recorded, including payments systems and trading platforms.
fiscal policy — Government spending and taxation policies that influence macroeconomic
conditions.
Future of Financial Advice (FoFA) — regulatory reforms relating to financial advice that
commenced in mid-2013. These reforms included the introduction of the ‘best interests’
duty and a ban on conflicted remuneration.
gross domestic product (GDP) — a measure of the value of economic production in the
economy.
Group self-annuitisation (GSA) — in a GSA, participants contribute funds to a pool that

is invested in financial assets. Regular payments from the pool are made to surviving
members. GSAs allow pool members to share, but not completely eliminate, longevity risk
and do not require capital to back guarantees.
Innovation Collaboration (IC) — a recommended public-private sector collaborative

committee, to be chaired by Treasury to facilitate financial system innovation and enable
timely and coordinated policy and regulatory responses.
insolvency — a situation where an entity has insufficient assets to cover the value of its
liabilities, resulting in an inability to meet its financial obligations as they fall due.
International Monetary Fund (IMF) — an international organisation of 188 member

countries that was established to promote international monetary cooperation, exchange
stability, and orderly exchange arrangements; foster economic growth and high levels of
employment; and provide temporary financial assistance to countries to help ease balance
of payments adjustments.
internal ratings-based (IRB) — an approach allowed under the Basel II guidelines, where
major banks use their own risk models to calculate risk weights for the purposes of
regulatory capital requirements.
Know Your Client (KYC) — customer identity verification requirements applied under
anti-money laundering legislation.
318
lender — a person or institution that provides loans on agreed terms to borrowers.
leverage — the amount of debt used to finance an asset. A firm with significantly more
debt than equity is considered to be highly leveraged.
liquidity — the capacity to sell an asset quickly without significantly affecting the price of
that asset. Liquidity is also sometimes used to refer to assets that are highly liquid.
liquidity management — activities within a financial institution to ensure that holdings of

liquid assets (for example cash, bank deposits and other financial assets) are sufficient to
meet its obligations as they fall.
longevity risk — the uncertainty about how long a particular person (or group of people)
will live. For an individual, it is the risk of outliving their savings. For providers of
guaranteed retirement income products, it is the risk recipients will live longer, and draw
more benefits, than the provider has allowed for.
lump sum — an amount of a superannuation benefit paid to a fund member as a

stand‐alone cash amount. Benefits can be paid as one or more lump sums.
monetary policy — the setting of an appropriate level of the cash rate target by the Reserve
Bank of Australia to maintain the rate of inflation in Australia between 2 and 3 per cent
per annum on average over the business cycle.
myGov — a secure single sign-on site that allows users to access a range of Australian
Government services.
MySuper — low-cost, simple default superannuation products, established as part of the

Stronger Super reforms announced in 2011.
Organisation for Economic Co-operation and Development (OECD) — a forum of

industrial market countries that seeks to encourage economic growth, high employment
and financial stability among its members and contribute to the economic development of
less-advanced members and non-member countries.
Payments System Board (PSB) — created in 1998, within the Reserve Bank of Australia
(RBA). The PSB is responsible for determining the RBA’s payments system policy so as to
best contribute to: controlling risk in the financial system; promoting the efficiency of the
payments system; and promoting competition in the market for payment services,
consistent with the overall stability of the financial system. Powers to carry out the PSB’s
policies are vested with the RBA.
319
platforms — administrative services made available by intermediaries for the holding,

dealing and viewing of investments selected by individual investors. They provide the
capability for investors to choose investment products and generally offer a range of tools
to analyse investment portfolios.
Productivity Commission (PC) — The Productivity Commission is the Australian

Government's independent research and advisory body on a range of economic, social and
environmental issues affecting the welfare of Australians. Its role is to help governments
make better policies in the long term interest of the Australian community.
Reserve Bank of Australia (RBA) — Australia’s central bank.
retirement phase — the period after an individual has retired from the workforce and
qualifies for, and may be in receipt of, superannuation benefits.
Self-managed superannuation fund (SMSF) — a superannuation fund with fewer than

five members, all of whom are trustees or directors of a corporate trustee.
simple bonds — bonds with certain features including a face value of less than $1,000, a
maturity of less than 15 years, and being issued by a listed entity or wholly-owned
subsidiary of one.
small and medium-sized enterprise (SME) — there are a range of definitions for SMEs
based on number of employees, turnover and other factors, but in essence the term relates
to businesses that are not large businesses.
Stronger Super — the Stronger Super reforms were implemented in response to the Super
System Review. Reforms include MySuper, SuperStream, strengthening governance and a
number of measures relating to SMSFs.
SuperStream — a Stronger Super reform implemented on a transitional basis starting in

2013. The reform is aimed at improving the efficiency of the superannuation system. Under
SuperStream, employers must make superannuation contributions on behalf of their
employees by submitting data and payments electronically in accordance with the
SuperStream standard. All superannuation funds, including SMSFs, must receive
contributions electronically in accordance with this standard.
320

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Financial System Inquiry

Treasury material used ‘as supplied’.

Source: The Australian Government the Treasury.

Based on The Australian Government the Treasury data.

Use of the Coat of Arms

Executive summary ................................................................................................. xiii

Chapter 1: Resilience ................................................................................................ 33

Chapter 2: Superannuation and retirement incomes.......................................... 89

Chapter 3: Innovation ............................................................................................. 143

Chapter 4: Consumer outcomes ............................................................................ 193

Chapter 5: Regulatory system ............................................................................... 233

Appendix 1: Significant matters ........................................................................... 261

Superannuation and retirement incomes ..................................................................... 267

Appendix 2: Tax summary ..................................................................................... 277

Appendix 3: Small and medium-sized enterprises (SMEs) ............................ 283

Appendix 4: Consultation ...................................................................................... 285

Appendix 5: Glossary, acronyms and abbreviations ........................................ 309

After completing this consultation process on 20 December 2013, the Treasurer

On 24 March 2014, the Treasurer appointed an International Advisory Panel

Financial System Inquiry Terms of Reference

1. how Australia funds its growth;

Financial System Inquiry Terms of Reference (cont.)

3. the current cost, quality, safety and availability of financial services,

1. balancing competition, innovation, efficiency, stability and consumer

2. how financial risk is allocated and systemic risk is managed;

4. the role of Government; and

5. the role, objectives, funding and performance of financial regulators

2. international integration, including international financial regulation;

4. changing organisational structures in the financial sector;

6. developments in the payment system.

Financial System Inquiry Terms of Reference (cont.)

1. promote a competitive and stable financial system that contributes to

4. create an environment conducive to dynamic and innovative financial

5. relate to other matters that fall within this terms of reference.

6. The Inquiry will examine the taxation of financial arrangements, products or

Financial System Inquiry Committee

Professor Kevin Davis

International Advisory Panel

• Treasury, the Reserve Bank of Australia, the Australian Prudential Regulation

• The large number of international agencies, regulators and financial system

• Mr Bruce White, the New Zealand observer to the Inquiry.

• Ms Karen Pryor for editing services.

• Strengthen the economy by making the financial system more resilient.

• Lift the value of the superannuation system and retirement incomes.

• Enhance confidence and trust by creating an environment in which financial firms

Guide to the Financial System Inquiry Final Report

Overview and general themes

Characteristics of an effective financial system

• Efficient: An efficient system allocates Australia’s scarce financial and other

• Resilient: The financial system should adjust to changing circumstances while

The Inquiry’s approach to financial system regulation

1. Funding the Australian economy.

Funding the Australian economy

A number of the Inquiry’s recommendations aim to assist small and medium-sized

The Inquiry’s approach to encouraging competition is to seek to remove impediments

Recommendations relating to funding and competition are listed in Table 1.

Table 1: Funding the Australian economy and competition recommendations

The Inquiry’s recommendations to improve resilience aim to:

• Reduce the costs of failure, including by ensuring authorised deposit-taking