Government response to the Financial System Inquiry An evolutionary blueprint endorsed November 2015

Introduction

On 20 October 2015, the Government released its response to the recommendations made by the Financial System Inquiry (the Inquiry). All but one of the 44 recommendations were agreed to and six additional measures proposed. The response contains an indicative timetable for implementation, with some measures already adopted while the active date for other measures extends beyond calendar 2016. EY is supportive of the proposed measures. In particular, we applaud the clear linkage to the Government’s emerging innovation agenda, along with moves to improve cyber security, enhance the accessibility and use of financial system data, promote stronger consumer protection, and boost competition and productivity — topics that resonate strongly with our financial services clients. Most of the regulatory/ resilience measures have been well-anticipated, with many of our clients moving ahead of the formal implementation timetable. Amid a heavy volume of commentary since the release of the Government’s formal response, we have already seen: • An announcement by the Assistant Treasurer, Hon Kelly O’Dwyer, on 6 November confirming a package of reforms for changes to remuneration arrangements in the life insurance advice sector; • A speech by Wayne Byres, Chairman of APRA, on 5 November highlighting six key priority areas that will be a focus for the prudential regulator in 2016, directed at further enhancing the resilience of the Australian financial system; and

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Government response to the Financial System Inquiry: EY analysis November 2015

• A speech by Philip Lowe, Deputy Governor of the RBA, on 5 November focusing on three topics also the subject of recommendations from the Inquiry: the importance of good quality data to monitoring issues affecting financial stability; innovation and regulation in the payments system; and crisis management arrangements, together with the growing threat from cyber attack, for financial market infrastructures. We expect that comments in similar forums by politicians, regulators and industry participants will be a recurring feature of public discourse over the coming 12-18 months as the final shape of the reforms is the subject of consultation. Rowan Macdonald, Managing Partner, Financial Services — Oceania

Overview The Government has accepted the overwhelming majority of the Inquiry’s recommendations. The Murray report and the Government’s response stand as a oncein-a generation root and branch review of Australia’s financial system. Together, the recommendations represent a robust plan for the future reform of Australia’s financial system, with a focus on: • Competition and productivity • Resilience and confidence • Innovation • Consumer outcomes • Superannuation and retirement incomes The following selected measures will have the greatest impact on our clients. Some affect individual sectors, others cut across the entire financial services industry. All of them will alter the risk universe for affected players.

Updating the Cyber Security Strategy We endorse the Government’s recommendations for measures to address cybercrime. Already, many financial institutions have been impacted by this growing threat. In future, cybersecurity will be a critical capability in every sector — and a particular challenge for those, like insurers, whose market disintermediation is creating more direct interaction with their customers. Once implemented, these recommendations will help improve the systemic defences of Australia’s financial services industry. 3

We believe that improving the level of actionable threat intelligence will help industry to anticipate and defend against cyber attack. The Government has an important opportunity to help improve intelligence sharing between the public and private sector with regard to actors, motives, techniques, targets and approaches to cybercrime. This will be critical to delivering the step change in capability required to defend the industry. Without an intelligence-led approach, we will be unable to focus defences on critical infrastructure at critical times, making the financial system increasingly vulnerable to cybercrime. Building out the scale and level of cyber security skills is another critical national lever. The Cyber Security Strategy must address the continued and growing skills gap. We must develop the workforce necessary to enable industry to respond to the accelerating cyber threat. This should involve a co‑ordinated collaboration between industry and government to help shape the next generation of cyber professionals. Although many financial services organisations are leaders in cyber security defence, their broader supplier base has significant capability gaps. Any actions to improve the financial services industry’s systemic cyber defences must take account of the ecosystem of service providers involved in delivering services to citizens. Broad, principle-based guidance to industry on cyber security, such as we’ve seen from ASIC recently, will help to build the general cyber security capabilities of Australian organisations.

Government response to the Financial System Inquiry: EY analysis November 2015

Improving data access and use The Government supports improving data access and use, providing further impetus for institutions to implement a comprehensive and enterprise-wide approach to data. Although many institutions have improved their data management practices in response to regulatory pressures, in our view, many of these attempts have resulted in increased complexity and higher operational costs. As an institution’s data represents its true operational fact-base, we believe stronger disciplines are warranted across the industry, especially as the volume and types of available data rapidly expand. We believe stronger enforcement of data management guidelines and the introduction of standards-based data collection is inevitable. Institutions must anticipate this new horizon. Simplifying data architecture, allocating clear accountabilities, making data security central to governance, and proactively introducing a data-driven culture are key elements. Such measures will not only meet regulators’ expectations, but should also allow institutions to take systematic advantage of richer internal and external data sources to manage risks, optimise performance and grow revenue. As we submitted in our response to the Final Report of the Inquiry, stakeholders also need to be mindful that, with increasing volumes of data, layered with increasing amounts of innovation, comes increased risk for consumers.

Collaboration to enable innovation The Final Report of the Inquiry highlighted innovation as an important enabler of competition, efficiency and growth, with recommendations to encourage and support new business models and new players. We concur that the rapid adoption of digital technologies, combined with increases in customer expectations and significant demographic shifts, means the imperative to innovate has never been stronger. In line with the Turnbull Government’s central policy narrative, the Government is planning a wide range of innovation measures for the financial system. These include agreeing to establish a public-private Innovation Collaboration Committee to support policy development and improve the speed with which government and regulators respond to innovation opportunities. A related measure focuses on making current and future regulation more technology-neutral. If policy and regulatory impediments to timely technology change are removed, technology innovation has the potential to truly transform the financial services sector. Successfully implemented, these measures could enable Australia to be at the forefront of financial innovation. The increased focus on innovation will force individual institutions to accelerate their own innovation to maintain competitive differentiation, including product design and coverage — especially given the Government’s stated aim to facilitate new business models and players.

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EY welcomes an innovation focus in all sectors, but particularly in financial services, where institutions already have a strong focus on innovation. We see these institutions partnering with players in the emerging fintech sector, embracing innovative methods such as ideation and collaborating with non-traditional industry partners in media, entertainment and travel, as well as supporting hubs and incubators to identify new digital opportunities.

Support consumers of financial products being treated fairly In accepting the recommendations on consumer outcomes, the Government raises the bar for licensees to treat consumers fairly. The recent history of public failures has continued to tighten the screws for distribution and extended the focus upstream in the value chain to product manufacturers. The inevitable accountability for product issuers is upon us, albeit with rules that will be subject to extensive and extended consultation. We are pleased to see the market moving ahead of the legislation, with some issuers already advanced in enhancing governance and controls for conduct risk and applying a customer lens across their products. However, we think the Government has missed an opportunity to move faster to facilitate the rationalisation of legacy products. ‘Beyond 2016’ seems a long way off. There are many consumers in antiquated products and too many issuers running creaky systems for a modern financial system.

Government response to the Financial System Inquiry: EY analysis November 2015

Introducing mechanisms to facilitate the rationalisation of legacy products will be an important development for the life insurance, and wealth and asset management sectors. This will help these sectors more effectively manage the transition from legacy products and structures to more contemporary versions. This in turn will help to provide customers with more modern solutions and better experiences, create a more efficient industry and remove legacy and operational risks. With increased accountability comes a new tool for ASIC in the form of product intervention powers. It remains to be seen how that will be exercised, whether having it in the tool kit is a deterrent in itself, and how the Financial Sector Advisory Council (FSAC) will view any interventions. We support ‘general advice’ being renamed as something more understandable. A new description based on consumer testing will go a long way to closing the advice expectation gap. However, general insurers, and wealth and asset managers will need to keep a close eye on how the renaming of general advice progresses. As product manufacturers, they will need to fully understand the potential implications on their advice and distribution obligations and by extension, their customer management strategies.

The Government’s reform of potentially conflicted remuneration structures continues, with life insurance, stockbroking and mortgage broking remaining firmly in its cross hairs. The Assistant Treasurer’s announcement of 6 November 2015 sets out the implementation details for changes to the structure of remuneration in the life insurance advice sector. With a formal review by ASIC to be conducted in 2018, the industry remains on notice that there will be further changes to permitted remuneration arrangements if significant improvements are not identified in that review.

Improving interchange fees and customer surcharging The Government has agreed to make interchange fee and surcharging arrangements more transparent and to achieve a more efficient system and fairer outcomes for consumers, merchants and system providers. Legislation is likely to be phased in banning surcharges that exceed reasonable costs faced by merchants. To prepare for the reduction in fees, we expect the banks will more critically evaluate the costs of product features attached to cards. Increased regulation in this space is likely to place additional pressure on interest free days, card fraud protection and  rewards programs, all of which provide significant benefit to consumers.

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Banking sector resilience Since the global financial crisis (GFC), governments and regulators have focused on improving the resilience of banks and striking the right balance between the cost to shareholders versus the cost to taxpayers in the event of future crises. A key recommendation of the Inquiry, fully supported by the Government, is that Australian banks’ capital ratios should be ‘unquestionably strong’. This is defined as being in the top quartile globally for bank capitalisation. In July, APRA released an international comparison that found that the four major Australian banks’ capital levels fell below this benchmark. The Government also fully supports the Inquiry’s recommendation for narrowing mortgage risk weights and APRA introducing a 25% risk weighting floor for banks using the internal ratings-based (IRB) model. Since May, we have seen more than $20 billion raised by the major banks in anticipation of increased capital requirements. This has strengthened the banks’ capital ratios and bridged the gap to international peers identified by APRA, bringing them closer to meeting the ‘unquestionably strong’ threshold. The recent out-of-cycle interest rate increases by the major banks have prompted further debate about the costs of regulation and, in particular, the costs of maintaining a strong banking system. On the other side of the ledger, the Inquiry’s consultation process has seen the Government abandon the previous proposals for a bank deposit tax to fund the Financial Claims Scheme.

Government response to the Financial System Inquiry: EY analysis November 2015

Bail-in and total loss-absorbing capacity measures, together with liquidity and funding profile measures, remain on the table. We expect these to be implemented in accordance with international trends — now confirmed in the speech delivered by Wayne Byres on 5 November 2015. The Government agrees that steps should be taken to reduce any implicit government guarantee and the perception that some banks are ‘too big to fail’ — a perception that has given the major banks a significant competitive advantage over other Australian market participants when it comes to funding costs. Regardless of where the debate lands, there can be little doubt that a strong and resilient banking sector that can cope with a future crisis is paramount to the Australian economy as a whole.

Comprehensive credit reporting The Government says it will not legislate for mandatory adoption of comprehensive credit reporting. However, if voluntary participation proves inadequate, the Government may reconsider. We believe both lenders and customers could gain significant benefits from mandatory reporting. With access to more customer data, institutions can make more informed credit decisions. Customers may benefit from accessing credit previously denied to them under existing third party credit assessment processes.

Purpose of the superannuation system The Government aims to develop and introduce legislation to enshrine the objective of the superannuation system by the end of 2016. However, it has stopped short of agreeing with the objective proposed by the Inquiry: to provide income in retirement to substitute or supplement the Age Pension. In our view, the objective should be framed around Age Pension substitution. It is important that the net impost on the Government is considered. For example, in the recent debate about the superannuation tax concessions afforded to high income earners, some research has quantified the value of the concession itself, without looking at the associated Age Pension cost reduction in addition to the impost on the Government of related health care and aged care costs.

Improving efficiency during accumulation and extending choice of fund The Government wants to open up the default superannuation space and dismantle protected arrangements included in workplace agreements. The transition is likely to be challenging and fought as a pitched battle between different sides of the industry. While understandable, such a battle does not serve, or positively engage members or regulators. Parties to the debate need to be careful not to lose the war (for engagement and long member durations) while fighting the wrong battle.

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We acknowledge there is more to member satisfaction than price. For this reason, there is space in the system for both small and large players with good strategies and strong focus on their chosen membership. We see benefit in the principle of all players — funds, regulators, custodians, administrators, investment managers, to name a few — continually improving efficiency, and we support systemic reforms that reduce costs for members. There is much to be gained from macro reforms across the system, from the structural efficiency of the contributions process to payment of retirement benefits. Some of this work is already underway. The payments system is one example where the industry is working on improving efficiency. But we are not convinced that the current planned architecture will stand up in the long term. Most of the work undertaken so far appears to be focussed on engineering the existing payments system to be more efficient using resources from within, or close to, the super industry. Contemporary views on the payments industry point to a step change for the global payments system coming from players and technologies well outside the current superannuation universe. We believe the government and system architects should be looking for efficiency opportunities using an outside-in approach rather than a legacy-tending, inside-looking-out approach.

Improving governance of superannuation funds We acknowledge the need for good governance in the super industry, which will be promoted by board members with appropriate skills and qualifications for:

Government response to the Financial System Inquiry: EY analysis November 2015

• Super Fund Board responsibilities generally; • Specific qualifications appropriate to the committees they serve on. We favour an emphasis on skills and experience over a disqualification criteria based on associations.

Development of comprehensive income products for retirement (CIPRs) The Government supports the development of CIPRs and will facilitate trustees pre-selecting these products for members. The Government will consult with trustees over the next 12 months to develop a principles-based framework supporting the development of these products. This framework will be developed with regard to the outcomes of the Tax White Paper process and the Retirement Income Streams Review. Although we support this initiative, as noted in our response to the Financial System Inquiry Final Report, a lot of effort will be required to properly develop and implement these products. So, with much uncertainty around the exact details of these CIPRs, we do not expect to see much new product development until the dust settles. This will not be until the Government’s consultation process with trustees, the Tax White Paper process and the Retirement Income Streams Review are complete. In the meantime, this provides a great opportunity for trustees to review their investment management and advice functions to ensure a smooth transition to multi-featured CIPR products when they are eventually legislated.

Publication of retirement income projections on member statements

The LIF reforms are expected to make advised life insurance a less capital-intensive business over time. However, the ongoing viability and attractiveness of advice businesses specialising in life insurance will be threatened, affecting future sales through this channel. Providers of financial advice may also be forced to widen their approved product lists. This would reduce the value of institutionally-owned distribution. The slated reforms have prompted life insurers to consider further diversifying their distribution channels and to seek opportunities to improve efficiency in the sales process.

Following the lead from the UK Financial Conduct Authority, ASIC’s existing mandate will be extended to include competition. We will wait and see how that interacts with the operations of the Australian Competition and Consumer Commission. We do know that our existing twin peaks prudential and conduct regulatory system not only withstood the GFC stress test, but has subsequently been adopted overseas. It’s clear that a degree of overlap is workable and preferable, although the FSAC’s oversight will be crucial as the regulators balance competition with other elements of their mandates.

We believe that projections should include a range of outcomes. At a minimum, projections for poor, average and strong market outcomes should be considered. Relying on a single return scenario does not accurately capture market risk to enable members to make informed product decisions based on the trade-offs involved.

The Government is due to review the effectiveness of the LIF reforms by the end of 2018. If consumer outcomes are not improved, the Government may revisit the options of a level commission structure or even banning commissions for life insurance advice altogether.

Life insurance incentives

Strengthen regulator capabilities and accountability

The Government looks to be backing a new funding model for ASIC. While this is subject to current consultation, the signs point to a better arrangement than the current short, and arguably inadequate, annual budget approach. A shift towards funding that is independent of the Government of the day, runs for more than 12 months, and provides for a regulator with the right mix of capacity and capability is welcome. The devil will definitely be in the detail, as the debate continues over who pays and how that will be measured: risk based, regulatory intensity, user pays?

With the advent of CIPRs, and multi-feature retirement products generally, we see compulsory retirement income projections on member statements as an excellent opportunity to educate members about product features such as longevity protection. This kind of consistent, system-wide education has the potential to significantly improve member engagement, increasing the effectiveness of other Government initiatives.

To address misalignment of incentives in life insurance, the Government has chosen to support the Life Insurance Framework (LIF) developed by industry in preference to the Inquiry’s recommendation of a level commission structure. The start of the transition to the new framework has been delayed six months to 1 July 2016.

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In a boost to investor confidence and market certainty, the Government has accepted the overwhelming majority of the Inquiry’s recommendations to strengthen regulator capability and accountability. While many have argued for a new body to oversee the regulators, the Government’s approach has been to resist creating new bureaucracy. Instead, it plans to reconstitute the FSAC, with its role to include oversight of the performance of the financial regulators.

Government response to the Financial System Inquiry: EY analysis November 2015

Contacts Our leadership Rowan Macdonald Managing Partner Financial Services — Oceania Tel: +61 2 9248 4019 [email protected] Tim Dring Banking & Capital Markets Leader Tel: +61 3 9288 8054 [email protected] Grant Peters Insurance Leader Tel: +61 2 9248 4491 [email protected] Antoinette Elias Wealth & Asset Management Leader Tel: +61 2 8295 6251 [email protected]

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Banking Resilience

Data Excellence

Conduct & Risk Culture

Steve Nagle Partner Tel: +61 2 9276 9010 [email protected]

Priyanka Paranagama Partner Tel: +61 3 9655 2869 [email protected]

Roberto Fitzgerald Partner Tel: +61 2 9248 5398 [email protected]

Superannuation

Cyber Security

Innovation

Jason McLean Partner Tel: +61 3 8650 7413 [email protected]

Rohit Rao Partner Tel: +61 3 9655 2603 [email protected]

Chris OHehir Partner Tel: +61 2 9248 5435 [email protected]

Andrew Harmer Partner Tel: +61 2 9248 5321 [email protected]

Maree Pallisco Superannuation Leader Tel: +61 3 9655 2508 [email protected]

Government response to the Financial System Inquiry: EY analysis November 2015

Anita Kimber Asia Pacific IT Advisory Leader Tel: +61 2 9248 5414 [email protected]

Anthony Robinson Oceania Cyber Security Leader Tel: +61 2 9248 5975 [email protected]

Rob Walsh Partner Tel: +61 2 9248 4861 [email protected]

Walter Poetscher Partner Tel: +61 2 9248 5145 [email protected]

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