Michael Keating. The Financial System Inquiry. Part 3: Investor protection and other matters.21/01/2015
I am reposting Part 3 of this important series by Michael Keating which was posted during the holiday period. John Menadue
It is now more than 15 years since the present regulatory system was established for the financial system. The basic presumption underpinning that approach to regulation has been that proper disclosure should be relied upon as much as possible. That way it was assumed that investors acting in their own interest would make the best decisions regarding the selection of financial products and services, and through competition thus maximise the efficiency of the system.
However, the Financial System Inquiry (FSI) has now found that ‘In terms of fair treatment for customers, the current framework is insufficient’, with ‘The most significant problems related to shortcomings in disclosure and financial advice, and over-reliance on financial literacy’. Furthermore, ‘consumers are taking risks they might not have taken if they were well informed or better advised’. The cost of this ‘poor advice, information imbalances and exploitation of consumer behaviour biases [are estimated by the FSI to] have affected more than 800,000 consumers, with losses totalling more than $5 billion, or $4 billion after compensation and liquidation recoveries’.
Part of the problem is the complexity of the financial system, which in turn is partly a response to regulation and taxation distortions. But the complexity also reflects the desire to provide consumer choice and flexibility, with a wide variety of financial products and services, which is constantly being augmented by further innovation. In other words there is a trade-off between complexity and choice, and this makes consumer protection more difficult.
One solution that many customers have adopted in response to this complexity is to rely heavily on financial advisors. Unfortunately some of these advisors have received inducements or are under pressure to not always act in the best interests of their customers, but instead to direct the customer to a preferred product or service. Of course such conduct should be illegal, and the FSI has recommendations to tighten regulation to prevent this sort of behaviour.
Another problem, however, is the competency of the financial advisers themselves. There is considerable survey evidence that many financial advisers do not have adequate knowledge of the products they are recommending and an appreciation of the risks involved. In particular, the FSI research suggests that some financial planners have limited knowledge of the longevity risk for someone considering retirement and how it can be managed. Accordingly the FSI has recommended that the competency of financial advisers should be raised, with a relevant tertiary degree being the minimum standard, plus additional competence for those advising in specialised areas such as superannuation. In principle this seems like a good idea, but it may prove difficult to implement, especially quickly because of shortages of suitably qualified advisors, and it will add to costs.
A second stream of recommendations relate to improving the information to the consumer. An interesting example is the recommendation that member statements from superannuation funds should include a projection of their retirement income, with the Australian Tax Office assisting members to consolidate this information where they have more than one superannuation fund. The FSI cites research showing that giving consumers retirement income projections improves their engagement with saving for retirement, and helps them make more informed decisions about their retirement savings.
Finally a third stream of recommendations, to assist customers to make better decisions in their own interest, relate to new products tailored to the needs of customers which can then be their default selection. For example, introduction of the comprehensive income product for retirement (CIPR), discussed in my previous comment on superannuation, would involve the trustees of a fund pre-selecting a suitable CIPR option on behalf of the members. This would typically improve retirement incomes, thus better meeting the needs of members in an accumulation superannuation scheme, and while such pre-selected options have been found to influence behaviour positively, they do not limit a member’s personal choice and freedom.
For reasons of space these three comments on the FSI report have not covered its consideration of innovation and regulation and associated recommendations. In brief, perhaps the most interesting conclusions in this regard are
- How the financial system can make more and better use of digital technology, and that
- Australia’s regulatory architecture does not need major change, but because sometimes regulation inevitably involves difficult judgements there should be a regular process that allows the Government to assess the overall performance of financial regulators.
One of the strengths of the FSI report is that while it lays out a path for reform of the financial system, it leaves the details to be settled by the appropriate regulator. That seems sensible because of the technical nature of the judgements involved and because it is desirable to settle these details in consultation with those affected.
Overall there is no reason to disagree with the FSI’s conclusion that the net result of its recommendations would be to:
- Encourage an efficient financial system that allocates scarce financial resources for the greatest benefit for the economy
- Promote competition
- Strengthen the resilience of the financial system, and
- Lift the value of the superannuation system and retirement incomes
Furthermore I doubt that there will be much opposition to most of the recommendations and so they should be relatively easy for the Government to adopt. The most difficult areas may be superannuation, if only because of the number of people affected and the importance of their stake in superannuation. The ‘observations’ by the FSI about taxation may well provoke more controversy, but this can only be determined following the Government’s separate review of taxation. Personally I think the Government would be well advised to pursue the changes to the taxation of superannuation first recommended by the Henry Review back in 2009 and now supported by the FSI. Indeed it is difficult to think of an easier option for Budget repair, while dramatically improving fairness and making little or no difference to the rate of household saving.
So as I suggested at the beginning of these three comments on the FSI Review, I think this report and the other reports that are in the pipeline may well provide the Abbott Government with the opportunity to develop a genuine reform strategy for the Australian economy which it can then take to the next election. In these circumstances the Opposition would also be well advised to consider its position on these issues. Indeed the great shame is that it allowed the Henry Report on taxation to languish while it was in government. It is now not too late to repair that damage to its credibility, but time may well be short.