Issues in the Financial System:
The Discussion Paper of the Financial System Inquiry
Presentation by Professor Jeffrey Carmichael
to the
Australian Business Economists
and
Economic Society of Australia NSW Branch
Sheraton on the Park, Sydney
Tuesday 3 December 1996
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Issues in the Financial System:
The Discussion Paper of the Financial System Inquiry
1.
INTRODUCTION
Delighted to be in my old stamping ground, - many familiar faces including my old boss.
Released our Discussion Paper last week and this week we start the round of follow-up
talks - on the principle that - if the paper didn’t put you to sleep then the talk is sure to -and, if that doesn’t get you, just wait for the movie.
I say that only partly tongue in cheek. The Discussion Paper has been described as fat
and flat -- and it is deliberately so. I want to make very clear from the outset that the
Discussion Paper is not a Draft Report. Given the very tight time frame that we have been
given for this Inquiry, we thought it best that the DP outline:

issues;

options; and

views presented to us through the submissions.
We will need the full 9 months to come to well-based recommendations and little would be
gained from setting the hares running before we have even agreed among ourselves.
So, against that, possibly disappointing, background, and before you start asking for your
lunch money back, what am I going to talk about today? Briefly:

I want to start with some background on the Inquiry; and the

Offer some thoughts on a subset of the main issues identified in the Discussion
Paper.
2.
BACKGROUND
This Inquiry, commissioned in June, is the first wide-ranging review of our financial system
since the Campbell Inquiry, a decade and a half ago. Like Campbell, the emphasis of the
Inquiry is on:

efficiency

competition

consumer interests and

regulation.
Unlike Campbell, we have a wider mandate to look at the role of change in shaping the
future of the financial system. In its place, Campbell had a greater focus on macro
economic policy issues.
[SLIDE 2 - SUBMISSION STATS]
Despite the very short time frame, we are attempting to meet the Treasurer’s commitment
for the process to be open. In September we received over 260 submissions (average >
100 pages), most of which have been made public, including through the Internet.
[SLIDE 3 - PUBLIC HEARINGS]
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Following the release of the DP we have will be holding public hearings in 5 cities and will
be taking further submissions by 13 January next year.
The Inquiry has also benefited from briefings from numerous local experts on specialised
topics, as well as the views of both regulators and market participants in half a dozen
countries overseas. Our recommendations will be made in our Final Report to the
Treasurer on 31 March. (If you think that is a luxurious timetable, Campbell had 18
months and Canadians have just set up a similar Inquiry with an 18 month time frame).
So why are we having the Inquiry?
I suspect you would all agree that proper accountability demands regular reflection. And
one group for whom accountability is fundamental is regulators (as someone who has
been a regulator for some years - and seen both sides of the equation - I can’t
overemphasise the need for accountability).
I suspect that you would also agree that reflection is best carried out free from crisis.
There are too many examples around the world of regulatory responses that have been
little more than band aid solutions - instituted purely to provide a visible political response
to a crisis.
We have the luxury of reviewing a system that clearly “ain’t broke”.
I can hear some of you already grumbling that reviewing a system that ain’t broke is a
recipe for disaster, since the natural bias of any Inquiry is to recommend change whether
it is needed or not (like the lawyer who charges $3,000 to review your contract - it is very
hard for her to call up and say “It is a great contract and doesn’t need any changes - oh,
and by the way, you can deposit the $3,000 electronically if you would like to save the
stamp”).
Let me assure you that “no change” is a very real option for us - across a very wide range
of issues. Perhaps it is an option that has not been emphasised enough. At the same
time, I should add that to rule out change simply because the system is working fine at the
moment would be to miss the point of the Inquiry -- it is certainly true that if you jump off
a 16 story building, the first 15 floors are clear sailing. The trick is to be able to look ahead
and anticipate what is coming.
On that note, let me turn to some of the forces that are changing our financial system.
You can decide whether or not they look like the pavement or a giant feather mattress.
[SLIDE 4 - FORCES FOR CHANGE]
3. FORCES FOR CHANGE
The evolution of financial systems around the world has been characterised by a struggle
between financial intermediaries and financial markets. That struggle has been fairly
finely balanced for much of this century. Developments over the past decade or so,
however -- including advances in information technology, globalisation of markets,
changing consumer demands and new forms of competition -- threaten to upset this
balance.
Technological innovation has arguably been the dominant factor in shaping financial
service delivery in the past two decades. Systems for processing, communicating and
storing information are an essential part of the infrastructure supporting financial activities.
Between 1987 and 1993 the real cost of processing power in a personal computer
dropped by a factor of one hundred. Over the same period, the cost of storing data
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dropped approximately twenty fold, and the cost of moving data dropped by a factor of
one hundred.
Importantly, technology has linked markets around the world and opened cross-border
distribution of both wholesale and retail financial products. In contrast with a decade or
two ago, we now live in an age where most financial transactions can be executed, if you
wish, without the need to deal directly with another human being.
Largely as a result of technological advances, there has been a growing trend towards
international integration among financial markets. In several areas of the Australian
market, particularly those associated with wholesale funding, international markets have
replaced domestic markets as the primary source of finance. A consequence of
globalisation is that competition between financial service providers occurs globally, rather
than at the national or regional level. Globalisation has spawned a generation of
institutional investors who command enormous portfolios and have no particular loyalty to
any product or national marketplace.
Markets developments have also been shaped by changing customer needs. In
Australia, the most obvious of these has been the growth of compulsory superannuation
and the accompanying growth in the funds management business.
In combination, these factors have encouraged new entrants and new ways of doing old
business. For example, unlike a decade ago, banks and building societies are now very
aware of the competition that they face from securitisers. When we look back in another
ten years I suspect it will be entirely different groups that will be causing the blood
pressure of our financial establishment to rise.
The application of new technology and the emergence of new competitors may
revolutionise our financial system more quickly than some expect. Most of the
foreseeable developments involve existing technologies, and their impact in some other
countries is already more advanced than in Australia. Not all of them rely on customers
accepting new technologies  a lot of what is happening is in the “back office”.
While the Committee is unlikely to pretend to know the precise shape of the future, it will
be essential that we consider the possible shapes of things to come and what changes, if
any, may be needed in the regulatory structure to best cope with these changes, however
they may emerge.
The experience of a changing financial system is, of course, by no means unique to
Australia. Other countries with developed financial systems are facing the same changes,
and are thinking similarly about the best policies and regulatory responses.
Most countries too are seeking the benefits of increasing exposure to global trade and
investment. They realise too that financial systems contribute to the competitiveness of
national economies. This parallel process of change and reform in other countries
demands that we strive for world best practice in the Australian regulatory framework.
[SLIDE 5… REASONS FOR IMPROVEMENT ]
Let me sum up the situation by saying there are three key reasons for wanting to improve
our financial system :

the need to obtain the benefits of new technology;

the need to increase investment returns through more efficient management of
financial resources; and

the need to compete globally.
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As members of the Inquiry, we see as our key goal as identifying the means through which
to increase the efficiency of the Australian financial system, without compromising its
safety and stability.
[SLIDE 6.. KEY MEANS ]
We believe the keys to increasing the efficiency of the financial system are greater
competition and contestability  which means more vigorous competition among existing
participants and more opportunities for competition from new participants. We are
considering how regulation can best bring this about.
Our search for increased efficiency in the financial system is motivated not by the interests
of participants in the financial industry, but by the prospect that a more efficient financial
system should bring greater benefits to customers.
While the Discussion Paper does not contain recommendations about how we might
achieve these outcomes, you will find in it a clear identification of the priority issues as we
see them. Let me turn now to several of these priority issues.
[SLIDE 7.. PRIORITY ISSUES ]
The priority issues that I want to touch on are:
1.

stimulating competition and innovation,

achieving more competitive financial markets in Australia,

achieving more cost-effective consumer protection,

preserving systemic stability and clarifying depositor protection, and

achieving better performance and co-ordination of the regulatory arrangements.
STIMULATING COMPETITION AND INNOVATION
The first of these priority issues asks how competition and innovation in the Australian
financial system can be stimulated, without undue risk to the safety of the financial
system? Can we have our cake and eat it too? Not easy.
[SLIDE 8.. CONTESTABILITY ]
The Discussion Paper questions the feasibility of allowing an increased range of
institutions to provide some or all of the core financial services.
Our regulatory structure is a creature of history. Its licensing, ownership and prudential
rules are largely based on institutions. We insist on separate institutions for banking and
insurance, for example, and place a lot of store on institutional labels. This works OK at
the moment, but it may be inadequate as the world develops, with more institutions
offering products which combine different services, and more institutions wanting to crosssell the products or services of other entities.
With this in mind, we are looking closely at the extent to which the regulatory system
inhibits competition among the traditional financial institutions, and restricts potential
competitors from entry  notably firms which operate globally in providing selective,
specialised services.
[SLIDE 9 OPERATING AND OWNERSHIP RULES ]
Australian financial institutions are subject to a range of detailed prudential rules about
their structure, manner of operation, and ownership. These are a barrier to entry and
limit competition and efficiency. This is no accident, they have been designed that way
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deliberately, for prudential reasons. The cost of such effects needs to be weighed against
their necessity or helpfulness for prudential purposes.
It may be possible, without compromising safety and stability in the system 

to allow an increased range of institutions to provide a wider range of financial
services, including allowing more scope for global specialist firms; or

to relax some of the ownership restrictions on banks; or

to enable branches of foreign banks to compete in the retail deposit market.
Each or all of these options could improve the contestability of our core banking markets
and will receive due consideration.
An important issue under the heading of financial structure and competition is
conglomeration. Conglomerates are not a new concept in the financial system. What is
new is the more aggressive diversification of services offered by the ‘full service’ banking
groups and life insurance groups, and their more aggressive leveraging of successful
brands.
The central issue here for prudential regulation is this  where conglomerates involve
some prudentially regulated institutions or activities, and others which are not, do
consumers understand fully the differing promises and risks involved?
There was universal support, in submissions to our Inquiry on this issue, for allowing
conglomerates with any mix of financial businesses, subject to their having a holding
company structure.
[SLIDE 10 HOLDING COMPANIES ]
The basic feature of the holding company structure is that the businesses within the group
are conducted in separate entities to whatever extent is warranted by operating and
accounting considerations, or by regulatory requirements.
Where we have financial conglomerates in Australia at present, most are headed by
banks, and several are headed by life insurance companies. Where a bank is the leading
business, the Reserve Bank as regulator takes a prudential interest in the operation of the
whole group. Our two more recent conglomerates, the first two to combine banking and
insurance in Australia,  Colonial State and the yet to be named Q Bank  have their
assets and businesses evenly distributed between banking and insurance.
There is therefore a relatively new principle involved in a model which would allow any
mixture of financial businesses within a conglomerate. It would transfer some of the
regulators’ attention from the leading business to the relations among the component
businesses.
[SLIDE 11 HOLDING COMPANY ISSUES ]
Opting for that model would introduce a number of important issues 

first, whether the companies at the top of each group should be non-operating
holding companies;

secondly, how can we ensure the adequacy of firewalls between the component
businesses, and the transparency of intra-group dealings;

and thirdly, whether business activities other than financial ones (or incidental ones)
might be permitted within the heavily-regulated components of the conglomerate.
All of these possible options were canvassed in submissions made to the Inquiry.
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[SLIDE 12 PAYMENTS AND SETTLEMENT ]
The payments system is another area where competition will be reviewed. The existing
terms of access to the payments, clearing and settlement systems is an impediment to
competition and innovation. These access restrictions have been justified because of
concerns about systemic risk. This overriding prudential objective has influenced the
Australian Competition and Consumer Commission in its consideration of the key
payments system agreements and arrangements.
In this Inquiry we are examining whether there are ways of widening access to the
payments system without sacrificing the system’s integrity.
We do realise the need to proceed carefully in this area. We know, for example, that
payments system standards are important for international confidence and recognition.
But this area appears also to be strategically important for competition, and to be one
where current technical innovations have the potential to affect the competitive dynamics.
Some of the policy options identified in the DP include:

widening the terms of access to clearing streams for specialist financial service
providers, which compete with banks, building societies and credit unions in
providing transaction services; and

allowing settlement access for a wider range of institutions, subject to prudential and
technical standards which would be specific to payments systems.
2.
ACHIEVING MORE COMPETITIVE FINANCIAL MARKETS
Let me turn now to the second of our priority issues, achieving more competitive financial
markets. We share the concern, expressed in many submissions made to the Inquiry,
about improving the international competitiveness of Australia’s financial services industry.
Many factors influence international competitiveness. Regulation is clearly important. But
so too are other factors such as technology, geography and taxation. Some of these we
can influence, others we can’t.
[SLIDE 13.. IMPLICATIONS OF TECHNOLOGY]
First, technology. Technology can alter barriers to entry, change the boundaries of
markets for financial services and the range of potential participants, and can also create
opportunities for new anti-competitive structures.
It is important that the regulatory framework recognise and be responsive to technological
innovation.
Submissions to the Inquiry pointed out several legal impediments to electronic commerce,
such as having electronic data admitted as evidence in litigation. Until unecessary
impediments are removed, regulation will constrain the rate of innovation as well as the
rate of take-up of innovation. Correspondingly, it may handicap our international
competitiveness.
[SLIDE 14.. TECHNOLOGY AND GOVERNMENTS]
One issue we are examining is the appropriate role of public policy:

Should the Commonwealth, State and Territory Governments act as facilitators of
technological change?

Should there be a specialist unit to promote the communications developments most
needed for financial innovation?
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
Should there be stronger intervention, insisting on a uniform national approach in
legislation and standards?

Or should we doubt the ability of government to second-guess the business experts,
and simply allow outcomes to be driven by market forces?
Regulation can also block product innovation. We have been particularly interested, for
example, in the development of securitisation in Australia.
[SLIDE 15.. SECURITISATION]
Securitisation has provided a quick and effective method for funding home loans. It has
introduced competition into that area of banking and has forced rethinking about cross
subsidisation of products.
At the same time, securitisation has not developed as fast or spread as widely across
different areas of lending as it has in some other countries. If it were to follow the US
pattern, for example, it could 

add depth to the domestic bond market, and

in time, help to open new channels for the finance of small and medium enterprises.
[SLIDE 16.. POSSIBLE IMPEDIMENTS]
So we are examining some apparent regulatory impediments to the spread of
securitisation that were identified in submissions. These include elements of the Uniform
Consumer Credit Code, the corporations law, and prudential rules for banks and other
deposit-taking institutions.
While there are many factors that affect competitiveness, let me mention just one more taxation.
Tax differentials, at least some of them, appear to be important for international
competitiveness.
In this area, our terms of reference prevent us from making
recommendations, but we can and shall draw conclusions about the impacts of various tax
measures on competitiveness.
[SLIDE 17... TAX BRAKES ON COMPETITIVENESS? ]
The large number of tax issues raised in submissions can be grouped in three broad
areas:
Firstly, there are policies which, it is argued, restrict Australia’s competitiveness in
international financial markets  for example, aspects of dividend imputation, the capital
gains tax regime, the regimes for Offshore Banking Units and Regional Headquarters, the
Foreign Investment Fund regime, Financial Institutions Duty and debits tax, and stamp
duties  quite a list!
[SLIDE 18... SAVING DISINCENTIVES / DISTORTIONS? ]
Secondly, there are policies which are perceived as disincentives to savings, or distortions
to the pattern of savings  for example, the taxation of life insurance, taxation of unit
trusts, and the preferential taxation treatment given to superannuation and owneroccupied housing.
Thirdly, there are policies which some have suggested are anti-competitive because they
favour some institutions over others  for example, exemptions from interest withholding
tax, and the special taxation of pooled development funds  or because they impose a
heavy administrative burden  notably the Financial Transactions Reports Act.
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3.
ACHIEVING MORE COST-EFFECTIVE CONSUMER REGULATION
The third priority issue we have identified is whether Australia’s consumer protection
regime for the financial system needs to be re-focused. I should start by stating the
obvious, that all regulation is about consumer protection, from prudential regulation
through to market conduct and disclosure. The trouble is, we sometimes end up
wondering just who is being protected from whom, and who is gaining from the protection other than the inevitable lawyers.
There seems to be widespread dissatisfaction with many aspects of the arrangements for
consumer protection in the financial system. We have had many suggestions in
submissions to the Inquiry about the need to streamline these arrangements and reduce
their cost, while ensuring that there is still enough protection of the interests of consumers.
The key suggestions include the following.
[SLIDE 19… CONSUMER PROTECTION POSSIBILITIES ]
One suggestion is to introduce a single regulatory regime for similar products, and
establish under Commonwealth jurisdiction a single consumer protection regulator for the
financial system.
Another suggestion is to establish a regime of ‘co-regulation’  where statutory provisions
provide the broad principles for regulation and the means of enforcement, but the details
of codes of practice and dispute resolution are left to more flexible industry-based
arrangements.
Both these suggestions have obvious attractions, but we wish to weigh up carefully their
feasibility. There is a linked question of whether the Australian Competition and
Consumer Commission should retain some role in this area, in order to ensure
consistency with consumer protection elsewhere in the economy.
The Inquiry will also look at new technologies which facilitate global sales of financial
services, notably the Internet, and their implications for consumer protection.
There are several other controversial issues in this area of consumer protection.
[SLIDE 20... CONSUMER PROTECTION CONTROVERSIES]
One is the suggestion, made by many of the consumer lending institutions, that penalties
for breaches of the new Uniform Consumer Credit Code should be proportionate to
economic losses incurred  a suggestion which is vigorously countered by some
consumer organisations .
Another is the public concern about fees and charges for operating retail deposit and
transaction accounts and, on the other side, the concern of many financial institutions that
there are cross-subsidies in this area which are inefficient and unsustainable.
A further issue is how to balance the appetite of the financial sector for information  as
part of operating prudently or meeting customers’ demand for services  against the
individual’s desire for privacy.
In all of these areas, we do not intend that this Inquiry take up an arbitrating role. But we
will have some observations to make, in addition to recommending a framework for
dealing with these and other such issues in the future.
A key issue under consumer protection is the role of depositor protection. It was one
issue in the DP that seemed to catch the eye of the press more than we had anticipated.
[SLIDE 21 DEPOSITOR PROTECTION ]
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At present, our arrangements for protection of depositors in retail deposit-taking
institutions are bound up partly with the prudential regulation of those institutions, and in
the case of banks, partly also with a legal obligation on the Reserve Bank to act to protect
depositors’ interests in handling weak or failing banks, and a legal priority of claims of
depositors in Australia over other creditors in the event of bank failure.
The same is true of our arrangements for the protection of holders of insurance policies.
They involve prudential requirements about the operation of insurance companies, the
actions of the Insurance and Superannuation Commission as prudential regulator, and the
legal priority of policy-holders’ claims.
Therefore, when we review our system of prudential regulation, we need to review those
depositor and policy-holder protections as well. The biggest concern noted in submissions
is the absence of clarity in existing arrangements. The possible options noted in the DP
include:

removing the laws for depositor protection all together;

clarifying that there is no government guarantee in any area of the financial system;
and

establishing means for making any guarantees and their funding explicit.
[SLIDE 22 ELECTRONIC MONEY]
A particular challenge for consumer protection regulators is that of keeping up with new
electronic means of offering financial services, notably the Internet.
The electronic technology now available for transferring value  through stored value
cards, or through commerce over the Internet with payment vehicles such as Digicash and
Cybercash  has the potential to revolutionise the way most financial transactions are
conducted by small businesses and households.
Around the world, authorities are trying to determine the extent of their responsibility for
ensuring that consumers are protected and that value is delivered. The key questions
being examined are 

What regulation may be needed to cover the new on-line forms of value transfer?

Could there be impairments of competition if telecommunications or software
companies were to form exclusive alliances to offer new types of services? and

Are entry restrictions or prudential standards required for the issuers of stored value
cards or other electronic forms of money?
4.
SYSTEMIC STABILITY
The fourth priority issue we have identified is how, in a more open, global and competitive
financial system, threats of systemic instability can best be met. Part of this task overlaps
with the previous issue of clarifying the scope of the protection afforded by prudential
regulation to depositors or other investors.
The Discussion Paper identifies the main options in regard to prudential regulation which
were canvassed in submissions to the Inquiry. Most relate to the structure of regulatory
agencies.
Questions about regulatory agencies are of course linked to questions about the two basic
objectives of prudential regulation 

to counteract risks to systemic stability, and
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
the protection of customers who entrust savings to financial intermediaries.
Immediately there are questions about scope  what parts of the financial system require
these efforts  and what intensity of regulation is needed.
These questions underlie the policy options concerning which agency or agencies should
carry out the prudential regulation. There are four main alternatives canvassed in
submissions:
firstly, continue the existing regulatory agencies;
Secondly, have one regulator for all deposit takers  with evident implications for the
States’ and Territories’ responsibilities;
The third option is to have a combined regulator of deposit takers, insurance and
superannuation and any other institutions that pose a systemic threat.
The final option is to have a genuine mega-regulator, responsible not only for all prudential
regulation but also for regulation of financial markets and consumer protection, and
perhaps for competition in the financial system.
A key issue in this sequence is, if the case for change can be established, what role
should the Reserve Bank play?; in other words, can prudential regulation be separated
from monetary policy and if so, what are the costs involved?
6.
CO-ORDINATION
The last of the six priority issues I want to cover is achieving better performance and coordination of the regulatory arrangements.
As I said earlier, we have the need, and the opportunity through this Inquiry, to pursue the
world’s best practice in regulation of our financial system.
A number of submissions to the Inquiry have addressed the issue of how to ensure that
the different agencies in the regulatory system are responsive, efficient, fully resourced,
well co-ordinated, and accountable.
In the Discussion Paper, we identify several basic options for achieving these goals.
Again there is considerable overlap with the last issue of structures appropriate for
prudential regulation. Obviously, the issues need to be considered in parallel.
One option is to combine all of the regulatory functions in the financial system in a single
‘mega-regulator’.
Another option is to establish a co-ordinating mechanism for separate regulators, such as
a board to guide them. This would need to take account of any decision to combine some
of these regulators.
Another option again is to establish co-ordinating mechanisms with more specific
functions, such as a council for considering issues in the development of financial
markets, or a unit to co-ordinate the regulators’ responses to new financial sector
technology.
[SLIDE 23… INQUIRY TIMELINE ]
I hope I have made at least one thing clear  that we have many factual and analytical
issues to settle before determining our recommendations.
In conclusion, therefore, may I repeat that we look forward to having reactions to this
Discussion Paper  we welcome further brief written submissions, but only until
13 January 1997.
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[TITLE SLIDE 24]
Thank you.