This paper was produced under the Funding Australia’s Future project which aims to better understand the changing dynamics of the financial system and its impact on future economic growth. The research from Stage Two drills down into the issues challenging the financial sector and culminates in a set of recommendations for improving Australia’s Financial System. 

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The Financial System Inquiry (FSI) should seize the moment and recommend an overhaul of the regulation of Australia’s financial system, says Alex Erskine, managing director and founder of Erskinomics Consulting.

He says the “efficient markets” regulatory philosophy that was the centrepiece of the Wallis/Costello approach to regulation failed in the GFC – and now is the time to recalibrate the regulatory architecture.

In a paper titled “Regulating the Australian financial system”, one of four papers that form part of the Australian Centre for Financial Studies’ Funding Australia’s Future initiative, Erskine argues that the Council of Financial Regulators (CFR) – a legacy of the Wallis Inquiry – should have a far greater role in regulating the system.

“This Wallis inspiration relies on clubby cooperation is not necessarily proactive and is unaccountable. It has worked well so far, but the future is likely to be more testing.

“But by recreating it as a statutory body with an independent non-executive chair, publishing an agenda and minutes for regular meetings and accountable half-yearly to parliament, the CFR should have two roles: to oversee the effectiveness of regulation and to be perpetually paranoid about systemic financial instability and make decisions on the conduct of macro-prudential policy.

“The Council could contract the RBA and other regulatory agencies as appropriate to implement its macro-prudential policy decisions, resolving the confusion between the RBA and APRA over macro-prudential policy.”

The Erskine prescription for a new regulatory framework also envisages revised roles for the major players in the system.

“The Reserve Bank’s responsibility for financial stability should be transferred to the CFR. This will let the council determine macro-prudential policy actions on a pre-emptive basis while allowing the bank to implement monetary policy with a sole focus on inflation.

“The Australian Prudential Regulation Authority (APRA) needs to have a mandate to protect taxpayers from the risk of bail-outs made explicitly part of its objectives.

“It should also be required to prepare a risk appetite statement, agreed with the government, and set capital and liquidity standards for prudentially-regulated institutions to protect taxpayers from all except a periodic ‘unavoidable’ financial crisis. To clarify its role and responsibilities, APRA’s competition mandate, which it has largely overlooked, should be transferred to the Australian Competition and Consumer Commission (ACCC).

“The Australian Securities and Investments Commission (ASIC), in a post GFC world, should have one objective: market integrity. It should be equipped with effective data, analysis, policy and regulatory tools to perform this task, with funding remaining with taxpayers to limit risk of regulatory capture. Its competition and consumer responsibilities should be stripped out and assigned to the ACCC.

“Finally, the role of the Australian Competition and Consumer Commission (ACCC) should be reinvigorated and made a member of the CFR.

“A vigorous competition regulator will be more important for Australia’s future: key competition questions will arise from the increasing vertical integration of the dominant banks into all aspects of finance and the implications of the emerging international trend to ring-fence core banking from riskier trading businesses. The ACCC should receive the competition mandates currently held (and generally ignored) by APRA and other regulators.”

Erskine says the “efficient markets” philosophy depended on banks and their investors fearing they can go bust and consumers fearing they will lose their deposits, creating sufficient incentives to manage their risks and, in doing so, and aided by prudential regulation, perpetually nudging the financial system towards equilibrium even while permitting individual failures.

“This unreality was made obvious in the systemic financial shock of the GFC. In Australia, every prudentially regulated entity became too-big-to-fail, key borrowings were guaranteed by government, and deposits are now largely insured through the Financial Claims Scheme (FCS), all in contradiction to the Wallis Inquiry intellectual underpinnings.

“The GFC showed beyond doubt a determination from governments, including the Australian Government, to limit through policies and regulations the risk and damage of systemic crises. In doing so, taxpayers were put at great risk, though fortunately in Australia the cost of support measures remained contingent and were not drawn on.

“It is time now to recognise the reality of this support and to devise a regulatory system that limits the risk to taxpayers in future crises. Financial system regulation, especially prudential and macro-prudential, needs to be reassessed in this ‘systemic stability’ light, and the risk to taxpayers appropriately managed.”


 

The Australian Centre for Financial Studies (ACFS) initiated the Funding Australia’s Future project in late 2012 to undertake a stocktake of the Australian financial system, and its role and challenges in facilitating future economic growth within the wider economy.

In an economy that has enjoyed 21 years of consecutive economic growth and shown a resilience through the Global Financial Crisis (GFC) which is the envy of many nations, the financial sector has played a strong and pivotal role. The past decade, however, has been one of significant change. The impact of the GFC and the subsequent wave of global re-regulation have had a profound effect on patterns of financing, financial sector structure, and attitudes towards financial sector regulation. Identifying the extent to which these changes are transitory or likely to be more permanent is crucial to understanding how financing patterns and the financial sector will develop over the next decade or so.

The Funding Australia’s Future project is in three stages, the second of which assessed how well Australia’s financial sector serves the economy, and how effectively it links the sources and uses of finance for the benefit of Australian society.

 

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