The financial crisis that engulfed global capital markets and brought a number of important international banks close to the brink last year has been followed by a good deal of soul searching among the regulatory community…Work is proceeding to try to establish better arrangements so as to prevent the next crisis, or, more realistically, at least make it less costly – all the while seeking to avoid doing things that make it harder to recover from this one.
Glenn Stevens, Governor of the RBA, December 2009
Treasury and ASIC have cast different visions for the future of financial product regulation in Australia. …it will be interesting to see whose views prevail in the battle between these heavyweight agencies.
Stephen Jaggers, partner, Mallesons Stephen Jaques, October 2009
IFSA does not believe that the recent financial service and product provider collapses are evidence that our regulatory regime has fundamentally failed or that the legislative requirements imposed on financial services providers are grossly inadequate…This is not to say that our financial services regulatory regime cannot be improved…We believe there is room for improvement.
Investment and Financial Services Association (IFSA), July 2009
As at 30 September 2009, funds management institutions in Australia had over $1.3 trillion of consolidated assets. To put this into perspective, the financial services industry controls a pool of money larger than Australia’s annual GDP. The average Australian has $62,632 invested in various managed funds. Aided by compulsory superannuation, superannuation co-contribution schemes and an increase in the export of financial services, the industry continues to grow.
Presently the funds management industry is subject to regulation primarily through the Australian Prudential Regulation Authority (APRA) and the Australian Securities and Investment Commission (ASIC). This includes the enforcement of legislation in the Financial Services Reform Act 2001 which was refined with the Corporations Amendment Regulations in 2005. The reforms introduced in 2005 included a relaxation of what constitutes the provision of a financial service. Providers of financial services were also given the ability to substitute a full Product Disclosure Statement (PDS) for a short-form PDS, provided a full PDS is available on request. However the global financial crisis has triggered a wave of distrust towards the financial services industry which now faces re-regulation.
Whilst the robust Australian regulatory system is generally viewed positively by international investors there are currently numerous reviews underway, including a submission by ASIC to the Parliamentary Joint Committee on Corporations and Financial Services (PJC). Although there has been regulatory changes regarding credit rating agencies and short selling, the government must consider broader reform encompassing greater protection for retail investors. Reform in the industry could also address many of the so-called contributory causes behind the financial crisis, including an inappropriate use of leverage and the provision of inadequate financial advice.
In its submission to the PJC, ASIC suggests several areas for reform such as prudential regulation of a larger range of financial products. This would involve more than conduct and disclosure regulation for products such as debentures or products where there is the potential for hardship to occur should the product fail. It is argued that this would negatively affect market efficiency by creating a lack of higher risk-return investments; however the severe losses incurred to retail investors over the past few years could have been minimised if more complex financial instruments had been subject to greater scrutiny.
Furthermore ASIC suggests restrictions on the type or design of products sold to retail investors in order to ‘safeguard investors from high-risk or unsuitable products’. In a world where CDOs, CMOs, and CLOs run riot it makes sense to protect the average investor, who struggles to understand even the basics of a credit default swap. ASIC suggests that investors are categorised in order to restrict access to riskier financial products. Only qualified retail investors that self-certify annually will receive access to certain securities. Although such a regulation would be beneficial, it could be interpreted as discriminatory and would create red tape that limits market efficiency.
Another area that could face reform is the licensing of financial advisors. An increase in licensing regulations such as the ability to ban individuals deemed improper would further mitigate risks to retail investors. On the other hand an increase in licensing laws could create high barriers to entry that prevent the industry from expanding, especially in terms of export potential.
In an alternative approach Treasury acknowledges that increased regulation in the financial sector seeking to remove risk could create a moral hazard if a sense of complacency were to develop among investors. Additionally an increase in regulation would increase costs resulting in ‘the community underwriting financial risk through the tax system’. Instead of supporting ASIC’s suggestions, including a restriction on remuneration for financial advisors, Treasury believes investors would receive greater benefit from improved disclosure. Therefore although regulatory action may be necessary in response to perceived vagaries in the funds management industry, it is certainly not the case that ASIC’s sweeping reforms must be undertaken.
Nevertheless given the economic instability and volatility caused by the crisis, it is clear that improved disclosure is not sufficient in preventing large-scale financial devastation. Thus in reviewing regulation of the funds management industry the government should not be lulled into a false sense of security by green shoots of recovery. The underlying issues such as the inappropriate use of certain securities are a result of insufficient regulation and the problems remain, hence reform is necessary or we could be witness to take two.
By Nicole Loewensohn and Emily Stewart