House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Honourable Peter Costello MP)

3 Regulation impact statements

RIS - Schedules 1, 4, 5, 6, 10, 11, 12, 13, 15, 16, 17, 18, 19

This Regulation Impact Statement ('RIS') accompanies the Financial Sector Reform (Amendments and Transitional Provisions) Bill 1998. It deals with a range of reform measures for regulatory arrangements governing corporations and consumer protection and market integrity in the financial system. In particular, the performance of those functions by a regulator to be known as the Australian Securities and Investments Commission (ASIC).

Regulatory objectives

3.1 To ensure efficiency in financial markets, participants must act with integrity and there must be adequate disclosure to facilitate informed judgements by consumers and investors. The need for regulatory responses to address potential market failure in those areas is well established.

3.2 Market integrity regulation seeks to promote market development by securing confidence and protecting participants from fraud and other unfair practices. Consumer protection aims to ensure that retail investors have adequate information, are treated fairly and have adequate avenues for redress. Often it is difficult to distinguish between regulation directed at market integrity and consumer protection, since both use the regulatory tools of conduct and disclosure rules.

3.3 There are several agencies at the Commonwealth and State/Territory levels which provide specific forms of market integrity and consumer protection regulation for savings, investment, risk management and payment products and the provision of advice. They include the Insurance and Superannuation Commission (ISC), the Australian Securities Commission (ASC), the Australian Competition and Consumer Commission (ACCC), the Australian Payments System Council (APSC), and the Australian Financial Institutions Commission (AFIC) and associated State Supervisory Authorities (SSAs). The regulation of credit is the responsibility of the States and Territories under the Uniform Consumer Credit Code (UCCC).

3.4 The Financial System Inquiry (FSI), which reported to the Government in March 1997 considered that, in relation to the regulatory framework for market integrity and consumer protection in the financial system, it would be desirable to ensure that:

•

the regulatory structure is flexible and responsive to the forces for change operating on the system;

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there is consistency in regulation of similar financial products to promote competition by improving comparability;

•

financial markets are more contestable, efficient and fair;

•

regulation of financial conglomerates is effective, which will facilitate competition and efficiency; and

•

international competitiveness of the Australian financial system is facilitated.

Problem

3.5 The efficiency and effectiveness of the regulatory framework for the financial system was examined by the FSI. Many persons expressed dissatisfaction to the FSI with the existing framework for delivery of market integrity and consumer protection regulation in the finance sector. The key concerns are that current arrangements with a combination of economy wide and institutionally based approaches produce:

•

inconsistency of requirements for functionally equivalent products in a number of areas, particularly product disclosure regulation and financial sales and advice;

•

duplication between specific financial system regulation and economy-wide regulation under the Trade Practices Act 1974 (TPA); and

•

a proliferation of dispute resolution mechanisms for consumers leading to overlaps, non-uniformity and inefficiency.

3.6 The FSI found that the financial system is undergoing rapid change due to technological innovation, an evolving business environment and longer-term changes in customer needs and profiles. Entry of new participants, products and distribution channels will cause the financial system to expand beyond the traditional categories of banking, insurance and financial exchanges.

3.7 The FSI considered that changes to the current regulatory framework were necessary for it to meet the regulatory objectives described above.

Options

3.8 The FSI considered a number of models for the regulatory framework in the financial sector.

STATUS QUO

3.9 The first option considered was the retention of the existing system comprising a combination of multiple institution-based regulators and general economy wide regulation. At the Commonwealth level, the relevant regulators are the ISC (insurance and superannuation), the RBA/APSC (banking), and the ACCC (economy-wide consumer protection). The ASC (corporations and securities/futures) is directly responsible to the Commonwealth Treasurer although, as discussed below, it is based on cooperation between the Commonwealth and other jurisdictions. There are other regulatory agencies at the State and Territory level administering relevant legislation. Chief among those is AFIC and the relevant SSAs which administer legislation concerning non-bank deposit-taking institutions (building societies and credit unions).

DUAL REGULATORY MODEL

3.10 The dual regulatory model involves the creation of a specialist consumer regulator for the financial sector which would take over the consumer protection role of the various existing financial sector regulators. The economy-wide coverage of the TPA and the ACCC would also be retained.

COREGULATORY MODEL

3.11 Under the coregulatory model, regulation would be built upon industry based self-regulatory codes in the various industry sectors. A self-regulatory umbrella organisation would be established and all institutions and individuals with retail clients would be required to be members and it would be governed by a council of representatives from the various lines of business and users. This organisation would be responsible for licensing and monitoring compliance and with codes and overseeing the dispute resolution schemes. The self-regulatory organisation would be monitored by the ACCC (which would retain jurisdiction over the universally applied consumer protection provisions in the TPA), and a small statutory consumer regulator in the Treasurer's portfolio which would be responsible for overseeing and auditing the performance of the self-regulatory arrangements.

SINGLE REGULATOR MODEL

3.12 Under the single regulator model, there would be established a single consumer regulator for the financial system which would take over primary functional responsibility for the consumer protection roles currently undertaken by the financial system regulators and the ACCC. This model could be advanced by a statutory scheme (as in the dual regulatory model) or a scheme based on self-regulation (as in the coregulatory model).

Impact Analysis

3.13 In assessing the options, there are a number of key issues which it is convenient to address in turn. They are:

•

which groups will be affected by a change in the regulatory framework for consumer protection in the financial system?;

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whether the advantages, relative to the costs of change, warrant bringing together into one agency the specific finance sector consumer protection regulation currently undertaken by the various finance sector regulators;

•

if so, whether the best approach is to base consumer regulation in the finance sector on self-regulation and industry codes of practice, statutory rules and procedures administered by public agencies, or a combination of each;

•

if a specialised agency consumer protection is established, should it be a stand-alone or should also be responsible for regulation of market integrity, securities and corporations; and

•

if a specialised agency consumer protection is established, how should it be funded?

Who are the affected parties?

3.14 The parties affected by a transfer of regulatory responsibilities for consumer protection functions in the financial system fall into three key categories:

•

the relevant regulators, being the ASC, the ISC, the ACCC, and AFIC and associated SSAs;

•

institutions offering retail financial services subject to consumer protection regulation, being banks, building societies, credit unions, superannuation trustees, general insurance and life companies, and friendly societies; and

•

consumers and investors whose interests are sought to be protected by the consumer protection framework.

Should consumer protection responsibilities in the financial sector be amalgamated?

3.15 The key possible advantages of combining regulatory arrangements for consumer protection across the whole financial sector would be:

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greater consistency of regulation;

•

minimisation of regulatory gaps or overlaps;

•

reduced risk of regulatory capture; and

•

the development of a stronger single body of expertise.

3.16 The key possible disadvantages would be:

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loss of specialisation and coordination with prudential regulation or other related areas of regulation in specific industry sectors;

•

loss of competition between regulators;

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costs of transition.

3.17 The FSI found the arguments in favour of amalgamation to be compelling. The existing system's negative consequences included substantially differing disclosure requirements for similar investment vehicles and inconsistency in approach to regulation of financial sales and advice. Although splitting the consumer protection function from other aspects of regulation (such as prudential supervision) means that some participants offering specific services would have to deal with two regulators when they previously dealt with only one which handled both functions, this disadvantage is outweighed by the advantage to participants offering a range of services who currently face a multitude of regulators which take different approaches to consumer protection issues.

3.18 Further, retention of institution-based regulators is unlikely to facilitate flexibility and responsiveness to the forces shaping financial markets, including new entrants to the industry, new products and means of service delivery which increasingly blur distinctions between products and institutions.

3.19 The FSI considered that better focused, more consistent and responsive regulation would be delivered by a single regulator performing the consumer protection function for banking services and comparable services offered by non-bank deposit-taking institutions, retirement savings accounts, superannuation, life insurance and general insurance. Other products and services with similar characteristics should also come within the ambit of the scheme. Accordingly, friendly societies should also be subject to the jurisdiction of the single regulator.

3.20 Although there will undoubtedly be transition costs in changing the regulatory framework, the factors mentioned above mean that the long term costs of retaining the status quo are, potentially, far greater.

What regulatory approach should be used?

3.21 The impact on participants in the financial sector of the regulatory arrangements is dependent to a large extent on the type of regulatory approach adopted. There are a number of approaches which could be adopted, including:

•

a statutory approach comprising specific detailed laws administered by the regulator;

•

a coregulatory approach where 'framework legislation' sets out general principles and the specific regulation of particular transactions is provided through detailed codes in particular industries; and

•

a self-regulatory approach where regulation is based in industry schemes alone with no legislative backing.

3.22 A statutory approach leads to greater consistency across industry sectors and is more effective in industries which are highly dispersed or have a history of conduct and disclosure problems. However, legislation is more difficult to change to reflect market developments.

3.23 A coregulatory approach is more responsive to market developments since codes are more readily modified. It has advantages in terms of funding because a large part of the cost is borne directly by industry and consumers who benefit. It is more susceptible than a statutory scheme to regulatory capture because of the high level of industry involvement, but oversight and audit by a public agency makes this of less concern than a system based purely on self-regulation. In the context of the financial system, coregulation could lead to disjointed regulation because of the numerous industry-based organisations that would be required to participate. Coregulation is less suitable at the retail level than the wholesale level because of greater information imbalances between consumers and suppliers.

3.24 The complexity of financial products means consumers can easily misunderstand or be misled and the consequences of dishonour are great. The special characteristics of the products, services and participants in the financial system means self-regulation will not normally be appropriate, especially at the retail level.

3.25 Since there are the differences in the environments of various sectors of the financial system, no particular regulatory approach is ideal for use across the board. The FSI considered that the best way to balance the objectives of efficiency and effectiveness would be to establish a regulatory framework which features a combination of regulatory approaches.

Should the consumer protection function be combined with other functions?

3.26 The FSI received some support for a dedicated consumer protection regulator on the grounds that there was a danger that, if it were combined with other functions, the consumer protection function would become secondary to other objectives. On the other hand, it is arguable that an agency should have a broader task than merely consumer protection to ensure there is a balance in pursuing regulatory objectives.

3.27 The FSI noted the strong links between market integrity and consumer protection in the financial sector. In fact, in some areas it is difficult to distinguish between them. It is also difficult to distinguish between wholesale and retail markets. Any attempt to draw a dividing line would necessarily involve an arbitrary element. Pragmatic approaches need to be adopted so that the regulatory framework is flexible and able to cope with shifts and imprecision in the dividing line. Furthermore, if a division was attempted, many market participants would be engaged in retail and wholesale transactions and would therefore be subject to more than one regulator covering much the same ground.

3.28 The FSI further noted that there were strong links between market integrity regulation in the finance sector and general corporate regulation. Both aim to promote disclosure to public investors of the nature of investments and both rely heavily on principles of good corporate governance. Furthermore, there are links between financial markets and the finance sector, given that the markets are an important source, and facilitate provision, of corporate finance.

3.29 In light of the above, the FSI considered that the single agency responsible for consumer protection should also have responsibility for market integrity in the financial system and general corporate regulation.

How should the CONSUMER PROTECTION regulator be funded?

3.30 The main options for funding a government agency performing consumer protection functions across the financial system are:

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by budget appropriation (that is, by taxpayers generally) with no cost recovery;

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by budget appropriation but with costs recovered from statutory fees and charges paid by industry participants to the Government; or

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through fees and charges paid by industry participants directly to the regulator.

3.31 The FSI report noted that it is desirable for the costs of regulation in particular industry sectors to be borne directly by the businesses and consumers who benefit from it rather than on the community as a whole. However, this must be applied in a practical way. It was considered that, so far as possible, industries should be levied to meet the cost of regulation in proportion to the agency resources expended on it. The charges of regulatory agencies should reflect their costs.

3.32 The FSI considered that, from the perspective of financial regulation, it is preferable for financial sector regulatory agencies to operate "off-budget". This would allow funding of financial regulation to be determined by reference only to market needs, rather than targets for the overall budget.

3.33 However, the contemplated agency will possess considerable investigative and enforcement tools which can be exercised against persons other than "market players". It is arguable that such an agency should be, and should be seen to be, accountable and responsible to the public as a whole. Further, the real costs of regulation extend beyond the running costs of the regulatory agency itself. Other government agencies, such as police, courts, tribunals and advisory bodies all play an important role in the system and it is appropriate that funds recouped are directed to funding a proportion of their activities also.

Consultation Process

3.34 A consultation process was undertaken by the FSI. The FSI received a total of 421 submissions, including 153 submissions responding to a Discussion Paper published by the FSI in November 1996. These submissions were prepared by a broad cross-section of industry participants and other interested individuals, corporations and groups. The FSI held public consultations in all mainland capital cities during December 1996, and met with a range of financial industry experts and participants, regulatory agencies and consumers, both in Australia and overseas. The FSI also participated in a range of conferences and seminars, and had a home page on the Internet.

3.35 The proposal that consumer regulation in the financial sector be placed under a single entity received wide support in submissions to the FSI from regulators, industry groups and consumers.

Conclusion and Recommended Option

Key Conclusions

3.36 The consumer protection functions across the financial sector should be combined in a single agency. Retention of the status quo is untenable in the long term.

3.37 A combination of regulatory approaches should be used, with industry-based regulation playing a role as appropriate. None of the regulatory approaches is suitable for use across the board.

3.38 ASIC should assume the primary functional responsibility for consumer protection in the financial system. However, to prevent regulatory gaps emerging, the ACCC should retain its economy-wide jurisdiction, underpinned by administrative arrangements to prevent regulatory duplication. The interaction of State and Territory provisions and agencies with the financial sector legislation and consumer protection regulator will need to be negotiated with the States and Territories at the same time as other aspects of the proposal.

3.39 The difficulties in separating market integrity regulation and consumer protection regulation is acknowledged. Further, there is merit in combining the function with others so that a balanced approach may be taken. Accordingly, the consumer protection function should be combined with market integrity and corporate regulation, which is currently administered by the ASC.

3.40 The fees and charges made by the regulator should be set to reflect the costs of regulation and, so far as is practicable, particular market segments (such as banking or insurance) should bear an appropriate proportionate burden. However, it is important to ensure that the total regulatory costs are taken into account, not merely the running costs of the agency itself.

Recommended option

3.41 A new body, to be known as ASIC, will be formed by using the ASC as a base and adding to its responsibilities the consumer protection functions of the ISC and the APSC. Since the corporate regulatory framework and the ASC exist by virtue of an agreement between the Commonwealth and the States/Northern Territory, the proposed change in structure and addition of functions ASC is subject to the agreement of those jurisdictions. ASIC would also (subject to the agreement of the States/Territories) accept responsibility for market integrity and consumer protection functions in connection with building societies, credit unions and friendly societies.

3.42 This would give ASIC responsibility for:

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regulation of corporations and securities;

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market integrity and consumer protection functions (particularly in connection with product disclosure) concerning:

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banks, building societies, credit unions and friendly societies;

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superannuation interests;

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retirement savings accounts (RSAs); and

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general insurance and life insurance products.

3.43 ASIC would be given broad framework legislation which allowed it to adopt detailed codes where necessary (a statutory approach), or leave it to industry bodies to develop the codes (a coregulatory approach). However, in recognition of the importance of the health, credibility and security of the financial system to the wider economy, ASIC would be given a full range of enforcement options, access to adequate resources and a mandate to use them where appropriate.

3.44 The funding arrangements for ASIC would be modelled on the existing arrangements for the ASC. The ASC collects statutory fees and charges which are channelled into consolidated revenue and the ASC, together with other bodies involved in the national scheme, are funded by Parliamentary appropriation. However, ASIC would be required to report on the costs incurred in regulating specific industry sectors and the fees and charges for those sectors would be set by the Government with a view to matching the charges recovered with the costs. The fees and charges for particular sectors (such as insurance or banking) may differ depending on the level of costs associated with regulating those sectors.

Implementation

3.45 The current legislative and administrative framework for corporate regulation is based on cooperation between the Commonwealth, the States and the Northern Territory ('NT'). The States and the NT continue to play a role in the national corporate regulation scheme and their legislation underpins the scheme.

3.46 Furthermore, the proposed transfer of some responsibilities currently governed by State and Territory law (in connection with building societies, credit unions and friendly societies) will require agreement of all States and Territories to be fully effective.

3.47 It is proposed that the conversion of the ASC to ASIC will occur in two stages.

3.48 The first stage will occur simultaneously with the establishment of APRA. It involves minimal change to the ASC, in particular to the Australian Securities Commission Act 1989, but will result in the ASC becoming known as ASIC. ASIC will continue to carry on the roles the ASC does now. In addition, it will perform the following Commonwealth functions:

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those currently performed by the ISC not transferred to APRA (namely consumer protection and market integrity functions relating to insurance and superannuation);

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monitoring of banking codes of conduct (currently performed by the APSC); and

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take over operationally some aspects of the ACCC's jurisdiction over the financial system (although there will be no legislative change to achieve this in the first stage).

3.49 Points to note are that:

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additional resources will be provided to ASIC to fully fund the performance of the additional Commonwealth functions, which will be recouped from regulated industry sectors (primarily superannuation and insurance) through levies, fees and charges collected by APRA and paid into Consolidated Revenue for channelling to ASIC;

•

there will be provision for cross appointments and cross delegations to facilitate ASIC and APRA personnel working together in the start up phase;

•

aside from being provided with additional resources, and some changes to reporting requirements to take account of the new functions, there are no significant changes to the financial management and governance structures of the ASC; and

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Stage one is primarily a change of administrative arrangements as a significant first step toward substantive harmonisation of regulation in stage two.

3.50 The second stage will occur simultaneously with the transfer of prudential supervision of State/Territory-based institutions which, subject to State and Territory agreement, would occur as soon as possible after the establishment of APRA at the Commonwealth level. As part of the second stage, significant changes to national corporate regulation scheme laws would be required to accommodate the range of new functions in connection with institutions currently regulated at the State/Territory level. The second stage would also involve amendments to harmonise regulatory requirements between industry sectors in matters such as disclosure and licensing. Development of harmonisation measures is already under way in the context of the Part 6 of the Corporate Law Economic Reform Program ('CLERP'), which is dealing with financial markets and investment products.

3.51 The second stage will also involve more significant administrative reforms for State and Territory-based financial institutions, particularly those regulated under the Australian Financial Institutions Code.

3.52 Since it is proposed that aspects of the regulation of the State-based institutions will be transferred to ASIC, there will need to be further amendments to the national corporate regulation scheme laws accordingly. There will also need to be amendments to the Corporations Agreement to take account of the functions transferred from States and Territories.

Review

3.53 Review and assessment of the success and appropriateness of these regulatory arrangements will be undertaken by various bodies.

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ASIC will be required to make regular, detailed public reports on its operations and sources and uses of funds and will also be answerable to the Parliament through the Treasurer as responsible Minister. This will not only enhance the accountability of ASIC, but will increase the degree of scrutiny on the effectiveness and continued relevance of its regulatory approach.

•

The Treasury will continue to fulfil its role in advising the Treasurer on issues including the development, implementation and efficacy of policy in the financial sector.

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The Financial Sector Advisory Council (FSAC), an independent body reporting to the Treasurer, will conduct a review of the regulatory framework five years after the commencement of the measures.

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The regulatory framework will also be reviewed ten years after the commencement of these measures as part of the Commonwealth's Legislative Review Schedule.

Schedule 2 - Amendments of the Banking Act 1959

3.54 This attachment contains four Regulation Impact Statements:

(a)

single licensing and prudential regulatory regime for deposit taking institutions (DTIs);

(b)

stability of the financial system and depositor protection;

(c)

licensing and regulation of financial conglomerates; and

(d)

non-callable deposits (NCDs)

Regulation Impact Statement 1 - Single Licensing and Prudential Regulatory Regime for DepositTaking

Problem

3.55 The current system of licensing and conducting prudential regulation of deposittaking is a source of considerable inconsistencies (non-neutrality) between institutions conducting essentially the same business. The current dual State/Commonwealth system is costly, constrains innovation, confuses consumers, involves considerable duplication of resources in both regulation and licensing, results in slow decision making and hinders non-bank DTIs in their attempts to become national players thereby constraining competition and providing higher cost products and services to consumers than would otherwise be the case. In addition, the current system is inflexible in adapting to change in the financial system.

3.56 Also, the safety of deposits is lowered by excluding unlicensed nonbank DTIs from licensing and prudential regulation.

3.57 The FSI found that the average cost of the Australian banking system between 1986 to 1994 was in the middle of the range of developed countries, but at the upper end of that range. The FSI suggested that this may have been indicative of the unwillingness of some Australian banks to reduce costs due to a lack of competition.

3.58 Government action is required to reduce the costs of conducting prudential regulation and to address the non-neutralities inherent in a system where regulation of the same activity occurs at both the State/Territory and Commonwealth level. At present, however, the Commonwealth scheme for the regulation of DTIs covers only institutions able to be licensed as 'banks'. There is no scheme for federal regulation of nonbank DTIs, which must either operate on a restricted basis without regulation or fall under the State and Territorybased regulation as building societies or credit unions.

Regulatory Objectives

3.59 The purpose of prudential regulation is to:

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protect consumers of retail financial products by increasing the likelihood that a financial promise can be met; and

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limit systemic risk by minimising the risk of insolvency of financial institutions.

3.60 To achieve these objectives, prudential regulation imposes a variety of restrictions on the conduct of financial businesses. While these restrictions are aimed at reducing financial risks, they may also have adverse side effects on competition, regulatory neutrality (applying the same regulation to similar products) and efficiency. The objective of government action should be to reduce the adverse effects of prudential regulation on competition, competitive neutrality and efficiency while maintaining or improving upon the current level of safety and stability in the financial system thereby reducing the associated costs to the community and business.

Options

Status Quo

3.61 Banks are currently licensed under the BankingAct1959 (the Act) and regulated by the Reserve Bank of Australia (RBA). Many non-bank DTIs are incorporated under State and Territory statute, are licensed under the Australian Financial Institutions legislation (oversighted by the AFIC) and regulated by the relevant State Supervisory Authority (SSA).

Single Licensing and Regulatory Regime for DepositTaking

3.62 This option would adopt an 'objectives-based' or 'functional' approach to the licensing and prudential regulation of DTIs. This would be achieved by the establishment, under the Act, of a single regulatory and licensing regime for all DTIs. Deposittaking would also be prohibited unless undertaken by a licensed DTI or by an entity granted exemption by APRA.

Impact Analysis

Status Quo

3.63 The prudential regulation applied to different DTIs and deposit products, and public perceptions of their safety, will continue to vary considerably depending upon the structure of the deposittaking entity or where it is incorporated. Under the status quo, the current 'institutional' approach to prudential regulation and licensing based on institutional types or labels (eg. bank, credit union, building society) would be retained.

3.64 The FSI found that a total of around 800 staff were employed in the regulation and supervision of the financial system in Australia in 1996. This compared with around 900, 1,400 and 1,500 staff fulfilling the same functions in Canada, UK and Germany respectively, although these countries have significantly larger financial systems. The FSI concluded that the costs of regulation in Australia are high by international standards, with some possible explanations being: the high standard of supervision in Australia; the costs associated with supervising compulsory superannuation; differences in regulatory approaches; the wide extent and overlap of regulation; and the existence of separate bodies undertaking similar regulation (regulatory fragmentation) which leads to duplication.

3.65 The status quo offers no improvements in efficiency, competition, regulatory neutrality, safety or stability from licensing and prudential regulation.

3.66 However, some sectors of the business community (particularly a number of the larger banks) may argue that the current system of prudential regulation has served the financial system and the wider community well with no major bank or insurance failures to date.

3.67 In addition, the RBA and the SSAs have built up considerable industry specific knowledge and expertise in the application of prudential regulation to those institutions they supervise. These arrangements, however, prevent the full consolidation, sharing and enhancement of particular expertise and corporate knowledge that could be achieved under a single regime for the licensing and regulation of DTIs.

3.68 The status quo will entrench the current (real and perceived) advantages conferred on banks as a result of being regulated by the RBA. State and Territorybased financial institutions will remain subject to varying regulation and consumers will continue to be denied the competitive benefits which would accrue from allowing more entities to compete in deposittaking markets (greater contestability).

Single Licensing and Regulatory Regime for Deposittaking

3.69 A single licence for all DTIs will enable regulation to be applied consistently across different entities accepting retail deposits (competitive neutrality) to achieve a minimum level of depositor safety. A single licensing and regulatory regime will, in turn, enable nonbank DTIs to operate on a national basis and compete on the same regulatory terms as deposittaking banks. Greater competition by DTIs may lead to increased choice, improved quality and lower cost products and services for consumers in the medium term. As the financial system feeds into almost every area of economic activity, any reduction in the cost of financial services or improvements in quality and type of services offered will provide ongoing benefits to consumers and other sectors of the economy that use these services.

3.70 By providing APRA with powers over a broader range of DTIs, depositor protection may be increased as currently unlicensed deposittakers are required to be licensed or apply for an exemption. The stability of the financial system is likely to increase to the extent that these entities are subject to greater scrutiny and regulation.

3.71 The proposed powers to prohibit any aspect of banking business would be general enough to enable APRA to take a flexible approach to licensing, especially as the financial system evolves and new ways of providing deposittype services arise. It is not proposed to explicitly specify exemptions in the legislation in order to not compromise future flexibility.

3.72 A more flexible regulatory environment will enable APRA to respond quickly to significant change occurring in the financial system as a result of technology, innovation, financial conglomerates and globalisation (ie more dynamically efficient regulation). This will provide a real benefit to financial service providers and may reduce the incidence of instability in the financial system as the financial system evolves and the risks faced by financial entities change.

3.73 Consolidation of the regulatory regimes covering banks and nonbank DTIs currently performed by the RBA, AFIC and the supervisory and inspection roles carried out by the eight SSAs may lower the costs of prudential regulation without lowering the level of safety and, in some cases, increase the safety of deposits.

3.74 The FSI also considered that, historically, building societies and credit unions have been innovative in the development and delivery of financial services. It also argued that State and Territorybased DTIs are capable of increasing market contestability and providing greater choice to consumers. It concluded that the current system of regulation is constraining this innovation and preventing State and Territorybased DTIs from operating on a similar footing to deposittaking banks, thus reducing their ability to compete on a national basis and be an effective source of competition for deposittaking banks.

3.75 The facilitation of more equal competition and contestability (the threat that someone else could enter and compete in the market) in deposittaking markets may result in resources being allocated more efficiently (allocative efficiency) in the financial system. This may also benefit consumers and other sectors in the economy.

3.76 Some banks may lose customers (and hence be critical of these measures) as a result of the greater competition flowing from State and Territorybased institutions and the loss of some of their "special" status in the deposittaking market.

3.77 The public may perceive that exempt DTIs are subject to the same degree of regulation as licensed DTIs. This risk could be minimised by the disclosure requirements under the Corporations Law.

3.78 Giving general powers may create uncertainty over the treatment of existing unlicensed deposittakers. The existing exemptions for money market corporations (with respect to banking), the taking of deposits under a prospectus and restricted deposittaking, such as by pastoral finance companies, would be continued but may be reviewed if the entities' circumstances change.

3.79 There may be some direct employment effects of increasing the degree of competition between DTIs. These effects are likely to be small.

3.80 In the short term, there may also be some transitional costs involved in transferring State and Territorybased DTIs to the Commonwealth level and consolidating State, Territory and Commonwealth regulatory bodies. However, the ongoing cost savings flowing from consolidated regulation should eventually offset these transitional costs.

3.81 The net cost to the Government would be negligible as financial enterprises will be charged a levy to fund, as far as practicable, the establishment of the new regulator and the ongoing costs of prudential regulation. The costs of amending the relevant legislation are minimal.

Consultation

3.82 The main consultation process was undertaken by the FSI. The FSI received a total of 421 submissions, including 153 submissions responding to a Discussion Paper published by the FSI in November 1996. These submissions were prepared by a broad cross-section of industry participants and other interested individuals, corporations and groups. The FSI held public consultations in all mainland capital cities during December 1996, and met with a range of financial industry experts and participants, regulatory agencies and consumers, both in Australia and overseas. The FSI also participated in a range of conferences and seminars, and had a home page on the Internet.

3.83 In the preparation of the Government's response, the Treasury consulted with the Attorney-General's Department, the Department of Finance and Administration, the Department of Prime Minister & Cabinet and the Department of Industry, Science and Tourism, and with the affected regulators, namely the RBA, the ISC and the ASC. The regulators and key industry bodies were consulted on the proposed legislative changes.

3.84 During the FSI process, the vast majority of submissions supported banks, building societies and credit unions being regulated by the same regulator. Credit Union Services (Australia) Limited (CUSCAL), the National Credit Union Association and the Australian Association of Permanent Building Societies (AAPBS) expressed the strong desire of their members to be regulated at the Commonwealth level on the same basis as deposittaking banks.

3.85 State and Territory Government agreement is not necessary for the establishment of a prudential regime at the Commonwealth level which encompasses nonbank DTIs. State/Territory agreement would, however, be required for the full transfer of responsibility for building societies and credit unions to the Commonwealth sphere. Negotiation on the proposed transfer of responsibilities is to occur in a two stage process with the first stage seeking in principle agreement. Stage two will require joint Commonwealth-State and Territory working parties to settle matters of policy and administrative detail necessary to implement the changes. It is anticipated that full implementation will be completed if possible by the end of 1998 or soon after.

Conclusion and Recommended Option

3.86 The preferred option is the establishment of a single licensing and prudential regulatory regime. This would result in a more neutral, flexible, efficient (technical, allocative and dynamic) and simple approach to regulation than the status quo. Increasing the powers of the prudential regulator over the general business of deposittaking would result in the greatest improvement in depositor protection and system stability. In addition, unnecessary regulation can be avoided by APRA having the power to exempt DTIs on a case-by-case basis.

Implementation and Review

3.87 Ongoing review and assessment of the success and appropriateness of these regulatory arrangements will be undertaken by various bodies.

•

APRA will be governed by a Board which will be responsible for ensuring that it performs in accordance with its charter, balancing efficiency, competition and stability objectives. It will be required to make regular, detailed public reports on its operations and sources and uses of funds, will be answerable to the Treasurer as responsible Minister and will be subject to budget scrutiny. This will not only enhance the accountability of the prudential supervisor, but will increase the degree of scrutiny on the effectiveness and continued relevance of its regulatory approach.

•

The Treasury will continue to fulfil its role in advising the Treasurer on issues including the development, implementation and efficacy of policy in the financial sector.

•

The Financial Sector Advisory Council (FSAC) will conduct a review of the regulatory framework five years after the commencement of these measures.

•

The regulatory framework will also be reviewed ten years after the commencement of these measures as part of the Commonwealth's Legislative Review Schedule.

Regulation Impact Statement 2 - Stability of the Financial System and Depositor Protection

3.88 The potential for market failure provides a role for government in protecting depositors and investors in the financial system. Market failure in the financial sector may result from significant information asymmetries (between institutions and the general public) or concerns relating to systemic risk and the impact that the failure of an institution (and possibility of contagion effects on other financial institutions) would have on the real economy. This regulation impact statement relates to the stability of the financial system and the protection of depositors and investors within that system. It deals with the proposal to clarify current legislation and strengthen the role of the regulator to act in the interests of depositors.

Problem Identification and Regulatory Objectives

3.89 There are two general problems with the current state of regulation for depositor protection:

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A lack of clarity regarding the extent to which deposits are protected and the moral hazard problem (whereby depositors, believing their funds are guaranteed, seek out the highest return without regard to risk) this induces in the behaviour of depositors. The current regulations are ambiguous in nature and lack transparency.

•

Concerns that in an era of constant change and increasing globalisation and competition, the powers of the prudential regulator to protect deposits should be updated to allow for earlier intervention, clearer mechanisms for intervention and increased flexibility in the options available for it to act in the interests of depositors.

3.90 The regulatory objectives are to achieve:

•

effective levels of depositor protection, consistent with the need to increase competition in the financial system, while minimising moral hazard and ensuring that the regulatory impact is neutral in other respects; and

•

clarity in the minds of depositors regarding the extent to which their deposits are protected.

Identification of alternatives

Retention of the Status Quo

3.91 Currently the RBA is responsible for depositor protection in the banking sector. Depositor protection is achieved by the RBA's ability to assume control of a troubled bank and by ranking depositors ahead of other creditors (ie depositor preference) in the event of bank failure.

3.92 The current legislative basis for depositor protection is embodied in Division2 of the Act. Section 12 of the Act requires the RBA to exercise its powers for the protection of depositors and section 16 gives priority to deposit liabilities above other liabilities. Section14 provides triggers for management intervention by the RBA and allows the RBA to assume control of a bank. Although such action is in part discretionary (the RBA is required to act in the interests of depositors), once taken, the RBA under subsection 14(5) must remain in control and carry on the business of the bank at least until such time as 'the deposits with the bank have been repaid or the Reserve Bank is satisfied that suitable provision has been made for their repayment'.

Deposit Insurance

3.93 A number of overseas countries rely on deposit insurance as the focal point of their depositor protection regime. Deposit insurance provides clearly identified depositor protection in the event of the failure of an institution. It could replace the depositor preference element of the current regulatory regime.

3.94 There is, however, a wide variety of such schemes in operation, with no agreement on which approach works best. Illustrating this point, deposit insurance schemes may:

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be government funded or industry funded;

•

be funded in advance or rely on levies once a problem has been identified;

•

be based on levies that are adjusted for risk or based on a flat-rate premium;

•

be compulsory or voluntary;

•

enforce an upper limit (cap) on insured amounts; and

•

involve additional layers of regulation.

Retention of the Present Protection Arrangements with Some Consolidation and Clarification

3.95 This option builds upon the existing depositor protection arrangements, but with some clarification and adjustment to correct the perceived deficiencies in the current regulation. It accepts that the general thrust of the current approach is appropriate but that there is a need for improvement.

3.96 The reforms envisaged in this option retain the current depositor preference regime but:

•

amend the current provisions to strengthen the role of the prudential regulator to act swiftly and with a range of options to better protect the interests of depositors;

•

better define and extend the existing mechanisms for exercising regulatory control; and

•

clarify the extent of protection offered to depositors and investors.

3.97 Specifically, this option would:

•

provide the prudential regulator with additional powers to direct the operations of a DTI or suspend any or all of its business activities if, in the opinion of the regulator, such action is in the interests of depositors or if the institution has materially failed to comply with prudential regulations or standards;

•

define statutory management powers which enable the regulator to replace the board when taking control and to act surely without intervention arising from external administrators or civil legal proceedings (subject to appropriate safeguards); and

•

amend the Banking Act 1959 to give the prudential regulator the discretion to seek a winding up order where an institution is not solvent and could not be restored to solvency within a reasonable period of time.

Remove Explicit Depositor Protection Provisions Entirely

3.98 The explicit depositor protection provisions could be removed completely and replaced by a reliance on information disclosure. New Zealand is the only developed country to have substantively taken this path.

Industry Self-regulation

3.99 It is possible to conceive of a self regulatory approach to depositor protection but there would be no real benefit to industry or consumers and there would be considerable practical difficulties.

Impact Analysis

Retention of the Status Quo

3.100 While existing arrangements may provide a reasonably effective degree of depositor and investor protection, they have never been tested in practice and do not address the concerns detailed above.

Deposit Insurance

3.101 Given such a range of options and with no consensus approach internationally, the specific elements of any such deposit insurance scheme would require careful consideration.

3.102 The FSI considered the option of deposit insurance for Australia, but rejected it since it was not convinced that it would provide a substantially better approach compared with existing depositor protection arrangements.

3.103 While deposit insurance makes clear the degree of depositor protection available, it does little to prevent a run on a troubled institution. This is particularly so if any attempt is made to narrow the scope of 'insured' deposits to increase the extent of retail deposit protection (eg by restricting the insurance provisions to retail accounts). Such action would simply heighten the risk that deposits outside the definition will become 'hot' money, depleting liquid assets in difficult times, to the detriment of retail investors. In turn, this could contribute to increased instability of the financial system generally.

3.104 Furthermore, deposit insurance can exacerbate the moral hazard problem. Overseas experience suggests that in the long run badly designed deposit insurance may raise the probability and cost of instability by weakening the incentive structure.

3.105 Another concern is the expectation that the Government would underwrite any such scheme. Even where schemes have been 'totally' industry funded, instances exist overseas whereby governments have had to step in to plug a shortfall to maintain confidence and or stability in the financial system.

3.106 The FSI noted that experience of the failure of the savings and loan insurance scheme in the United States has created public resistance to the concept in Australia.

Retention of the Present Protection Arrangements with Some Consolidation and Clarification

3.107 This option provides strong grounds for both earlier and more flexible regulatory intervention than is currently the case, where this is in the interests of depositors.

3.108 International experience shows that the early resolution of failure is the most effective way of avoiding depositor losses. In some countries, (eg the USA and Canada) the requirement for early action has been legislated.

3.109 The increased flexibility is an important element given the current dynamic nature of the financial system and may be particularly relevant in the management of financial conglomerates.

3.110 Increased depositor protection through stronger and better defined powers will help to provide an additional safeguard against any detrimental effects from globalisation and increased competition as the financial sector is liberalised further. This is likely to lead to increased depositor confidence in the stability of the financial sector.

3.111 Providing for the early wind up of an enterprise could prevent further losses for depositors while clarifying that deposits are not guaranteed. This approach gives the prudential regulator substantial flexibility to protect depositors as much as possible but also to terminate efforts once they have reached a point where further protection is not feasible.

3.112 By making it clear that deposits continue to be subject to preference, but are not guaranteed, the ambiguity of the existing regulation is removed and its transparency increased. Importantly this will serve to decrease the extent of moral hazard from current levels. Some consumers may oppose this outcome.

3.113 There are no expected Commonwealth revenue impacts of these reforms the day-to-day role of the prudential regulator is not being altered. No new requirements are being placed on the day-to-day operations of the financial institutions.

Remove Explicit Depositor Protection Provisions Entirely

3.114 In brief, this approach would create a significant burden on: the Government to detail and enforce the degree of disclosure required; financial institutions to comply with the disclosure 'rules'; and consumers to access and investigate the information regarding the investment opportunities available to them. While it would remove the moral hazard problem, it may unduly increase the risk of instability in the financial system - customers may be less confident in the financial system. This could heighten concerns relating to systemic risk and increase the fragility of the economy to economic shocks and shifts in sentiment.

Industry Self-regulation

3.115 Because self-regulation would be unlikely to provide acceptable levels of confidence in DTIs, industry does not want it and the community would be unlikely to regard it as an acceptable approach. Moreover, there are no real public cost implications of current policy because deposits are not guaranteed. From a practical point of view, it would also be very difficult to secure industrywide agreement because stronger institutions would resist proposals to provide protection to the deposits of those institutions that they perceive to be weaker or more at risk.

Conclusion and Recommended Option

3.116 While retaining the status quo is a viable option, it does not address the current concerns, which are shared by large numbers of smaller financial institutions. These concerns may be heightened by their entry to the Commonwealth's regulatory sphere. There is scope to enhance the current approach to remove present uncertainties relating to the degree of depositor protection and provide additional powers for the regulator to intervene in the interest of depositors. The case for rejecting the general thrust of the current approach has not been clearly demonstrated. For this reason, and due to their risks and costs, the second, fourth and fifth options can be rejected.

3.117 The third option builds on the current approach, addressing the flaws contained therein and is therefore the recommended option.

Administrative Simplicity, Economy and Flexibility

3.118 The depositor protection reforms provide simple methods for intervention, employ Corporations Law processes for winding up an institution and approaches modelled on the AFIC scheme for regulatory intervention. Additional powers for early intervention may prevent the need for more costly control measures and increase the flexibility of crisis management regulation.

Consultation

3.119 Submissions to the FSI relating to depositor and investor protection arrangements, especially those under the Banking Act, expressed a mixture of views.

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Some supported the thrust of the existing arrangements.

•

Others advocated extension of the arrangements to other deposit-taking institutions.

•

Finally, some submissions argued that depositor protection schemes be limited.

3.120 In general, however, a common theme amongst submissions to the FSI was that the current depositor protection arrangements should be clarified.

3.121 Submissions generally had little to say on the issue of deposit insurance. Most of the submissions which did address the issue opposed the introduction of deposit insurance on the basis that it would:

•

create adverse incentives for depositors and management of institutions;

•

involve difficulties in setting premiums relating to risk; and

•

increase moral hazard.

3.122 In the round of discussions after the Final Report of the FSI was released and again following the Government's announced response to the report, there appears to be general consensus that the recommendations offered in the above discussion amount to a suitable and appropriate course of action. The Commonwealth regulator most affected by the proposed changes to depositor and investor protection, namely the RBA, has been given the opportunity to comment on draft legislation and its comments have helped shape the Bill.

3.123 In the preparation of these reforms, the Treasury consulted with the Attorney-General's Department, the Department of Prime Minister & Cabinet, the Department of Industry, Science and Tourism, and with the affected regulators, namely the RBA, the ISC and the ASC. The Treasury has also participated in some further discussions with industry bodies representing banks, building societies and credit unions.

3.124 There have been some discussions with the States and Territories and further discussions will be held regarding full implementation of the reforms.

Review

3.125 The adoption of an objectivesbased approach to regulation (as embodied in the recommendations proposed above) provides the flexibility necessary for regulation to remain relevant in a sector undergoing constant change. Formal reviews after 5 and 10 years will, however, also be undertaken as outlined in the single licensing regime Regulation Impact Statement (RIS).

Regulation Impact Statement 3: Facilitation of Non-Operating Holding Companies and Multiple Bank Licences

Problem

3.126 Currently the Banking Act does not facilitate the use of non-operating holding company (NOHC) structures for the ownership of banks and other financial entities. In addition, the RBA has prohibited financial groups from holding more than one bank or deposittaking entity licence.

3.127 The financial conglomerates initiative is designed to address inflexibility in the financial system that prevents both the formation of financial conglomerates that would be in the public interest and financial conglomerates holding more than one licensed bank or DTI.

3.128 Government action is needed as the current regulatory regime is responsible for this problem by placing excessive restrictions on the structure of, and licences held by, financial conglomerates.

Regulatory Objectives

3.129 The Government's regulatory objective in acting would be to regulate financial conglomerates in a way that minimises the chances of both systemic risk and possible conflicts of interest within the group without unduly interfering in the commercial decisions of the group.

Options

Status Quo

3.130 Banks or insurance companies would have to remain the ultimate holding company, removing any potential for beneficial regulatory arbitrage. Financial groups would continue to be prohibited from holding more than one bank or deposittaking entity licence.

Non Operating Holding Companies and Multiple Bank and DepositTaking Licences

3.131 Financial conglomerates could be allowed to adopt a nonoperating bank or deposittaking holding company structure, subject to the conglomerate meeting various prudential requirements. The NOHC may be required to be licensed. Financial conglomerates would also be allowed to hold more than one licensed bank or deposittaking entity.

Impact Analysis

Status Quo

3.132 The inability of financial conglomerates to use NOHC structures, where a bank is involved, has provided a high level of depositor protection and stability in the financial system. The current arrangements may, however, have unduly interfered with the commercial decision making of conglomerates. By restricting the structure, financial conglomerates may have been forced to adopt less efficient structures and denied some possible benefits of using differences in the costs of regulation between products (regulatory arbitrage) thereby raising costs. As a consequence, these costs may have been passed on to consumers in the form of higher prices and lower returns for financial products and services.

3.133 The prohibition of multiple licences has ensured that depositors are treated equitably in the event of a wind up of a failed financial institution. Financial entities, though, have been prevented from pursuing legitimate commercial practices that require holding more than one bank or deposittaking licence.

Non-Operating Holding Companies and Multiple Bank and DepositTaking Licences

3.134 Under this option, financial conglomerates would have greater commercial freedom in selecting their appropriate structure and number of licences. Allowing the use of NOHC structures will reduce barriers to entry and may result in a more competitive financial system. Entities may be able to provide a wider range of financial services, face reduced regulatory costs and use more efficient corporate structures thereby providing ongoing benefits to consumers and users of financial services in the form of lower cost and more competitive financial products.

3.135 Applications will be considered on a case-by-case basis, however, to ensure that prudential standards are not compromised and depositors and investors are treated equitably in the event of a wind up.

3.136 Requiring the conglomerate to satisfy certain prudential requirements by licensing NOHCs may provide a more transparent mechanism to regulate financial conglomerates thereby improving safety. A possible cost associated with this approach is that the public may perceive that all of the financial entities in the conglomerate are prudentially regulated which need not necessarily be the case.

3.137 As APRA will take a flexible approach to licensing of NOHCs, it is not envisaged that the licensing process will create inappropriate barriers to entry and exit.

3.138 Allowing financial conglomerates to hold more than one class of financial licence would enable greater commercial freedom in decision making by these entities without resulting in a proliferation of licences.

3.139 The net cost to the Government of acting would be negligible as financial enterprises would be charged a levy to fund, as far as practicable, the costs of prudential regulation. The costs of amending the relevant legislation are minimal.

Consultation

3.140 There is widespread industry support for allowing the establishment of a NOHC structure with operating subsidiaries, such as banks and insurance companies.

3.141 Industry groups are also in favour of the proposal to allow conglomerates to hold more than one authorised deposittaking institution (ADI) licence.

3.142 See consultation in single licensing regime for general consultation process.

Conclusion and Recommended Option

3.143 Maintaining the status quo would maintain stability and depositor protection while restricting flexibility in commercial decision making.

3.144 Allowing both NOHCs, where a bank or DTI is present, and financial groups to hold multiple licences, where appropriate, has the potential to increase commercial freedom in decision making, increase competition and lower costs for financial conglomerates (and thus consumers of financial products) without a significant change in stability and the level of depositor protection.

3.145 On balance, the preferred option is to allow NOHCs, where a bank or DTI is present, and to allow financial groups to hold multiple licences in order to enable greater commercial flexibility while still ensuring that conglomerates meet prudential standards.

Implementation and Review

3.146 Please see single licensing regime for general implementation and ongoing review processes.

Regulation Impact Statement 4: Future of Non-Callable Deposits

Problem

3.147 Under the Act, the banks are required to hold one per cent of eligible liabilities with the RBA as NCDs. Interest currently paid to the banks on these deposits is generally at a rate 5 percentage points below the prevailing market rate. Interest rates have been varied from time-to-time by the RBA. The current rate, which came into effect in May1995, was justified 'as a payment for the benefits which accrue to banks from being authorised by the Government and subject to RBA supervision'.

3.148 NCDs impose a significant cost on the banking system. Furthermore, as the funds raised greatly exceed the cost of prudential regulation of banks, this excess charge represents a considerable regulatory distortion between banks and non-bank DTIs with implications for the efficiency of the financial system.

Regulatory Objectives

3.149 As the only residual justification for the NCD requirement appears to be as a funding mechanism, its future must be considered against the background of the broader funding issue outlined above that industries should pay only the costs of their supervision. The objective is to remove the regulatory distortion created by the current imposition of NCDs.

Options

Abolition of NCDs

Extension of NCDs to other dtis

Impact Analysis

Abolition of NCDs

3.150 The RBA has advised that there is no prudential rationale for the continued imposition of NCD requirements. The funding role would disappear with the transfer of prudential regulation of banks to APRA. The abolition of NCDs would satisfy the stated regulatory objectives of minimising the cost of regulation and competitive neutrality. The decline in net revenue earned from NCDs would, however, affect the RBA's income and, as such, the Budget. Nevertheless, to continue the use of NCDs on revenue grounds would effectively mean the imposition of a discriminatory and inefficient tax.

3.151 While the banks would be clear beneficiaries of any abolition of NCDs, the extent to which bank customers would benefit would depend on competitive pressures in the industry.

Extension of NCDs to other dtis

3.152 An alternative approach might be to extend NCDs to all other DTIs, with the objective of achieving some element of competitive neutrality. This option, however, would appear to have only an attraction from a revenue raising perspective and would do nothing to provide a means of funding for APRA; it would be in addition to it. Furthermore, an extension could not only seriously undermine the possibility of establishing a rational funding mechanism, but could also discourage other DTIs from participating in the new prudential framework.

3.153 A variation of the extension option would be to pay the full market interest rate on the first $10million of NCDs. This would effectively exempt most non-bank DTIs from the NCD revenue charge because they are too small to have NCDs above $10 million. Similarly, there would be a $500,000 p.a. benefit to banks which would largely offset the impact of new APRA regulation fees. While this would remove some of the more undesirable features of the original version of this option, the fact remains that, with prudential regulation moved to APRA, there is no reason to maintain NCDs.

Consultation

3.154 See consultation for single licensing regime.

Conclusion and Recommended Option

3.155 Retention of NCDs, whether extended to other DTIs or not, would involve maintaining an anachronism, which would undermine efforts to develop an efficient and simple funding mechanism for APRA. Abolition of NCDs is, therefore, supported.

Implementation and Review

3.156 The adoption of an objectivesbased approach to regulation (as embodied in the recommendations proposed above) provides the flexibility necessary for regulation to remain relevant in a sector undergoing constant change. An important implication of a flexible regime is that it significantly reduces the need to establish, at the outset, a timetable for a formal review. For this reason, and in conjunction with the additional safeguards discussed below, no formal review is proposed for the immediate future. The level of the levy will, by necessity, be the subject of annual review and will require the Treasurer's approval for the rate set.

3.157 For general implementation and review processes please see implementation and review in the single licensing regime RIS.

Schedule 13 (Part 7) - Amendments to the Life Insurance Act 1995

Problems

3.158 The Life Insurance Act 1995 (LIA) establishes a scheme of prudential supervision for the life insurance industry. The LIA came about following a major review of its predecessor, the Life Insurance Act 1945. It is administered by the Insurance and Superannuation Commission. Two problems have been identified with the scheme.

3.159 First, the existing shareholder minimum capital requirement provisions of the LIA are being interpreted by some insurers in a way which is inconsistent with the original intentions behind the provisions. As a consequence, some insurers are maintaining unsatisfactory levels of capital. The original intention of the LIA was that at all times a life company shareholders' fund would have paid up share capital of at least $10 million. Further, at least $5 million would be secured by eligible assets in excess of liabilities. To satisfy these requirements simultaneously it was intended that the company would effectively have to have at least $10 million net assets in the shareholders' fund at all times. Due to the wording of the relevant enabling provisions there is some uncertainty as to whether the LIA gives full effect to these intentions. Some insurers have expressed the view that the respective provisions are open to the interpretation that the capital requirements are complied with in a situation where the net asset position of the shareholders fund is less than $10 million but greater than $5 million. This was not the intention.

3.160 The second problem concerns the inability of a life insurer, because of existing statutory provisions, to charge assets of a statutory fund for purposes of entering into relevant derivatives transactions.

Objectives

3.161 The objective in relation to the first problem is to ensure that the interests of policy owners are adequately protected. A key prudential means for achieving this is to ensure that companies who conduct insurance business are companies of financial substance, able to withstand severe business fluctuations, and that shareholders have a financial commitment to the success of the business.

3.162 The objective in relation to the second problem is to ensure that while regulation adequately protects the interests of insurance policy owners it does not unnecessarily interfere with or restrict the business activity of the insurer.

Options

Option 1: Amend the LIA to give effect to measures which would overcome the problems.

Option 2: Take no action to overcome the problems.

Option 3: Overcome the problems by means of education (including guidelines or circulars).

Impact Analysis

Impact Group Identification

3.163 Groups likely to be affected by the proposed amendments include: all life insurers; prospective and existing life insurance policy owners; competitors of life insurers; and APRA.

Assessment of Costs and Benefits

3.164 Two problems are identified. Each is discussed below.

(i) Differing Capital Levels Being Maintained By Insurers.

Option 1 (regulation):

3.165 This option proposes that the relevant provisions of the legislation be amended to reflect the original intent of the LIA. A major benefit of this option is that it would establish certainty and ensure that all insurers provide adequate shareholder commitment to the effective operations of the life company and that additional financial support will ultimately be available to the statutory funds, should this prove necessary, to ensure the interests of policy owners are protected. It would produce consistency and a level playing field across the industry in terms of (minimum) shareholder capital requirements. Consumers and their advisors, in selecting an insurer with whom to place business, could be confident that all insurers were subject to the same minimum capital requirements. The option may also result in some decrease in regulator costs as the maintenance of a minimum $10 million net asset position by all companies would ease the need for close regulatory scrutiny of those companies who were previously maintaining less than that amount.

3.166 In terms of costs, the major potential cost of Option 1 would be for those insurers who are currently interpreting the legislation so as to maintain a lower level of net assets (between $5 million and $10 million). These insurers would have to increase their net assets by a relevant amount (potentially up to $5 million although in practice most are already significantly above the $5 million minimum net asset level and therefore the increase would be less than $5 million). There are not expected to be more than 10 such insurers on the basis of analysis conducted by the ISC in mid-1997. It should be noted, however, that in practical terms the cost is likely to be in the nature of an opportunity cost rather than a direct cost as insurers generally have access to sufficient funds, either within the company itself (such as surplus assets in its statutory funds) or elsewhere in the company grouping.

3.167 A potential cost of Option 1 for the community is that some insurers could decide not to continue business if required to maintain net assets of $10 million, thereby reducing competition. However, a circular sent to each insurer by the ISC in November 1997 seeking an indication as to whether the insurer would have difficulty in meeting a $10 million net asset requirement has, to date, elicited no response. On the basis of this feedback and consultations the ISC has had with insurers it is extremely unlikely that any insurer would withdraw from the market as a result of this measure.

3.168 However, even if there were one or two withdrawals, the industry would still comprise more than 50 insurers, making the possibility of a diminution in competition remote.

Option 2 (no action):

3.169 The major cost of not taking any action to address the problem, would be that some insurers would continue to maintain amounts of shareholder capital that are considered insufficient to provide a prudential level of protection to the interests of policy owners.

3.170 A further possible cost of this option is that it may result in increased regulatory costs as the regulator intensifies its attention on those insurers maintaining the lower capital levels. As well, there may be increased costs for prudent consumers and their advisors as they undertake a process of ascertaining the capital levels being maintained by individual insurers before placing insurance. On the benefit side, the opportunity for the existing provisions to be interpreted so as to require a lower level of capital than that originally intended may entice newcomers into the market, thereby increasing competition and potentially producing consumer benefits in terms of price reductions and product innovations. As well, insurers would continue to have the option of maintaining lower amounts of capital in their insurance business and could employ that capital elsewhere.

Option 3 (education):

3.171 Using means such as guidelines or circulars to address the problem would produce costs and benefits similar to that for option 2. That is, as there would be no legal obligation on insurers to follow the guideline or circular the existing situation would largely continue.

(ii) Reduction in current restrictions relating to charging of assets.

Option 1 (regulation):

3.172 Section 40 of the LIA severely restricts the extent to which a registered life insurer may charge or mortgage an asset of a statutory fund. In particular, the prohibition effectively prevents a life insurer from engaging in the internationally accepted practice of lodging cash or share scrip with a broker on a recognised trading exchange as collateral to meet obligations associated with derivatives transactions entered into on behalf of the life company. Under this option, the legislation would be appropriately amended to enable an insurer to charge assets of a statutory fund for purposes of entering into relevant derivatives transactions.

3.173 The prohibition, by restricting the ability of the insurer from using derivatives transactions to manage risks to which the statutory fund may be exposed (eg market risk, currency risk), may not be in policy owners best interests. Thus, under option 1 both the life insurer and policy owners potentially benefit. On the cost side, there is the potential that proceeding with the amendment could pose some prudential risk in that improperly managed derivatives transactions may expose statutory funds to additional loss. However, it is proposed that the amendment will include a regulation power to allow APRA to set appropriate conditions to ensure prudential risk is minimised. This would impose some regulatory cost in terms of establishing and monitoring compliance with conditions but it would be relatively minor and outweighed by the potential benefits to insurers and policy owners.

Option 2 (no action):

3.174 Under this option, the status quo would remain. There is little benefit in this option except to the extent that minor additional regulatory processing may be saved, however it would be at the cost of the potential benefits to both the insurer and policy owners (better management of risks).

Option 3 (education):

3.175 Since the prohibition on charging of assets is enshrined in existing primary legislation (that is, section 40 of the LIA) option 3 is not a workable way in which to solve this problem.

Consultation

3.176 The Investment and Financial Services Association Ltd (IFSA), the industry body for life insurers, has recently been consulted on the proposed measures and in their response foreshadowed no significant concerns with them.

3.177 In regard to the first problem (ie, minimum capital requirements), extensive consultation took place with interested parties, including the industry body and individual insurers, during the formulation of the LIA. Further consultation has taken place with various individual insurers on a number of occasions since the LIA's enactment (in 1995). In November 1997 the ISC sent a circular to all insurers that advised of the ISC position in regard to the LIA s capital requirement provisions and requesting all life companies comply with intent of the LIA by their next balance date. The circular invited feedback from any insurer who would have difficulty complying with that proposal. To date, no responses have been received.

Conclusion and recommended option

3.178 In respect to the capital requirements, given the importance of capital as a fundamental prudential means of safeguarding the interests of life insurance policy owners, Option 1 is the preferred option. This option will give effect to the original intentions relating to the LIA's capital requirements and establish certainty and consistency in the legislation. Insurers have been aware of the intended capital requirement for many years through various ISC written and verbal communications. As a consequence, most insurers already comply and of the few who don't none have indicated an inability to comply. The IFSA has not raised concerns about any costs of compliance. The potential benefits of Option 1 in terms of policy owner security far outweigh the costs, which are mainly in the form of opportunity cost to insurers. Option 2 would perpetuate the present uncertainty in relation to the relevant provisions, an undesirable regulatory situation reducing policy owner protection. It is not recommended. Option 3, using education to overcome the problem, has actually been practiced by the ISC since the problem first became known. However, as there is no legal obligation for insurers under this option, this option has the same disadvantages as Option 2, and is also not recommended.

3.179 In respect of expanding the scope for life insurers to charge assets of a statutory fund (to include derivatives transactions), Option 1 is recommended. It will give greater flexibility to operations of life insurers whilst continuing to ensure adequate consideration is given to the interests of policy owners. Option 2 is not recommended as it would continue to require life insurers to manage risks in a less efficient manner than would otherwise be possible.

Implementation & Review

3.180 Regulation of life insurance was the subject of a major review in the early 1990 s. Subsequent to that review, the life insurance legislation at the time (that is, the Life Insurance Act 1945) was repealed and replaced by the current LIA. The LIA is the subject of ongoing review by the ISC to ensure its continuing efficiency and effectiveness in light of trends and developments in the marketplace and the community. This review will be continued by APRA.