COBA speech on the impact of increased regulation on competition – Future Banking Forum, 10 October 2019


Speech to Future Banking Forum 2019, Sydney, 10 October 2019

Impact of increased regulation on competition - post-Royal Commission

Luke Lawler, COBA Director of Policy

Good morning, it’s a pleasure to be here.

It’s been eight months since Commissioner Kenneth Hayne handed down the final report of the Financial Services Royal Commission and its 76 recommendations. Eight months since Commissioner Hayne’s awkward photo opportunity with Treasurer Frydenberg.

The Government says its response to the Financial Services Royal Commission is the largest and most comprehensive corporate and financial services law reform package in 30 years.

Many new laws are on the way, regulators are taking a more hardnosed approach to enforcing the law and are more willing to go to court.

The Royal Commission has also changed the retail banking environment by shifting the focus beyond just legislative compliance to a higher and somewhat less precise benchmark: ‘meeting community expectations’.

The sheer volume of new regulatory measures is itself a challenge for smaller players in the market – COBA member banking institutions and new entrants such as neo-banks.

The pace of implementation of regulatory change amplifies this problem and also increases the risk that regulation may not be well designed.

This has an impact on competition.

Clearly there has been serious and widespread misconduct and the response in terms of new regulatory measures and tougher regulators is the reality for all players, whether or not they engaged in misconduct.

The customer owned banking sector’s ownership model is a fundamental distinguishing feature for our member institutions compared to investor owned banks.

Customer owned banking institutions are concerned with outcomes for customers rather than outcomes for a separate group of shareholders.

As noted by the Interim Report of the Royal Commission, "the interests of shareholders are not the same as the interests of customers. It may be that they are opposed. Shareholders will see what happens at the entity only through the lens of dividend and share price. Some shareholders will take a short term view of both dividends and share price, others may have a longer term view. But customers are concerned only with how the entity's conduct affects them in their dealings with the entity."

Eight of COBA’s larger members were asked by the Royal Commission at an early stage to provide information concerning instances of misconduct or conduct falling below community standards that the entity had identified in the past 10 years.

The responses explained the natural customer focus of our model and indicated that although our sector is not immune from conduct risk, that risk is relatively low.

Importantly, the submissions emphasised our sector’s culture of response and remediation when problems occur.

The key point is that no customer owned banking institutions were called to appear before the Royal Commission and none were subject to criticism by the Royal Commission.

Collectively, our sector has four million customers and in terms of assets and deposits is the fifth largest entity in the banking market.

Each credit union, mutual bank and building society is an independent business with its own strategy and customer base but each is owned by its customers rather than a separate group of shareholders.

All COBA members are Authorised Deposit-taking Institutions (ADIs) under the Banking Act like the major banks and are subject to the same prudential and consumer protection regimes as the major banks.

Our model, our strong customer connection and our strong ties to communities, particularly regional communities, workplaces and groups like teachers, the defence force, police and emergency services gives us a strong foundation to provide competition and choice in the retail banking market.

Our sector continues to experience very positive customer satisfaction levels.

Our sector’s average customer satisfaction level is 88.5 per cent. This is compared to the major banks average rate of 75 per cent. Even outside of the major banks, our sector is ahead of the broader investor owned banking sector which sits at a satisfaction rating of 78.5 per cent.

In fact, recent data from research firm Roy Morgan showed that during the Royal Commission satisfaction with the Big Four dropped to a low of 75 per cent, while Building Societies and Credit Unions never dipped below 87 per cent.

The continuing growth of our sector and our consistent performance on customer satisfaction metrics underlines our capacity to compete against larger players in a post-Royal Commission world.

Consumers have an appetite for institutions they can trust.

As noted politely by the Reserve Bank recently, shortcomings of culture and governance within banks, insurers and superannuation firms have been well documented by the Royal Commission.

Remediation costs associated with poor customer outcomes and regulatory non-compliance have amounted to $7½ billion across the financial sector over the past two years and are expected by bank analysts to increase.

Add to this the considerable cost to banks of upgrading their risk and compliance functions.

APRA has also imposed additional capital requirements on the major banks and an insurer to account for poor operational risk management practices.

Before the Royal Commission commenced, the Government responded to debate about the need for a Royal Commission by introducing various pre-emptive measures:

Nevertheless, the Royal Commission still came up with 76 recommendations for further reform.

Underpinning these recommendations, the Royal Commission identified six fundamental norms of conduct and six general rules.

The recommendations reflect these norms and rules.

The norms are:

The general rules are:

In late August the Government released its Financial Services Royal Commission Implementation Roadmap detailing how the Government would deliver on its commitment to take action on the 76 recommendations.

As noted earlier, the Government’s response to the Royal Commission is said to be the largest and most comprehensive corporate and financial services law reform package in 30 years.

Responses to the Royal Commission are not restricted to decisions by Parliament.

For example, as part of our review of the Customer Owned Banking Code of Practice, the independent reviewer is suggesting we pick up the Royal Commission’s norms of conduct as the starting point for refreshing our key promises.

But in terms of reform flowing from the Royal Commission to be dealt with by legislation, the Government has released a detailed timetable.

Some of the measures relevant to retail banking are:

A number of Royal Commission recommendations are being implemented by regulators – for example, APRA’s implementation of the new product responsibility under the Banking Executive Accountability Regime (the BEAR).

A number of Royal Commission recommendations are for industry to implement, with the Government and the Parliament intending to keep industry accountable.

These include changes to industry codes and a requirement for all financial services entities to review at least once a year the design and implementation of their remuneration systems for front line staff.

Looking over the horizon, the Government is committed to a number of reviews in 2022:

The prospect of these reviews will help to keep all stakeholders honest and keep the Royal Commission’s agenda alive and relevant.

Legislation to be introduced by the end of 2019 includes:

Legislation to be introduced by mid next year includes:

As noted earlier, there is a lot of legislation on a tight timetable and this creates the risk that if there is too much of a rush, a law aimed at solving one problem creates a new problem.

Further down the track, legislation to give ASIC joint responsibility with APRA to administer the BEAR is due to be introduced by the end of 2020.

The new ASIC-administered accountability regime, focused on conduct, will apply to all financial services licensees and all credit licensees.

Many of the reforms flowing directly or indirectly from the Royal Commission overlap to some degree.

New design and distribution obligations for product issuers will apply to consumer credit. These will require each product to have a defined target market. This new requirement will have to sit alongside the existing responsible lending obligations on credit licensees.

The new BEAR product responsibility will impose new accountability obligations in relation to product design, distribution and remediation.

It’s a lot to digest, understand and implement.

The Reserve Bank warned recently that although the reforms flowing from the Royal Commission should be implemented in a timely manner, there is a risk that the large body of work required to do this could be distracting for financial institutions and could lead to “an excessive tightening in the supply of credit.”

Turning to the regulators..

Both APRA and ASIC have responded to the Royal Commission by taking a more assertive approach to enforcing the law and they’ve been more willing to go to court.

APRA is a taking a new “constructively tough” approach to enforcement.

The regulators aren’t winning all their court cases but they’re certainly going to court more often.

Both APRA and ASIC have elevated their consideration of competition in regulatory decision making.

One of the first recommendations of the Royal Commission to be implemented was a capability review of APRA which called for changes in the way APRA considers competition.

The capability review recommended that:

In its response, APRA said it supports the objective of the recommendation for a competition champion but that all APRA Members have overarching responsibility for achieving APRA’s mandate, including consideration of competition.

APRA has committed to enhancing its decision-making processes to more actively champion the consideration of competition and to strengthen its engagement with the ACCC.

Turning to ASIC, the corporate regulator has given a commitment to embed in its decision-making processes consideration of how the performance of its regulatory functions and the exercise of its powers affect competition.

ASIC recently identified five key thematic drivers of harm to consumers and markets and one of these was ‘Poor conduct in financial markets driven by lack of competition, structural challenges or conflicts of interest’.

This move by ASIC to nominate ‘a lack of competition’ as one of its top five drivers of harm is welcome recognition of the importance of competition to delivering better consumer outcomes.

We expect that accountability for APRA and ASIC will be further enhanced by implementation of the Royal Commission recommendation to create a new Regulator Oversight Authority.

Legislation to create the Regulator Oversight Authority is scheduled to be introduced by mid 2020.

It is important that regulators constantly bear in mind that regulation is not cost-free for consumers.

Smaller banking institutions are subject to relatively higher regulatory costs due to the high fixed costs of regulatory compliance - costs such as information technology, staff and specialised skills. High regulatory costs handicap the capacity of challenger banking institutions to grow and expand into new markets.

High regulatory costs hurt consumers because resources are diverted away from investment in product innovation, better service and better pricing.

Every dollar that a customer-owned banking institution has to spend on regulatory compliance is a dollar lost to product development or better customer service.

The regulatory compliance cost burden reduces our members' capacity to grow, promote the customer-owned model and apply competitive pressure to listed banks.

These factors also create barriers to entry and barriers to expansion to new entrants into the banking market.

It’s encouraging that regulators are addressing the role they play in supporting competition. We would welcome them paying more attention to regulatory costs.

So how will this tsunami of regulatory change affect competitive dynamics in the retail banking market?

Most of the changes are designed to improve conduct and culture and protect consumers but some changes are intended to empower consumers to promote competition.

One piece of regulatory reform that is often talked about as a ‘game changer’ in financial services is Open Banking.

Open Banking is shorthand for a newly legislated regime that creates a ‘Consumer Data Right’ for all Australian consumers.

The objective is to empower consumers to unlock the value of their personal data to get better products, more tailored products and to switch between providers. How rapidly consumers embrace this new right remains to be seen.

It may be the case that one of the early practical applications of Open Banking will be help banking institutions meet their responsible lending obligations by getting more efficient access to customers’ expenses data – that is, how much wagyu steak and fine shiraz they consume.

What we do know is that the Open Banking regime is now settled, in the form of legislation, rules and technical standards, with rules and standards to continue to evolve.

The clock is ticking towards the commencement dates for various elements of the regime.

APRA recently noted that Open Banking has the potential to significantly alter the competitive landscape.

Our view is that banking institutions with excellent customer service and highly competitive pricing, like customer owned banking institutions, stand to gain from Open Banking.

Many of our members have invested significant resources into preparing for Open Banking and look forward to participating in the new system.

One of our members, Regional Australia Bank (headquarters in Armidale in northern New South Wales) was one of 10 successful applicants selected by the ACCC last month to participate in testing of the Consumer Data Right ecosystem in the run up to the launch in February 2020.

The ACCC received 40 expressions of interest and Regional Australia Bank’s selection demonstrated:

A more competitive market will make the players in that market think twice before acting in ways that harm consumers and cause reputational damage.

Policymakers can create the conditions for a more competitive market by leveling the playing field, keeping regulatory compliance costs in check and empowering consumers.

If consumers aren’t willing to shop around and shift their business, competitive pressure is weak.

We at COBA are very keen to push along the debate about how to tackle consumer inertia.

Consumer inertia is where consumers fail to act in their in own interests by shopping around and switching.

They get plenty of advice to shop around, but there are barriers to doing so. What are those barriers and how can we get rid of them? I’ll come back to this point shortly.

Proportionate regulation is regulation that is proportionate to the risk, size and complexity of the regulated entity and is tightly targeted at the regulatory objective.

Proportionate regulation enables the delivery of regulatory objectives, such as consumer protection and financial system stability, in a more cost-effective, pro-competitive way.

Keeping regulation proportionate will boost competition in retail banking, promoting innovation and efficiency and more choice and lower prices for consumers.

The Productivity Commission’s Report last year on Competition in the Financial System found that the banking sector is an “established oligopoly” where the four major banks hold substantial market power over their competitors and consumers.

This structure is supported by regulatory settings which contribute to the major banks’ advantages.

The PC found that the major banks have the ability to pass on cost increases and set prices that maintain high levels of profitability — with minimal loss of market share.

The PC found evidence that the high concentration of market power among a very small number of institutions is resulting in poor consumer outcomes in Australia.

Regulation is partly to blame for this state of affairs.

The PC stated: “Regulators largely have the tools to support a competitive marketplace but their focus is tilted towards the stability of the system, with regulatory regimes that are indifferent to, or actively discourage, innovation and competition.”

An independent survey of Australian bank executives commissioned by COBA from Grant Thornton found growing concern about the cost of regulatory compliance. Over the 12 months ahead, the survey found:

Policymakers need to make a stronger commitment to delivering proportionate regulation.

We have come up with a list of principles that can be applied to help deliver regulation that, as far as possible, does not hinder competition.

If these principles were guiding policymaking a couple of years ago, customer-owned banking institutions would not be subject to the Banking Executive Accountability Regime (BEAR). BEAR was a response to accountability problems in the major banks. In developing the BEAR policy, there was no evidence sought, and none produced, about accountability problems in customer-owned banking institutions. Nevertheless, the BEAR was imposed on all ADIs.

Our eight principles of Proportionate Regulation are:

  1. Recognise that regulatory costs can affect competition and are ultimately borne by customers. 
  2. Avoid a one-size-fits-all approach to regulation. 
  3. Ensure regulation is tightly targeted at a clearly defined problem or regulatory objective and seek to minimise regulatory costs. 
  4. Recognise the impact of the cumulative regulatory cost burden, particularly on smaller banking institutions
  5. Positively consider banking institutions’ size, risk profile and complexity when designing and implementing new regulation.
  6. Allow smaller banking institutions at least 12 months extra time to comply with significant new measures. 
  7. Recognise that for the same regulatory proposal, economies of scale could potentially result in costs outweighing benefits for smaller banks but the benefits outweighing costs for larger banks. 
  8. Accommodate different models, such as the customer-owned model, particularly where the model itself can mitigate risks that are otherwise addressed by regulation.

Paying close attention to regulatory compliance costs is important to create a level playing field for all players in the market.

What is just as important, is empowering consumers to find the supplier that suits them – the supplier with the best deal or best price or most suitable product.

I mentioned Open Banking earlier – and Open Banking should help provide consumers with better capacity to shop around.

But more needs to be done.

The Australian Government’s Behavioural Economics team has noted that:

The ACCC’s recent Residential Mortgage Inquiry found that there is more intense competition for borrowers who are actively engaged and well informed in their choice of residential mortgage.

There are three ways that other borrowers can benefit from this:

However, the ACCC also found there is widespread consumer inertia. Large numbers of existing residential mortgage borrowers do not regularly review their choice of lender.

The ACCC found that all banks profit from the inertia of their customers. However, widespread inertia makes it challenging for smaller banks to win market share from the big four banks.

A range of factors are behind this consumer inertia.

If we can reduce consumer inertia with policy measures, we can create a more competitive market, with all the benefits that come with a more competitive market – lower prices and better products.

Research by a UK thinktank, the Social Market Foundation, indicates that a fully engaged consumer is one that can go through four stages of making decision:

Consumer inertia can happen at any one of the four stages:

First, consumers must be motivated to identify the best value deal.

Second, the consumer must be able to access information about the various offers.

Third, consumers must be able to assess these offers in a well-reasoned way.

Fourth, consumers must be able to act on this information and analysis by making the purchase.

Motivate, access, assess and act.

So, what can we do to motivate consumers to access and assess the information they need and to prompt them to act?

That is not a question I can answer today but finding the solution to that puzzle should be the top priority for policy makers who want to see a more competitive banking market.

We at COBA have an open mind and only one condition – do not introduce policy measures that add to the regulatory cost burden on challenger banking institutions. We’ve got enough on our plate.

Thank you for your time today.

A PDF of this speech can be downloaded here.