Background
The bills before the committee during the inquiry are largely the same as those put forward by the Coalition Government in 2021.
Coalition Senators support the passage of the Financial Accountability Regime Bill 2022 and the Financial Sector Reform Bill 2022 but have reservations about the Financial Services Compensation Scheme of Last Resort Levy (Collection) Bill 2022 and Financial Services Compensation Scheme of Last Resort Levy Bill 2022.
In July 2021, the then Shadow Minister for Financial Services and Superannuation, Mr Stephen Jones MP, said that the Coalition’s proposed compensation cap of $150,000 was far too low.
When the Committee reported on those bills in February 2022, Labor recommended that the Compensation Scheme of Last Resort (CSLR) be extended to cover managed investment schemes (MIS’s).
In these bills put forward by the Labor government, neither the $150,000 cap nor the scope of this scheme have been altered.
The main difference is the increase of the sub-sector levy cap, which the Labor Government has doubled from $10 million to $20 million. It is unclear why this cap has been doubled given complaints over inappropriate advice halved in the last financial year, as noted by a joint submission from accounting industry associations.
These bills form the final tranche of legislation as part of the implementation of the recommendations of the Hayne Royal Commission, of which a CSLR was put forward as recommendation 7.1.
Coalition Senators express the following concerns with the CSLR.
Moral Hazard
The CSLR establishes an enormous moral hazard for consumers, the market and regulator.
A running theme across these bills is the diminishing primacy of personal accountability for financial misconduct. Senior Lecturer in Law at the University of Wollongong, Dr Andrew Schmulow, has noted that the proposed Financial Accountability Regime (FAR) does not ‘provide for personal accountability by way of civil penalties or otherwise’.
In their complexity, these bills do not increase the accountability for financial misconduct, but rather disperses the risk across the entire financial system. Increasing the level of financial regulation without taking into account the need to enforce the existing rules already on the books is a never-ending strategy.
The Financial Services Council (FSC) provided testimony on moral hazard that both consumers and regulators face from the proposed CSLR:
I think there are a couple of moral hazards that come through the scheme, and I will just unpack that. The first one that comes to mind is consumers potentially not taking enough precautions to make sure that they're dealing with a bona fide and reputable financial services provider and adviser. There's the moral hazard of the parties that could conduct fraud. … there's also the moral hazard that the regulator might not do as effective a job of enforcement, because of the fact that they could just allow claims to go through to the scheme. Those are probably the three main channels that have been identified.
The Australian Banking Association (ABA) expressed their concern with ASIC’s potentially already seeking to broaden the scheme beyond a last resort:
... there are features of the compensation scheme which mean that the posture—and ASIC's posture has been that this is not so much a scheme of last resort. And we saw that with the media release earlier this year, where ASIC was encouraging customers to make claims with AFCA in order to potentially benefit from the scheme... ASIC has a responsibility to have informed investors and provide that sort of information, but we would like to see a posture from ASIC which is about last resort, not second or third resort.
The Australian Banking Association (ABA) is referring to the Australian Security and Investment Scheme’s (ASIC’s) advice on 3 August 2022 that former Dixon Advisory clients should consider lodging complaints with the Australian Financial Complaints Authority (AFCA) in anticipation that these complainants may be eligible ‘for compensation under a potential future Compensation Scheme of Last Resort (CSLR)’.
If a licensed corporation has breached their obligations to their customers, and those customers have incurred losses as a result, liability should in general rest with the corporation or the relevant responsible persons. The community expects this, and the viability of our financial system relies on this.
If this scheme is not implemented as truly “last resort”, then it inevitably produces a moral hazard. Consumers could be incentivised to expose themselves to risk where they otherwise would not, and regulators could be incentivised to not adequately enforce the laws against financial misconduct, as they know victims of such misconduct will be compensated.
Ministerial intervention
The Minister has considerable powers to issue further and special levies under the CSLR.
Ongoing funding is to be provided by levies upon four sub-sectors: financial advice, credit intermediation, securities dealing and credit provision.
The FSC has explained how the ongoing funding model would work as detailed in the draft regulations:
For each subsector, there's a $20 million cap, and so claims that get attributed to that subsector are up to that subsector, are allocated to that subsector. So, for example, if there was $10 million of unpaid determinations in financial advice, then the financial advice sector would pay $10 million. If there was $25 million of claims, then the minister would have to, for that $5 million element, make a determination of how to allocate that extra $5 million, and that would be subject to ministerial discretion.
The scheme has a levy cap of $250 million which applies an overall ceiling.
Across the bill and the proposed regulations, the Ministerial discretion to impose a special levy is quite broad. A special levy on the relevant short-falled primary sub-sector, in the case where the estimate exceeds the sub-sector cap, must not exceed the difference between the revised estimate (say $25 million) and the total amount already levied in that period (say $10 million). The regulations set out how this amount is calculated by the CSLR operator.
When imposing a special levy on other sub-sector(s) and not just the primary sub-sector, the level of ministerial discretion is equivalently broad, with regard only given to:
(a)
the impact that imposing that total amount of special levy may have on the financial sustainability and viability of the specified sub-sector; and
(b)
the impact that imposing that total amount of special levy across all members of the specified sub-sector may have on the financial system more broadly.
The Minister must also be satisfied that the special levy is necessary to meet the number claimants that will accept payments in that period and for the relevant sub-sector with the shortfall, and that it is necessary to meet the sum of those compensation payment amounts.
It is also notable that the Minister must be satisfied that such a special levy is ‘the most effective way of enabling payment of those compensation amounts to the claimants in a timely manner’.
This gives the Minister very broad discretion to determine further levies upon industry to fund the scheme.
In calculating the amount of levy payable, in both cases of an annual levy and special levy, the regulations provide for how this is determined.
The Explanatory Memorandum of the draft regulation’s points to ‘the necessary prerequisites’, with respect to ‘the CSLR operator making a revised estimate and the Minister subsequently determining that a special levy needs to be imposed on several subsectors’.
It is unclear what prerequisites determine whether the Minister should decide that a special levy needs to be imposed on several subsectors.
How can we reduce the risk of a Minister working with a weak regulator to expand moral hazard?
This could be reduced by restricting the enormous power delegated to a Minister by putting more of the detail of these matters in the bill, rather than the regulations.
A limiting measure such as this should be incorporated into the primary legislation, and not left to the regulations.
To address this broad discretion, the ABA has said that:
To the greatest extent possible, the exercise of such discretion under section 1069H (Part 1 Subdivision C) of the bill should be clearly prescribed and independent as it essentially empowers the Minister to levy an unspecified amount on any firm, reduce a customer’s compensation without consultation, and provide no explanation of the decision or provide a right of redress.
In the case of a future phoenixing event in the financial advice sector, and AFCA reported resultant unpaid claims to the CSLR operator, on such a scale that the levy required did meet the criteria to exceed the $20 million sub-sector cap, it seems that other industries not involved in the failure would be liable in that scenario.
It would be at the discretion of the Minister, but the way the legislation and the regulations can operate is that the credit subsector, which is generally ADIs, would or could be very heavily exposed to that liability.
In response to this broad discretion, the FSC has suggested that:
More consideration could be given to removing this wide discretion by limiting the amount any individual sector should provide as cross subsidy as part of a special levy (for example by imposing a $20m sub sector cap), and/or by clearly articulating a transparent formula for the calculation of such a special levy (for example, imposing the costs on all entities required to hold AFCA membership).
The explanatory memorandum justifies the proposed structure of these powers by stating that:
Minister’s power to exercise their discretion has been sufficiently constrained with reference to the principles outlined in the Ramsay Review which ensures the scheme is designed to limit reliance on ad-hoc funding through a carefully calibrated levy calculation methodology, and by clearly specifying the circumstances where a Ministerial determination is warranted.
It is unclear how this discretion is ‘sufficiently constrained’ in the legislation. To provide certainty and clarity, these constraints must be included in legislation and not left to the regulations. Currently, in the legislation, the Minister has broad discretion to make determinations of special and further levies simply if the CSLR notifies the Minister of a revised estimate which exceeds the $20 million cap, in a manner prescribed by the regulations.
Existing legal obligations
Extraordinary legal powers have already been provided to the regulator following the Royal Commission such as:
product intervention power through the Treasury Laws Amendment (Design and Distribution Obligations and Product Intervention Powers) Act 2019;
design and distribution obligations through the same legislation; and
warning and reprimand powers through the Financial Sector Reform (Hayne Royal Commission Response—Better Advice) Act 2021.
After the Royal Commission final report was released in 2019, the previous government provided $400 million in additional funding to ASIC over the following four years, which represented a 25% increase on 2017-18 funding. The annual appropriation given to ASIC has risen substantially over the last five years, from $607 million in 2016-17 to $861 million in 2021-22.
ASIC appears to be struggling as a regulator on law enforcement.
Recent reports found ASIC investigated less than 1% of misconduct reports received during the 2020-21 Financial Year. The investigation process of ASIC must be examined in detail to determine the causes behind these low rates of investigation.
As expected, ASIC has dismissed these reports, refusing to accept responsibility for mismanaging their enforcement obligations. For ASIC, it could be that the CSLR provides an opportunity to relinquish their obligations.
By failing to invoke their investigative powers, ASIC has facilitated the culture of misconduct identified. For the CSLR to be effective policy, ASIC must be held accountable to ensure they investigate complaints, to prevent the need to invoke the CSLR.
In their submission, the Australian Finance Association (AFA) noted that:
Through the work we do with complaints, the AFA is aware of unpaid determinations that are outstanding for a long period of time, even whilst a licensee remains operational. Seemingly the full force of the law is not being applied soon enough to get these firms to pay the determinations that have been awarded. We would therefore like to see a stronger enforcement regime.
Clearly, the regulator is becoming a point of failure in our efforts to restore trust in the financial services sector.
The lack of oversight and conflicts of interest
The bill grants extraordinary powers. It establishes the entity as a subsidiary of the AFCA and grants strong powers to the Minister as canvassed above.
ASIC has insisted that ‘there is no conflict between ASIC’s enforcement role and the funding of the CSLR’ as AFCA and the CSLR operator are ‘independent entities, each established under legislation, and subject to Ministerial authorisation’.
The CSLR operator will be managed by a board whose chair is appointed by the Minister, and the board must include a board member of AFCA.
…the authorised operator of the CSLR will be subject to regulatory oversight by ASIC, in a manner similar to the regulatory oversight arrangements in place for AFCA.
The problem is that the AFCA is exempt from the usual Parliamentary oversight expected of government bodies, as it is ‘a not-for-profit company limited by guarantee that does not fall under the Public Governance, Performance and Accountability Act (2013)’. As it does not receive an annual appropriation of public funds, AFCA is allowed to hide behind ASIC and does not report directly to Parliament.
In response to questions on notice, AFCA has stated that ASIC has the primary oversight role over their operations. They also are also required to report to ASIC. In the proposed legislation, the CSLR is also to be regulated by ASIC.
AFCA has stated that the ongoing oversight of AFCA by ASIC will not change with the introduction of the CSLR as ‘the operator of the CSLR scheme will be a subsidiary of AFCA Limited’.
Downplaying their influence over AFCA, ASIC has said that ‘neither AFCA nor the proposed CSLR, are subsidiaries of ASIC’.
Upon further examination the reporting and oversight structures in the Bills remain unclear. Currently ASIC has an oversight role over AFCA and its subsidiary CLSR operator, who both have reporting requirements to ASIC. Their statutory independence was used during the hearings as justification to guard against any conflict of interest. In the legislation, ASIC has powers to direct the CSLR operator if it:
…does not comply with the mandatory requirements that apply to the operator, conditions set by the Minister at the time of authorisation, or other regulatory requirements set by ASIC.
ASIC’s influence over the AFCA and the CSLR’s levying determination is theoretically limited, given they are independent bodies. It is perplexing, that ASIC is content to take responsibility for their operations when facing Parliamentary scrutiny. They have insisted that they’re ‘happy to appear and account for our own oversight role, set up in the legislation’ with regard to AFCA and the CSLR operator. The Parliament should determine whether it is satisfied with this arrangement.
We cannot have a situation where this subsidiary body of AFCA can then work with ASIC and the Minister to extract funds from the financial sector to cover the trail where ASIC has failed to enforce the law.
The conflict of interest is that ASIC can fail at law enforcement, then cover its tracks by seeking industry funding through the CSLR/AFCA. ASIC represents both bodies to the Parliament as a quirk in convention allows AFCA and CSLR to avoid scrutiny.
Appropriate measures must be taken to ensure that ASIC does its job of law enforcement, and that AFCA and its CSLR subsidiary are subjected to greater Parliamentary scrutiny given the massive expansion of their role through this legislation.
Small Amount Credit Contract Reforms
The Financial Sector Reform Bill 2022 has experienced a substantial change since it was introduced in the previous parliament, to include a suite of reforms to consumer leases and small amount credit contracts.
While this legislation is largely similar to legislation introduced to the 46th Parliament, there are a number of changes that witnesses, in their submissions to the committee, expressed concern about.
The committee heard from a number of witnesses in the sector that expressed concern about these reforms, particularly the operation of section 133C and section 133CF.
Consumer groups and industry associations were unanimous on the need for further protections to protect consumers.
However, the impact of these regulations needs to be weighed against the impact on good faith operators in the sector, along with the potential impacts on consumers who are currently locked out of traditional credit markets.
This is particularly necessary given the impacts of inflation and interest rates will have on access to credit for financial management to low-income earners, and the number of comparatively unregulated products that currently exist on the market.
These measures need to be closely monitored and reviewed to ensure that they do not have unintended negative consequences on businesses and result in financial exclusion.
Recommendation
AFCA, along with the CSLR operator, should be required to face stronger Parliamentary scrutiny with the passage of these bills.
Recommendation
To ensure the CSLR is truly ‘last resort’, the Senate should inquire into the enforcement capacity and capability of ASIC, given the moral hazard that the CSLR poses for the financial regulator.
Recommendation
Consideration should be given to:
amending the bill to limit Ministerial discretion on further and special levies and to provide clarity to the market;
a statutory reporting obligation to capture any communication between ASIC and the CSLR operator and AFCA to reduce moral hazard and ensure law enforcement remains ASIC’s key focus;
any unintended negative impacts of the Protected Earnings Amount within the Financial Sector Reform Bill 2022 on financial exclusion, quality of life and consumer outcomes and industry viability.
Senator Andrew Bragg
Deputy Chair
Liberal Senator for New South Wales
Senator Dean Smith
Member
Liberal Senator for Western Australia