Dr William Isdale and Nicholas Simoes da Silva
At the core of finance is the concept of risk. So too is the story of financial regulation a story of risk and how to deal with it. It is a story etched in our law, and like an archaeologist probing sedimentary rock, exploring that history can yield new insights on regulation and risk.
In a new Background Paper — Risk and Reform in Australian Financial Services Law (FSL5) — the Australian Law Reform Commission explores how an evolution in thinking about risk has been an important driver of financial services law reform. In particular, the Paper reveals how the ‘shifting sands’ of regulatory approaches have resulted in legislation that is unwieldy and extraordinarily complex. The Paper highlights how the existing legislative model has proven inadequate, and how a new architecture could better accommodate change going forward.
In this short article we provide an overview of key themes arising from the ALRC’s new Background Paper.
The context for shifting approaches to the regulation of financial risk
Two broad changes have emerged over time and provide the backdrop for much of the evolution in regulatory responses to financial risk:
- First, there has been a ‘risk shift’, in which individual citizens have increasingly borne a greater degree of risk. For example, a move away from interest rate controls, and the lack of long-term fixed-rate residential mortgages, has meant that households bear the risk of changes in interest rates. Further, individuals are increasingly exposed to risk in respect of their retirement. Superannuation that is subject to financial market risks has increasingly replaced schemes like the age pension, or defined-benefit plans, in which those risks were borne by government or employers.
- Second, there has been ‘financialisation’ of the Australian economy, involving increasing exposure to financial assets and markets and continuing growth of the financial sector relative to the real economy. The overall size of the financial sector has grown enormously, in both relative and absolute terms. For example, household exposure to financial markets increased from roughly 30% of total household assets in 1980, to in excess of 40% in 2021 (with the total wealth of financial assets owned by Australian households now in excess of $6.2 trillion). The absolute size of financial markets has also grown considerably.
Collectively, these trends have meant that financial risks pose a greater threat to both the wellbeing of individual citizens and the Australian economy. These trends have served to underscore the public interest in regulatory intervention to address risks, and to increase the political salience of doing so. Perhaps unsurprisingly, then, the past 20 years — since the commencement of the Corporations Act 2001 (Cth) — have heralded a wide variety of new regulatory interventions, reflected in extensive legislative amendments.
The story told by regulatory intervention is not a consistent one. Amendments over time have reflected different approaches to risk, and different views on the extent to which individuals should be able to assume it, or be considered capable of addressing it for themselves. While the story is not a linear one, to the extent there has been a theme, it is this: there has been a move away from a philosophy of ‘buyer beware’ — and the assumption that individuals can understand and address risks on their own accord — and towards an approach that is increasingly interventionist and less tolerant of risk.
How shifting approaches to financial risk are reflected in our law
The Corporations Act’s regulation of financial products and services has been premised on disclosure. Disclosure of information — including as to risks — was presumed to be sufficient to ‘enable a consumer to make an informed decision relating to the financial product’ (as the Wallis Inquiry observed, prior to the Act’s commencement). To this day, disclosure enjoys pride of place in financial regulation, reflected in the over 45,000 words instituting its various requirements in the Corporations Act (with an additional 65,000 words in regulations, and tens of thousands more in other legislative instruments).
However, very soon after the Corporation Act’s commencement, the inadequacy of disclosure began to be recognised. In an Explanatory Statement accompanying amendments in 2005, it was observed that the average retail investor found it ‘difficult to absorb the large volume of information’ in product disclosure documents, and was therefore ‘deterred from using the information to make investment decisions’. The field of behavioural economics — which came to public prominence in the 2000s, and garnered the attention of financial regulators and policymakers — also challenged assumptions about the ability of humans to understand and deal with risk, probabilities, and uncertainties.
As a result of all this, coupled with the broader changes canvassed earlier in this article, Australia’s approach to financial regulation began to change. A key turning point came with the publication of the Murray Inquiry in 2014. Despite the extensive pre-existing disclosure regimes, Murray was concerned that ‘consumers are taking risks they might not have taken if they were well informed or better advised’. While acknowledging that ‘[c]onsumers should generally bear responsibility for their financial decisions’, Murray argued that policymakers should aim to ensure ‘fair treatment’ of consumers and be ‘aware of, and design regulatory frameworks that take into account, behavioural biases’. Two of Murray’s key recommendations, which subsequently became law, were that:
- Financial firms should be subject to ‘design and distribution’ obligations, designed to ensure that financial products only end up in the hands of consumers for whom they are suitable. Rather than leaving the choice of product acquisition entirely to consumers, these reforms implied that consumers cannot be entirely counted on to make good decisions for themselves; and
- The Australian Securities and Investments Commission (‘ASIC’) should be granted ‘product intervention powers’ enabling it to ban or impose conditions on the sale of certain financial products. For example, in 2021 ASIC used the power to ban the sale of binary options to retail clients (80% of whom had lost money in such transactions). Again, the bestowal of these powers ran completely contrary to the notion that consumers can be regarded as the best guardians of their own interests.
The broader story — of increasing intervention and intolerance of risk, and a move away from reliance on individuals to decide for and protect themselves — is also reflected in numerous other regulatory initiatives introduced since the commencement of the Corporations Act in 2001. Those changes include: ‘responsible lending’ requirements for the provision of credit (under the National Consumer Credit Protection Act 2009 (Cth)); provisions depriving ‘unfair contract terms’ of force or effect (in the ASIC Act 2001 (Cth)); and the ‘Future of Financial Advice Reforms’, which imposed new conduct obligations on providers of personal financial advice to retail customers (in the Corporations Act 2001 (Cth)).
Why our existing legislation has proved inadequate
Financial services law has undergone significant change over the past 20 years. Notably, when it commenced in 2001, the Corporations Act was a (comparatively slight) 1866 pages long. It has since ballooned to in excess of 3,900 pages, and a commensurate increase in size is also seen in its accompanying Regulations and other legislative instruments. Much of this increase is attributable to reforms that are in response to — and aim to address — risks of various kinds.
The daunting volume of law is cause for concern enough, but even more concerning is its ‘Byzantine complexity’ (as described by former High Court Chief Justice, Sir Anthony Mason). The divergent and varied approaches to risk that have accumulated in the law over the past 20 years are contributors to the law’s complexity. In particular, this is because new law has simply been added to the old. The accretion of law has reflected varied approaches to risk, but there has been little desire to revisit or dismantle what came before.
Evolution in approaches to the regulation of financial risk is inevitable and often welcome. However, the ALRC considers that a survey of our existing law and its history highlights two particular needs:
- First, the need for comprehensive and ongoing review of the law, to ensure it remains coherent, comprehensible, and accessible. This is part of the work now being undertaken in the ALRC’s Financial Services Legislation Inquiry. However, there may also be a role for a body akin to the former Corporations and Markets Advisory Committee (abolished in 2018), to continually review and make suggestions for improving the law.
- Second, the need to ensure that the legislative framework for regulation provides an architecture that is sufficiently flexible to accommodate inevitable future changes. In the ALRC’s view, the Corporations Act’s structure – and particularly, the use of legislative instruments to modify or amend it — are unsuitable. The ALRC’s research suggests the legislation administered by the Australian Prudential Regulation Authority (‘APRA’) has better adapted to changing approaches to financial risk. Whether or not one agrees with the particular design choices underlying the APRA model of regulation, it has the key attribute of consistency: a regulated entity generally knows who will make the rules that affect it, the manner in which they will be made, and where those rules are located.
The recommendation of a more suitable legislative architecture will be a core component of the ALRC’s Interim Report B, due in September 2022, as part of its Financial Services Legislation Inquiry.
In the end, the history of Australian financial regulation highlights a risk of an entirely different stripe: the risk that the law will become, or already is, too complex, incoherent, or inaccessible to be understood or applied. Or, that it imposes a disproportionate burden on those who are required to try and understand it — including consumers of financial products and services (and their lawyers), financial firms, courts, and regulators. However, those risks are also an opportunity: to improve the law for the benefit of all. That is the task the ALRC is currently embarked upon.
Stakeholders are encouraged to engage with the ALRC and the Financial Services Legislation Inquiry. Feedback is welcome at any time by email to: firstname.lastname@example.org
|Download Background Paper: Risk and Reform in Australian Financial Services Law (FSL5)|
 Stan Wallis, Financial System Inquiry (Final Report, 1997) 264.
 Explanatory Statement, Corporations Amendment Regulations 2005 (No. 5) (Cth) 24.
 David Murray et al, Financial System Inquiry (Final Report, 2014) 28.
 Ibid 42.
 Sir Anthony Mason, ‘Corporate Law: The Challenge of Complexity’ (1992) 2 Australian Journal of Corporate Law 1.