Despite being nine years since the idea was first floated, a compensation scheme of last resort for the retail financial services industry is still highly contentious.
Is a compensation scheme of last resort the answer?
By Emily Dawson
Despite being nine years since the idea was first floated, a compensation scheme of last resort for the retail financial services industry is still highly contentious.
UNSW Business School Professor and Director (Research) Pamela Hanrahan says such a scheme is not necessarily the answer because she fears it will drive complacency in the industry.
“The question I’m interested in is: will it be part of the solution for an overall better model, or will it work against that?
“My view is that it is in no one’s interest there are undercapitalised or under insured firms operating in our market,” Professor Hanrahan said.
“It’s more important to fix the root cause of financial losses to customers rather than compensate them once losses have been incurred.”
Professor Hanrahan says much of the heavy lifting on the issue can be done by fixing minimum standards of capitalisation and professional indemnity insurance.
Counter-productive for competition
But the ombudsman doesn’t necessarily agree.
Financial Ombudsman Service Chief Ombudsman Shane Tregillis says the cost to firms of using insurance and additional capitalisation in this way would be prohibitively expensive and counter-productive for competition.
Mr Tregillis says he is in favour of pricing mechanism such as paying into an insurance pool, as it incentivises better mitigation measures.
“If the mitigation measures don’t work, then the cost of the scheme will go up. That’s quite clear. What that means is the industry gets skin in the game and actually has an incentive to make sure the mitigation measures are put in place,” Mr Tregillis said.
He is also clear that the scheme should not cover all losses, but it would cover conduct failings by financial firms that have a causal link to losses suffered by customers.
Who would fund it?
The cost of the scheme is another consideration.
Cadence Economics modelling suggests the fund would need $105 million a year to effectively compensate for losses in normal, recession and crisis years.
Cadence Economics Director Bob Scealy points out that as much as 60% of the cost comes from compensating for events such as the global financial crisis.
The modelling assumes this to be a once in 40 year event. Five per cent of the cost comes from compensating in a regular year and about 35% from compensating in a recession year.
In terms of costs and design of the scheme, the Ombudsman said crisis style events could be left out of the equation and instead be covered by reinsurance.
“If you were running this as a commercially pooled insurance scheme you would actually run it at the lower cost… and then you would buy stop-loss reinsurance to cover extreme events,” Mr Tregillis said.
Whether or not there is a role for public funds in the establishment of a compensation scheme of last resort is another area up for debate.
Mr Scealy says levying the financial services sector is one of the least efficient ways to raise money and public funds would be a more sensible option.
The merits of a compensation scheme of last resort, including options for retrospective compensation, are currently being considered by the Review of the Financial System External Dispute Resolution Framework.
The conversation was part of the 2017 FSC Leaders Summit in Sydney on July 26.