The bank, Australia's second largest by market capitalization, said the 72-year-old would become a non executive director in February before taking the chairman's role in April.
McFarlane stepped down as chairman of Barclays in May after four years. Previously he had chaired British insurer Aviva which followed nine years as chief executive (CEO) of Westpac rival Australia and New Zealand Banking Group (ANZ).
Scottish-born McFarlane takes over just two months after Westpac's top two executives stepped down following charges by the regulator for breaching of anti-money laundering laws which potentially facilitated child exploitation.
Westpac's current troubles are part of wider ructions in the Australian banking industry. Two of the top four banks that dominate the domestic market have lost their leaders in the wake of damaging revelations from a government-backed inquiry into misconduct in the industry.
McFarlane's appointment, however, failed to boost the bank's shares on Thursday as investors said the prospect of a huge fine - estimated by analysts to be up to A$1 billion - for the anti-money laundering breaches continued to weigh on the bank's earnings prospects.
Westpac shares closed at $A25.08, down 0.24% while the broader benchmark S&P/ASX200 lost 0.6%.
"I was surprised to see the stock was down. I thought there would have been a better reaction," said Matt Haupt, portfolio manager at Wilson Asset Management, which owns Westpac shares.
"I think some investors are still worried about the size of the fine and what will come out of the Austrac investigations."
'MACK THE KNIFE'
Westpac's chief financial officer Peter King, who had flagged his retirement, is currently serving as Westpac's interim chief executive.
McFarlane has been a hands-on chairman in previous roles, sparking speculation he may not rush to appoint a new permanent CEO.
"He will shake up the executive ranks, and he won't hurry in appointing a CEO, he will back his own ability to be an executive chairman," said Matthew Wilson, banking analyst at Evans and Partners.
In Britain McFarlane was nicknamed “Mack the knife” during his chairmanship of Aviva and then Barclays. In both, he acted as executive chairman for some time.
In a statement earlier on Thursday, McFarlane said that the appointment of a "world-class" CEO could "take time".
Vas Kolesnikoff, Australian head of governance adviser ISS, said Westpac needed to ensure there was a distinction between the chairman and the executive, with the search for a permanent chief executive underway.
"You need to have somebody who is running the bank and you need to have a board that is sufficiently independent to oversee management and addressing all the issues," Kolesnikoff said.
Martin Lawrence, governance analyst at Ownership Matters, a proxy advisory firm, said McFarlane came with a reputation for "drastic change".
"If there needs to be hard decisions made, I don’t think he is going to be afraid to make them," he said.
Former Westpac chief executive Brian Hartzer left the bank after the money-laundering scandal was revealed while chairman Lindsay Maxsted also accelerated his departure from the bank's board.
At last month's annual meeting, the lender's shareholders voted down executive pay for a second year due to investor outrage over the scandal..
Westpac gave no details on Thursday of McFarlane's remuneration.
By Paulina Duran and Scott Murdoch