Financial Stability Review – September 2008
Developments in the Financial System Infrastructure
Crisis Management Arrangements
Events in the global financial system over the past year have focused attention on the arrangements for dealing with difficulties in markets and in individual financial institutions. As discussed in earlier chapters, Australia’s financial markets and institutions have performed well through the recent turmoil and its regulatory system is highly regarded. Notwithstanding this, the Australian authorities – primarily under the auspices of the Council of Financial Regulators – have continued to examine crisis management arrangements in Australia. In particular, the Council – whose members comprise APRA, ASIC, the Treasury and the RBA – has considered the various recommendations of the Financial Stability Forum (FSF) as well as potential lessons from the problems experienced by institutions such as Northern Rock in the United Kingdom, and Bear Stearns in the United States.
Financial Claims Scheme
For some time the Council has seen a need for the introduction of a scheme that would provide depositors with timely access to at least some of their deposits in a failed Authorised Deposit-taking Institution (ADI). The events surrounding Northern Rock reinforced this view. The introduction of such a scheme was also supported by the IMF as part of its assessment of the Australian financial system in 2006 and is consistent with the recent recommendations of the FSF. In response, in June this year the Government announced its intention to establish a Financial Claims Scheme under which depositors in a failed ADI and policyholders in a failed APRA-regulated general insurer would be provided with timely access to funds owed to them. In relation to ADIs, the up-front payments under the Scheme to individual depositors would be capped at $20,000 per depositor.
This approach strengthens the existing provisions of the Banking Act which give depositors first claim over the assets of a failed ADI. If activated, the Scheme would be administered by APRA, with the necessary payments initially being funded by the Government. APRA, on behalf of the Commonwealth, would also be able to borrow from the Reserve Bank for the purpose of the Scheme. APRA would then have first claim over the assets of the failed entity. Only in the highly unlikely situation that APRA was unable to recover the full cost of the Scheme through the sale of the failed ADI’s assets, would an industry levy be required.
Memorandum of Understanding Between the Members of the Council of Financial Regulators
Throughout the recent turmoil in financial markets the various regulators in Australia have been in close contact with one another. The Council of Financial Regulators has discussed developments in the Australian and international financial systems on a regular basis and there has been a steady exchange of information between the Reserve Bank and APRA on a range of policy and operational issues. These arrangements have worked very well and reflect the strong relationships among the various members of Council. In an effort to further strengthen these relationships and to improve public understanding of the responsibilities of each of the agencies, the Council members have recently agreed on a joint Memorandum of Understanding (MOU) dealing specifically with crisis management arrangements. This MOU is being publicly released on 25 September 2008 and can be found on the websites of all four agencies and is reproduced at the end of this Chapter.
The MOU reflects the strong commitment of Australia’s regulatory agencies to the open exchange of information and to a co-ordinated response to potential threats to the stability of Australia’s financial system. The release of this document should help public understanding of the responsibilities of each of the agencies in the areas of financial stability and the objectives and principles that would guide their response to potential threats to financial stability.
Other Activities of the Council of Financial Regulators
The Council has also been considering other aspects of crisis management, including options for dealing with a severely troubled institution whose immediate closure might be expected to have significant effects on the stability of the financial system. Following this work, the Government has accepted the Council’s recommendations for a number of changes to current legislation including: providing enhanced arrangements for transfer of business in banking, general insurance and life insurance, with appropriate oversight by the courts or APRA; and facilitating the recapitalisation of failing entities by removing some potential legal barriers. Legislation to give effect to these changes, as well as the Financial Claims Scheme, is currently being drafted with the expectation that it will be introduced later this year.
Another aspect of crisis management arrangements identified by the FSF is the need for cross-border information sharing and cooperation in a crisis. This is particularly an issue for Australia and New Zealand, given that Australian banks have significant operations in New Zealand, with these operations accounting for around 90 per cent of New Zealand banking system assets. Reflecting this, the members of the Council of Financial Regulators and the Trans-Tasman Council on Banking Supervision are working together to strengthen current arrangements for dealing with potential stresses in a bank with operations on both sides of the Tasman Sea, as well as arrangements for the exchange of information more generally.
Over the past year, the Council has also considered the results of a pandemic stress test of the insurance industry conducted by APRA, and the policy responses to the failure of a number of property companies offering unlisted and unrated debentures to the public (see below).
Other Actions Being Undertaken to Address FSF Recommendations
As discussed in The Global Financial Environment chapter, in April 2008 the FSF made a number of recommendations to improve the resilience of markets and institutions. In June 2008, the Treasurer announced Australia’s comprehensive response to these recommendations. In addition to those measures concerning crisis management outlined above, this response detailed the actions being taken by individual Council members, some of which are outlined below.
In response to the FSF recommendation to examine the role and regulation of credit rating agencies, particularly in relation to structured and securitised products, the Treasury and ASIC are consulting with the ratings agencies and the industry on how to improve the quality of the rating process. This includes examination of: how to manage the conflicts of interest in rating structured products; the extent to which investors rely on the ratings agencies; and whether the level of diligence and discussion undertaken by agencies warrants this reliance. The review will also examine financial product research houses, in particular, the role they played in providing advice to investors in several recent major corporate collapses. The Treasury and ASIC expect to report to the Government towards the end of 2008.
The FSF also highlighted the need for more attention to be paid to the management and supervision of liquidity. As detailed in the March 2008 Review, APRA had begun an extensive review of its approach to liquidity risk management prior to the onset of the recent turmoil. It plans to strengthen the current liquidity regime by: enhancing supervisory information on ADIs’ liquidity positions; strengthening ADIs’ approaches to liquidity stress testing, including potentially determining new “minimum survival” scenarios involving a protracted period of market disruption; and enhancing ADIs’ contingency planning in respect of retail run management strategies. In doing so, APRA will take into account the output of a working committee of industry participants, which has recently been established to translate the draft Principles for Sound Liquidity Risk Management and Supervision developed by the Basel Committee on Banking Supervision (BCBS) into new liquidity rules.
The BCBS principles are based on the premise that a bank’s liquidity risk framework should ensure it maintains sufficient liquidity to withstand a range of stress events, including those that affect secured and unsecured funding. They underscore the importance of establishing a robust liquidity risk management framework that is well integrated into the bank-wide risk management process. The principles also strengthen expectations about the role of supervisors, including the need to intervene in a timely manner to address deficiencies in liquidity management and the importance of communication with other supervisors and public authorities, both within and across national borders.
Another of the FSF recommendations is for financial institutions to strengthen their risk disclosure in relation to exposures to certain instruments that the market now recognises as involving more risk than previously appreciated. To assist this, a template was developed incorporating leading-practice disclosures in areas such as collateralised debt obligations, residential and commercial mortgage-backed securities and leveraged finance. To give effect to this recommendation, the Reserve Bank Governor wrote to internationally active banks in Australia encouraging them, where relevant, to draw on the template in considering what additional information they could provide in their next reporting cycle.
The FSF has also called for flexibility in central banks’ operational frameworks . The Reserve Bank’s long-standing arrangements meant that it was well placed to respond to the turmoil in interbank markets that began around the middle of last year. These arrangements are very flexible, with the RBA dealing in the market every day and able to deal with a wide range of counterparties, in a wide range of securities and across a wide range of maturities. The Bank’s initial response, in August 2007, was to significantly boost the pool of exchange settlement funds that commercial banks hold at the RBA, in order to maintain the cash rate at the target set by the Reserve Bank Board. Also, as outlined in The Australian Financial System chapter, in September last year the Bank broadened the pool of securities it would accept under ‘repo’ to include some commercial bank paper not previously accepted and certain residential mortgage- backed securities and asset-backed commercial paper. The Bank has also lengthened the maturity of its operations significantly, indicating at various times that its preferred term for repos was around one year.
Prohibition on Short Selling of Equities
In response to the extremely unsettled market conditions over recent weeks and international actions, ASIC has introduced a ban on the short selling of all listed stocks, with the ban effective from 22 September 2008. The ban is subject to a small number of exceptions, including to permit limited hedging activity, particularly by market-makers. In announcing the ban, ASIC noted that while short selling can play a valuable role, recent market conditions and extensive short selling of stocks created the risk of unwarranted price fluctuations which, if left unchecked, could threaten the operation of fair and orderly stock markets.
The current ban will be re-assessed in October, at which time an announcement will be made on whether to re-allow covered short sales for non-financial stocks. A ‘covered’ short sale is a sale of a product that the seller, at the time of sale, does not currently own, but does have a presently exercisable and unconditional right to vest in someone else – typically through a binding securities lending agreement. The ban will otherwise apply until the Government’s short selling legislation becomes effective.
ASIC has also exercised its powers under the Corporations Act to require the disclosure of covered short sales. This will also continue until the implementation of the foreshadowed legislation in this area. Previously, disclosure was only required for those securities involving so- called naked short selling. In practice, at least until late October, the new disclosure requirement will apply only to the covered short sales exempt from the prohibition.
Developments in Payment and Settlement Systems Infrastructure
As outlined in the March 2008 Review, wider competition in the provision of market services for equities is currently under consideration, with three companies, AXE ECN, Chi-X Australia and Liquidnet Australia having applied for market licences to operate trading platforms for ASX-listed equities. The platforms would compete directly with the ASX market. In March 2008, ASIC provided advice to the Minister for Superannuation and Corporate Law on these applications and the regulatory framework that might apply to these new trading platforms; the Minister is currently considering that advice.
The prospect of new trading platforms has required ASX to consider in detail how it might open access to its clearing and settlement facilities. As part of this process ASX has conducted a series of public consultations, the most recent of which, released in July 2008, outlined the proposed processes and information flows between the aspirant trade-execution-only platforms and the Clearing House Electronic Sub-register System (CHESS). Further input from settlement and clearing participants and other stakeholders is being sought in order to refine the operational and systems solutions.
The Reserve Bank has oversight responsibility for financial stability and risk issues arising from clearing and settlement arrangements in the Australian equity market. Reflecting this responsibility, the Bank has established Financial Stability Standards for licensed clearing and settlement facilities and reports publicly on its assessment each year. While the Bank is satisfied that the facilities are meeting these standards, in late January 2008, the inability of a participant to meet its payment obligations resulted in settlements in the Australian equity market being delayed on two occasions. There was never any doubt that the central counterparty for equity transactions, the Australian Clearing House, would be able to meet its obligations, but the settlement delays prompted the Bank to examine whether some changes to the settlement procedures in the Australian equity market could make the settlement process more robust.2
Settlement of most equities transactions in Australia occurs in a single daily batch process run by CHESS, which is owned and operated by ASX. This batch process reduces all scheduled securities transfers, including both novated and non-novated transactions, to a single net transfer per line of stock for each participant. Settlement occurs on a delivery-versus-payment basis, with associated interbank payment flows settled across Exchange Settlement accounts at the Reserve Bank, also on a net basis. Netting reduces the amount of equities and funds that need to change hands, providing benefits to participants, but introduces additional interdependencies.
As part of the Review of Settlement Practices, the Reserve Bank considered possible fundamental changes to current settlement arrangements, concluding that a move to a system in which settlement occurs on a trade-by-trade basis would reduce the dependence of market-wide settlements on a single participant. However, neither ASX nor market participants are persuaded of the need to move to a new settlement model, citing, in particular, the considerable cost of transition. While the Bank continues to view such a change as worthy of consideration over the medium term, it does not see the matter as being so pressing as to require a change through regulation. In the meantime, the Bank sees a strong case for modifications to existing batch settlement arrangements to increase their robustness. One modification considered in the Review is the introduction of an explicit window for completion of settlement. Other possible refinements include: the clarification of lines of communication and deadlines for decisions, including by settlement banks; and amendment to the cut-off time for new settlement instructions, so as to allow more time prior to batch settlement for participants to ensure that securities and funds are in place. These, among other options, are currently under consideration by ASX, in consultation with the Reserve Bank. In the Review, the Bank also examined potential changes to arrangements for dealing with settlement fails. ASX has since increased the fees applying to failed trades and has announced prospective new arrangements for the forced close-out of trades remaining unsettled beyond the fifth day after trade date.
The Reserve Bank has also been discussing with industry participants ways of improving the disclosure of securities lending activity. Improved disclosure in this area would help enhance participants’ understanding of settlement risk and would be complementary to improved disclosure of short selling. One option that the Bank is considering is an amendment to the Financial Stability Standard for Securities Settlement Facilities to effectively require ASX to collect and publish data on securities lending activity. The Bank is currently discussing this possibility with industry participants.
In February 2008, the Treasurer and the industry announced a reform package aimed at making it easier for retail customers to move their business between financial institutions. Elements of the initiative include a single consumer complaints hotline, comprehensive consumer education resources and an ASIC-led industry review of entry and exit fees. Another key element of the package is the introduction of a ‘listing and switching’ service in relation to transaction accounts, to simplify the process of identifying existing direct debit and credit transactions (for example, payroll and bill payments) and redirecting these to the customer’s new account. Currently, identifying and redirecting these payments can be a difficult and time consuming process and can limit competition by discouraging customers from moving between financial institutions.
The Australian Bankers’ Association and Abacus-Australian Mutuals (the industry association for building societies, credit unions and friendly societies) have committed to the introduction of this service, which is being co-ordinated through a group convened by the Australian Payments Clearing Association (APCA). The key elements of the service include:
- upon request, a customer’s old financial institution will provide a list of direct debit and credit arrangements over the previous 13 months to the customer. The list will be provided as soon as practicable and no later than five business days after the customer ’s request;
- the new financial institution will provide the customer with information and support to help the customer make the switch. Institutions will provide customised ‘switching packs’, taking into account guidelines provided by APCA; and
- if requested by the customer, the customer’s new financial institution will assist in notifying billing and crediting organisations of new direct debit and direct credit arrangements.
The industry has committed to having the listing and switching service operational by 1 November 2008. APCA has provided regular progress reports to the Reserve Bank and these have been made available on the Bank’s website.3
Regulation of Credit and Financial Services
In June 2008, the Government released a paper on Financial Services and Credit Reform discussing options to improve, simplify and standardise regulation of financial services and credit. The paper included options for reform across six broad areas involving: the development of a comprehensive approach to the regulation of mortgages and mortgage broking advice and non-bank lenders; the regulation of margin lending; the creation of a national market for trustee corporations; reforms to improve the existing regulation of debentures; issues relating to property investment advice; and consideration of the most appropriate regulation of credit products, such as credit cards and personal loans.
Following consultations across the different levels of government and with the business and consumer sectors, the Council of Australian Governments (COAG) agreed that the Commonwealth should assume responsibility for the regulation of all consumer credit (that is, personal loans, credit cards, pay day lending and micro loans), as well as for regulating mortgages, mortgage brokers, non-bank lenders, trustee companies and margin loans. This is a welcome development, given that consideration of some of these issues, for example, the introduction of consistent national regulation of mortgage brokers, had been under consideration for many years. A plan for implementation of this agreement, drawing on the comments received on the consultation paper, is to be presented to COAG before the end of 2008.
Efforts to Improve Disclosure
As reported in the March 2008 Review, ASIC has taken a number of steps over the past year to improve disclosure requirements applying to unlisted and unrated debentures. These include: the establishment of disclosure benchmarks in areas such as equity capital, liquidity, related-party transactions and credit ratings; and the requirement that if issuers do not meet these benchmarks, they are required to explain why this is so (known as the ‘if not, why not’ approach). ASIC has examined the implementation of the new regulatory measures and while it found significant improvements in the quality of disclosure to retail investors, it also considered that some refinements to the practical implementation aspects of the requirements were warranted. Accordingly, in August 2008, an updated regulatory guide was released that clarified some of the implementation aspects of the disclosure benchmarks, as well as the obligations for issuers who on-lend funds indirectly through a related party and the auditors’ report on the benchmarks. This guide also confirmed that the arrangements do not apply to debentures that are to be quoted on a financial market, or ones that are convertible into listed securities at the discretion of the investors.
In line with the efforts to improve disclosure of unlisted debentures, regulatory guides aimed at improving disclosure to retail investors in other unlisted schemes have been released by ASIC. Drawing on the model adopted last year for debentures, and following consultation with interested parties, companion investor guides for unlisted mortgage and property schemes have been produced to assist investors in understanding the enhanced disclosure and making better informed investment decisions.4
For unlisted mortgage schemes, a benchmark-based disclosure model has also been developed. These benchmarks differ from the ones introduced for debentures reflecting the different risk profile of unlisted mortgage schemes and the different legal structures and rights associated with this type of investment. As with debentures, however, the issuers are required to disclose against the benchmarks on an ‘if not, why not’ basis. ASIC requires responsible entities for existing mortgage schemes to report against the benchmarks to existing investors by 30 November 2008. From this date, new fundraising documents for mortgage schemes will need to address the benchmarks and ASIC will conduct a review of disclosure practices against the new requirements.
Regarding unlisted property schemes, ASIC has developed disclosure principles designed to give issuers guidance on key areas that need to be prominently disclosed to existing and potential retail investors in order to allow investors to compare the relative risk and return of unlisted property scheme investments. The new principles have to be applied by 30 November 2008 for open schemes, while closed schemes have been allowed a longer time period for transition, with these schemes having until 31 March 2009. After this ASIC will review the unlisted property schemes sector to see whether the guidance has improved investor disclosures, as well as the impact on the sector of any changes in market conditions.
More generally, the issue of financial disclosure documentation is being examined by the Australian Government’s newly established Financial Services Working Group. This Group was initially asked to examine financial disclosure documentation for the First Home Saver accounts, before turning to the broad task of examining product disclosure documentation across the financial services arena. The Working Group is also examining the issue of the availability of advice on choices within an existing superannuation account (intra-fund advice), with a view to identifying steps that could be taken to help more consumers get access to low-cost advice.
Cross Border Recognition of Financial Regulation
The Australian Government is examining the framework for Australian investors to access other well regulated capital markets, advisers and products, subject to ensuring the integrity of financial markets and protection of investors. A joint consultation paper on this issue was released in June 2008 and included proposals to develop a mutual recognition framework to be applied in agreements between Australia and overseas jurisdictions as well as to refine ASIC ’s existing framework of unilateral recognition of securities regulation.
The general approach of the Australian Government to recognising foreign regulation of financial markets and financial services providers has been based on unilateral recognition of the foreign jurisdiction. This means that a foreign entity operating both in Australia and the foreign jurisdiction will need to comply with only the foreign regulatory regime; not all the Australian regulatory requirements need to be complied with and the foreign jurisdiction need not recognise Australian regulation. This policy allows Australian investors to benefit from access to markets and financial services without the foreign‑service provider being subject to duplication of regulation.
In order to better enhance the effectiveness of the Australian arrangements, the consultation paper proposes both refinements to the unilateral approach and a framework for mutual recognition of securities regulation. Mutual recognition would enable an Australian entity to operate in a foreign jurisdiction on the basis of compliance with the Australian regulatory framework and vice-versa. One of the pre-conditions of mutual recognition is that the regulatory framework of each jurisdiction must be substantially equivalent, thus ensuring investor protection and market integrity irrespective of the location of the investor.
Separate from this process of consultation, there have also been developments on mutual recognition with individual countries. In June 2008, Australia undertook its first mutual recognition agreement with New Zealand on securities offerings. Issuers of securities can now use one prospectus to offer shares, debentures or managed or collective investment schemes to investors on both sides of the Tasman Sea, subject to certain requirements. Following this, Australia and Hong Kong extended mutual recognition to authorised collective investment schemes that will facilitate the sale of retail funds in each other’s market. Furthermore, in August 2008 Australian authorities signed a third mutual recognition arrangement, this time with the United States Securities and Exchange Commission.
- See Reserve Bank of Australia (2008), Review of Settlement Practices for Australian Equities, May.
- These reports are available at: http://www.rba.gov.au/payments-system/reforms/asi/index.html
- Investors in a mortgage scheme receive income based on loans for property development, whereas investors in a property scheme receive income based on rents and capital appreciation upon disposal of assets.