Reserve Bank of Australia Annual Report – 1986 Supervision of Banks


Prudential supervision in Australia is based broadly on institutional rather than functional lines. The Reserve Bank is responsible for the supervision of banks authorised under the Banking Act and also has the co-operation of the State banks on prudential matters. Formal responsibility for the supervision of non-banks rests with other Commonwealth or State authorities. This demarcation in supervisory responsibilities is mainly a historical development reflecting the different characteristics of banks and non-banks; despite some blurring of these characteristics in recent years, banks continue to have a special status and position in the community.

Work of the Bank's Supervision Unit in 1985/86 included: the lead-up to the authorisation of new banks; further development of the supervisory framework in relation to bank liquidity, large commitments and off-balance sheet activities; the establishment of links with external auditors of banks; and regular consultations with individual banks on their domestic and overseas operations.

Approach to Supervision

The broad principles of the Bank's approach to supervision were set out in a paper published in February 1985 entitled “Prudential Supervision of Banks”. Deregulation of the financial system and international precedents have led to rapid expansion and innovation by banks; with more banks now operating, banking business has become more complex and competitive and potentially riskier. In this environment, the Bank has encouraged the banks — with whom prime responsibility for their stability lies — to maintain high prudential standards, and has itself moved towards somewhat greater formality in supervision. One step was the inclusion by the Government of conditions in all new banking authorities requiring new banks to consult with the Reserve Bank on prudential matters and to operate within prudential standards determined by the Bank.

Continuing Supervision

Supervision of individual banks continues to be based on assessment of the adequacy of management systems for controlling exposures and limiting risk, on the observance of standards relating to levels of capital and holdings of prime assets, and on analyses of statistical returns and other information covering aspects of banks' global banking operations. There is a formal consultation with each bank at least once a year about its operations. Matters covered include corporate strategy, capital adequacy, earnings, the quality of assets, risk exposures both on and off-balance sheet, and management and control systems. The Bank may initiate discussions with a bank at other times as matters of interest arise. Banks are also encouraged to consult the Reserve Bank in advance in respect of new activities.

The international operations of Australian banks continued to grow faster than their domestic operations during the year. However, the rate of expansion of overseas assets moderated from the high growth of recent years. Factors contributing to this moderation included the narrowing of interest margins in the highly competitive international financial markets and the impact of the devaluation of the Australian dollar on banks' capital ratios. Overseas assets are now close to 40 per cent of the total assets of the four major trading banks, compared with about 25 per cent only four years ago. Australian banks' international commitments are predominantly to borrowers in major industrial countries; exposures in countries experiencing debt servicing problems represent only about 1 per cent of the major banks' total assets.

The Bank has continued to pay close attention to the capital adequacy of banks. Capital ratios have been broadly maintained, and in some cases strengthened, in recent years in line with the marked growth in assets. The trend has been assisted by strong profitability, greater retention of profits, new equity issues, revaluation of premises and, in some cases, restraint by banks themselves on the growth of balance sheets. With the nature and range of business of Australian banks undergoing rapid change, the Bank has counselled them to avoid a weakening of their capital ratios. All new banks have been required to maintain, during their formative years, a minimum capital ratio of 6.5 per cent. This is higher than the current capital ratios of the long-established banks. It is not designed to thwart competitive aspirations but to provide an extra margin of support for depositors of the new banks while they establish a foothold in the Australian market. As each new bank develops a stable funding base and a diversified portfolio of assets, and demonstrates through sound management its status in the local market, its minimum capital ratio will be reviewed.

New banks — whether locally or foreign owned — are on a common footing as regards prudential supervision. New foreign banks are required to operate in Australia as locally incorporated subsidiaries. (During the year the Bank of China resumed its earlier branch operation.) This means at law that they are entities separate from their parents, have capital “on the ground” in Australia, and are subject to the supervision of the Reserve Bank. The locally incorporated bank is also required to be the holding company for all the overseas parent bank's interests in Australian financial institutions. An important established guideline is that the aggregate size of a bank's associates and subsidiaries in Australia should not be unduly large in relation to the bank itself. Some of the new foreign banks already had substantial equity interests in non-banks in Australia. The Reserve Bank has asked them to achieve an appropriate balance between the size of the bank itself and its other financial interests within a reasonable period.

Developments in Prudential Arrangements

Prime Assets Ratio

As explained in last year's Report, the Prime Assets Ratio (PAR) is a prudential standard under which each trading bank agreed, in May 1985, to hold at all times a tranche of high quality liquefiable assets (“prime assets”) equivalent to 12 per cent of its total liabilities in Australian currency (other than shareholders' funds). The ratio was extended in November 1985 to apply also to foreign currency liabilities used to fund Australian dollar assets. The Reserve Bank sees this arrangement as an important underpinning of confidence in banks.

Initially, as a carry-over from the LGS Convention which the PAR arrangements replaced, trading banks were holding more “prime assets” than were necessary to meet the minimum requirement. This surplus was run down, as conditions permitted, in four steps between June 1985 and March 1986.

Liquidity adequacy

In addition to their holdings of prime assets under the PAR arrangements, banks are expected to hold an adequate stock of suitable assets in appropriate currencies in order to meet day-to-day fluctuations in liquidity needs. The Bank is strengthening its data base to monitor the adequacy of banks' liquidity in respect of both their domestic and offshore operations.

Large exposures

During the year, the Bank expanded its arrangements to monitor banks' large credit exposures. It introduced, from end March 1986, a revised collection of information on the number and amount of banks' large exposures to individual clients or groups of related clients which exceed 10 per cent of a bank's capital. Clients' names are not sought. The new information includes both on-balance sheet and off-balance sheet commitments.

The Bank also put its approach to the monitoring of large credit exposures on a more formal basis. It obtained from each bank a statement of its policy in respect of large exposures. It asked that such exposures be kept under close review and that banks place a limit on the size of large exposures relative to their shareholders' funds. The Reserve Bank has indicated that a bank with any exceptionally large exposures, or with a large number of exposures each of more than 10 per cent of its shareholders' funds, should be able to show that excessive risks have not been undertaken. In the Bank's view, a bank wishing to maintain a high volume of large exposures could need more capital.

Off-balance sheet activities

Australian banks, like their counterparts overseas, have become increasingly involved in off-balance sheet activities such as interest rate swaps, options, etc. Deregulation in a number of countries, financial innovation and technological change have been major incentives behind this trend; relating bank capital requirements to on-balance sheet items only might also have been relevant.

The Bank, in common with supervisory authorities in other major countries, has been reviewing the prudential implications of off-balance sheet business. Its work so far has been directed at improving the information base and encouraging banks to ensure that they have adequate management systems for measuring and controlling the risks involved. The risks associated with off-balance sheet business are not necessarily different from on-balance sheet risks and ultimately it is to be expected that authorities internationally will need to take account of both in assessments of capital adequacy.

External auditors

Supervisory authorities naturally need to know that data on which they make prudential assessments are reliable. In a number of countries this is achieved by examination and inspection of individual financial entities by the supervisory authorities. In Australia, the Reserve Bank does not have legal authority to inspect individual banks. As a middle way, in the past year the Bank commenced discussions with banks about establishing links between the Reserve Bank and banks' external auditors. Arrangements were agreed with all banks; they will be fully implemented during each bank's next financial year. Each bank will ask its external auditor to report on the observance of prudential standards and other requirements set by the Reserve Bank; the effectiveness of, and observance of, its management systems to monitor and control risks; the reliability of statistical data provided to the Reserve Bank; and compliance with relevant regulatory and operating requirements. External auditors will also be asked to bring to the attention of the Reserve Bank, through and after discussion with the bank itself, any matters which, in the auditor's opinion, might have potential to prejudice materially the interests of depositors of the bank.

These arrangements are not intended to interfere with customary relationships between a bank and its external auditor; communications between the Reserve Bank and the auditors will pass through the bank concerned.

International Co-operation

The Reserve Bank has welcomed the movement in recent years towards closer international co-operation in prudential supervision. This movement owes a great deal to the work of the Basle Committee on Banking Regulations and Supervisory Practices, which comprises the supervisory authorities of the Group of Ten countries and Switzerland, and which meets under the auspices of the Bank for International Settlements. The Basle Committee has given wide circulation to its papers on supervisory practices and has fostered international co-operation through meetings of banking supervisors.

The Reserve Bank is a member of the SEANZA Forum of Banking Supervisors which comprises supervisors from South-East Asia, the Indian sub-continent, Japan, New Zealand and Australia. The Forum has met several times, most recently in Bangladesh in April 1986.

The Bank maintains particularly close bilateral relations with supervisory authorities in countries in which Australian banks operate and with the parent supervisory authorities of foreign banks operating in Australia.