Reserve Bank of Australia Annual Report – 1987 The Bank's Relationships with Financial Institutions

The Bank has formal responsibility for prudential supervision of banks authorised under the Banking Act; it also receives the co-operation of State banks on prudential matters. In addition:

  • the Bank has a contractual relationship with each of the nine authorised dealers in the short-term money market. Adherence to operating guidelines issued by the Bank is a condition of authorisation; these guidelines concern dealers' ownership, capital, assets structure and dealing practices. By arrangement, considerable information about the short-term money market provided by the dealers is published regularly by the Bank. During 1986/87 there were a number of changes in the Bank's guidelines for dealers' operations. These are outlined on pages 18 and 19 of this Report;
  • the Bank maintains a general oversight of the foreign exchange market, including dealing practices. In this, it is assisted by its participation in the Foreign Exchange Market Consultative Group. Companies wishing to deal in foreign currencies require authorisation under the Banking (Foreign Exchange) Regulations and must meet, on a continuing basis, conditions set by the Bank relating to minimum capital, dealing and management resources and open-risk positions. For this market too, the Bank collects and publishes a range of information; and
  • in the longer-term (over one year) Commonwealth bond market, the Bank seeks to encourage a deep and efficient market by concentrating its own dealing with those companies which make the biggest contributions to market turnover. It does not supervise the affairs of individual companies but collects from these companies (the “Reporting Bond Dealers”), and publishes, a volume of market information.

Banking supervision[+]

Following the establishment of a large number of new banks in the previous year, 1986/87 was largely a year of consolidation of the Bank's supervisory work. Apart from regular consultations on the performance of individual banks and discussions on specific matters, arrangements were completed for external auditors to report on banks' observance of prudential standards and on other aspects of their operations. In May 1987, the Treasurer announced that the Bank's supervisory role would be given more explicit legislative backing.

Changes in the structure of banking

The structure of the Australian banking industry has changed rapidly in recent years. Between June 1984 and June 1987, the number of banks more than doubled; there are now 34 banking groups operating in Australia. Banks have had to work hard to maintain market share and profitability in the face of intensifying competition, both in Australia and abroad. Many banks, including new entrants, have turned increasingly to business involving off-balance-sheet financing.

The 16 new foreign-owned banks now operating in Australia have generally grown relatively slowly over the past year. The high degree of competition, both from the established banks and from new and established merchant banks, together with a relatively flat economy, served to inhibit their growth. Their combined capitalisation is about $2 billion, around 13 per cent of the aggregate capital of all trading banks. At end June 1987, aggregate assets of the new foreign-owned banks were around 11 per cent of all trading bank assets in Australia. However, because of their relatively heavy involvement in off-balance-sheet business, this measure of market share probably understates their penetration of the Australian banking scene.

In financing their business, the new foreign-owned banks have been relying more heavily on bill acceptances and foreign currency borrowings than have the established banks. At end June 1987 their Australian dollar deposits funded some 14 per cent of their total assets compared with about 44 per cent for all trading banks. The new foreign-owned banks attribute this disparity to strong competition from established banks and non-banks and to the SRD requirement on trading banks, which is an added factor making the average cost of deposits higher for those banks without an established core of lower-cost deposits. In its discussions with the new foreign-owned banks, the Bank has emphasised the desirability of diversifying their funding and developing a stable base of deposits in Australian dollars.

During the year, some banks expanded their operations through mergers and acquisitions. One trading bank established a savings bank subsidiary by purchasing the assets of a large building society. In July 1987, another trading bank acquired, as subsidiaries, several banks in the United Kingdom and Eire. The Primary Industry Bank of Australia (PIBA) was acquired by the Rural and Industries Bank of Western Australia. PIBA was granted a new authority in terms of the Banking Act, which allowed it to undertake a full range of banking business. A new savings bank was formed through the merger of two building societies. The Bank was satisfied with the prudential aspects of these transactions.

International exposures

International commitments of Australian banks are predominantly to borrowers in major industrialised countries. Exposures of the major banks to countries experiencing debt servicing problems, except in one case, do not exceed one per cent of their group assets. The Bank is encouraging banks to maintain adequate provisions against these loans.

Some banks which had made loans in foreign currency to Australian residents, particularly in the rural sector, became exposed to potential losses through the depreciation of the Australian dollar. Special provisions have been made against these exposures.

Off-balance-sheet business

Banks' off-balance-sheet business has grown rapidly in recent years and in aggregate is now around twice their combined balance sheets. A large proportion of this business represents outstandings in respect of forward foreign exchange contracts. However, newer types of off-balance-sheet business such as interest rate and currency swaps, options and forward rate agreements are becoming increasingly significant.

The Bank encourages banks to assess carefully the risks involved in the various facets of off-balance-sheet business. Each bank has provided the Bank with a written description of management systems used to measure and control risk associated with its business both on and off-balance-sheet. The Bank also receives regular information on each bank's off-balance-sheet business, including the bank's own assessment of its exposure to risk from these activities.

The Bank takes account of off-balance-sheet activities in its assessments of banks' capital adequacy.

Capital adequacy

During the year, requirements for bank capital were reviewed in the light of the rapidly changing financial environment. Increased competition, new instruments and activities and greater hazards in foreign currency business have added to the potential risks faced by banks. The Bank concluded that it was appropriate for banks generally to strengthen their capital positions. At the same time, the Bank widened the definition of capital to achieve a greater degree of consistency with practices in other countries.

Australian banks' capital is basically in Australian currency but their international business is mostly in foreign currencies. There are substantial barriers to raising multi-currency capital to underpin that business. Partly in recognition of this difficulty, the Bank agreed that banks may include a limited amount of carefully defined subordinated perpetual debt, which may be raised in foreign currencies, in the definition of capital for prudential purposes.

Under arrangements which came into effect in September 1986, trading banks established before 1981 have agreed to maintain minimum capital ratios in the vicinity of 6 per cent of total assets; this is about one percentage point higher than the previous minimum. Within total capital, shareholders' funds under the new, wider definition will bear a higher ratio to total assets than in the past. Trading banks established in or after 1981 continue to observe a minimum capital ratio of 6.5 per cent during their formative periods. One trading bank which was established in 1985 now meets the same minimum capital ratios as the longer-established banks.

Banks moved to meet the new requirements in a variety of ways. Increases in shareholders' funds during the year came mainly from internal sources. These may now include all formal revaluations of properties and general provisions as well as retained earnings, though profitability of most banks has been fairly subdued over the past year or so. New issues of equity and “capital stock”, an instrument which has many of the characteristics of irredeemable preference shares, were also used. Several banks raised substantial amounts of foreign currency subordinated perpetual debt in acceptable form.

The current approach to capital adequacy relates capital to total assets. This does not take account of differences in risk attaching to various classes of assets in a bank's portfolio nor of the risks associated with its off-balance-sheet transactions. There is growing support among supervisors in other countries for a “risk ratio” approach to the measurement of capital adequacy. This assigns risk weightings to the various categories of assets and off-balance-sheet business and then relates the aggregate assessed risk of the bank to its capital. The Bank is holding discussions with banks on technical aspects of moving to a “risk ratio” approach.

Proposed amendments to the Banking Act

The need for more formal powers of prudential supervision has risen with the increased number and variety of banks in Australia, and the more competitive banking environment following the introduction of new foreign-owned and domestic banks. In this changed banking environment, it is desirable to have a clear statutory basis for prudential supervision rather than relying on the informal arrangements that have operated successfully in the past.

All banking authorities granted since 1981 have required new banks to consult the Reserve Bank on prudential matters and to operate within prudential standards determined by the Bank. In May 1987, the Treasurer announced that the Government had decided to introduce amendments to the Banking Act which would make more explicit the Reserve Bank's powers in relation to the prudential supervision of banks subject to the Act.

The proposed changes will be in line with the recommendation of the Martin Group that the Reserve Bank be provided with explicit legal backing to its existing supervisory role, while still enabling as much flexibility and informality of administration as possible to be maintained.

Ownership and control of banks

The Banks (Shareholdings) Act limits the proportion of voting shares in a bank which may be held by an individual shareholder or group. Paralleling the question of ownership is that of control. During the year, the Bank issued a statement outlining its view that no single shareholder (or group of associated shareholders) of a bank should be in a position to exercise an undue measure of control or influence over the policies or operations of the bank. This reflected the belief that such arrangements contribute to the stability of banks and help to ensure that they are operated with due regard for the interests of depositors.

In keeping with this view, the Bank believes it is desirable that control of a bank should be in the hands of a board of directors which is proportionately representative of the shareholders as a whole. For example, the Bank expects that a shareholder (or group) which had an interest in up to 15 per cent of the voting shares in a bank, would be represented by no more than one person associated with the shareholder (or group) on a board consisting of up to six directors, and by no more than two such persons on a board consisting of seven or more directors.

Large credit exposures

During the year, the Bank took steps to strengthen its supervision of large exposures. In order that it have an opportunity to comment before a bank commits itself, the Bank has asked banks to give it prior notice of intention to enter into any exceptionally large credit exposure to an individual client or group of related clients. In all such cases, the Bank asks the bank concerned to show that the proposed exposure would not result in it undertaking excessive risk. During the year, the Bank reviewed with individual banks their involvement in the provision of some very large credit lines for the financing of takeovers of companies.

The Bank's concern is not with the creditworthiness of the exposure itself; that is a matter primarily for the commercial judgement of the lending bank. The Bank's interest is in the possible impact of such a transaction on the stability of the bank undertaking it should it prove to be a bad risk.

International supervisory co-operation

The increasingly international character of banking and the deregulation of financial systems are hastening the convergence of international supervisory standards. During the year, the Fourth International Conference of Banking Supervisors, in which the Reserve Bank participated, noted a need for improvements to the flow of information between supervisors and also a need for more uniform capital standards internationally, not only for prudential reasons but also to lessen competitive inequities arising from differences in national supervisory practices. The Conference endorsed the “risk ratio” approach as the preferred basis for measuring capital adequacy.

In January 1987, the Bank of England and U.S. Federal banking authorities announced agreement on a common “risk ratio” approach for the measurement of capital adequacy of banks in both countries. These proposals are currently being considered by banks and other interested parties in the United Kingdom and the United States. As indicated above, the Reserve Bank is also considering a move towards a “risk ratio” approach.

The Bank is a member of the SEANZA Forum of Banking Supervisors which draws its membership from South-East Asia, the Indian sub-continent, Japan, New Zealand and Australia. The Bank will host a meeting of the Forum in Sydney early in 1988.

Developments in the payments system

The Bank maintains a close interest in developments in the payments mechanism because of its importance in the efficient operation of the economy and also because of the part played in it by banks. A major development was the passing into law of the Cheques and Payments Orders Act in 1986. The Act, as well as revising and developing the law relating to cheques, makes provision for the inclusion in the payments mechanism of an instrument, the “payment order”, on the same basis as cheques. The major difference between the cheque and the payment order is that the former is drawn on a bank and the latter on an authorised non-bank financial intermediary. The non-banks are not subject to prudential supervision by the Reserve Bank. However, the Bank will take a close interest in arrangements entered into by banks and the authorised non-banks for the handling and presentation of payment orders. Payment orders will be cleared through the cheque-clearing system. Arrangements will continue whereby some non-bank financial intermediaries offer their customers facilities for drawing cheques on a bank account.

The Australian Payments System Council is primarily concerned with monitoring and aiding developments in the payments system. During 1986/87, the Council considered a range of issues associated with the continuing development of facilities for electronic funds transfers at point-of-sale, including security, technical standards and consumer protection. It also advised on the Cheques and Payments Orders Act.[*]


Details of the Bank's statements on supervisory matters are contained in a booklet entitled “Prudential Supervision of Banks” which is available from any branch of the Bank. [+]

More detailed accounts of the activities of the Council are available in its Annual Reports. [*]