Reserve Bank of Australia Annual Report – 1997 Surveillance of the Financial System

The Bank conducts a range of policies concerned with the stability of Australia's financial system, with the goal of reducing the likelihood of financial shocks and strengthening the system's resilience. These responsibilities are exercised by supervising each bank with an authority to conduct business in Australia, by close involvement in the payments and settlement system, and by co-ordination with other financial regulators to promote the general soundness of the financial system.

Bank Supervision

The Australian banking sector did not experience any significant difficulties in 1996/97. In this environment, the Bank's supervisory efforts concentrated on detecting any early signs of weaknesses in credit standards and on further improvements to the supervisory framework. Work associated with the Financial System Inquiry (the Wallis Committee) also absorbed considerable resources.

Financial System Inquiry

The Bank welcomed the Government's decision to hold an inquiry into the Australian financial system and provided a detailed submission to the Wallis Committee in September 1996. This submission contained an assessment of key trends in the financial system to help the Committee in its consideration of where the structure of the system may be heading; a description of the present regulatory structure and an assessment of its strengths and weaknesses; an analysis of the main issues in the future development of Australia's payments system; and information on international regulatory practice.

In its submission, the Bank emphasised that the public dealing with financial institutions faces two distinct types of risk, which call for different approaches to regulation. The first risk arises where an institution offering a product promises to repay funds in full on demand or on maturity (for example, bank deposits and some insurance products). Institutions offering such products are candidates for prudential supervision because their ability to honour the promises depends on their continuing solvency. The second type of risk is associated with investment products where an institution manages the public's funds on a ‘best endeavours’ basis; here the investor, not the institution, bears the risk of a fall in the value of the investment. These products need to be regulated through disclosure to the public of the nature of the risks being taken.

The submission also addressed the issue of whether bank supervision should be carried out in the central bank or by a separate authority. The Bank's strong view was that bank supervision should remain in the central bank because there were major synergies between monetary policy, financial system stability and bank supervision. If it were segregated, there would be difficulties in drawing the line between responsibility for financial system stability and responsibility for bank supervision. There would probably be duplication and/or difficulty in co-ordination between regulators if there were a need to act because a bank failure was imminent.

In January 1997, the Bank made a supplementary submission which set out how it saw the financial system developing over the next ten years; discussed the implications of technology, financial innovation and the entry of new competitors; and considered alternative approaches to achieving depositor protection. These issues had been highlighted in the Committee's discussion paper published the previous November.

The Wallis Report was released in April 1997. In its initial response, the Government agreed to the recommendation to abolish the ‘six pillars’ policy which, since 1990, had imposed a blanket ban on mergers between the four major banks and the two largest life offices. The Government also made clear that it would not permit mergers among the four big banks at this time, but would review this issue when satisfied that competition in the financial system had increased sufficiently. The Government also announced the removal of the blanket prohibition on a foreign takeover of any of the major banks. Any such proposal will in future be assessed on its merits, but against the Government's view that a large-scale transfer of Australian ownership of the financial sector to foreign hands would be contrary to the national interest.

Other recommendations in the Wallis Report aim to increase competition by reducing barriers to entry to the banking and payments system, and propose far-reaching changes to the design of Australia's regulatory system, including the establishment of a single prudential supervisor for deposit-takers, insurance companies and superannuation funds. The Government will be responding to these recommendations over coming months.

Approach to supervision

During 1996/97, the Bank's supervisory emphasis continued to shift towards greater reliance on banks' own risk management systems, provided these systems meet certain objective requirements. The major examples, discussed in more detail below, were:

  • adjustments to capital adequacy standards, announced in January 1997, which allow banks to use their own risk measurement models to calculate capital requirements for market risk in their trading portfolios;
  • reforms announced in May 1997 which make boards and chief executives of banks clearly accountable to the Bank for the identification, measurement, management and control of key risks facing their institutions; and
  • changes to liquidity arrangements in June 1997 involving a reduction in the Prime Assets Requirement (PAR) of banks, counterbalanced by a greater reliance by the Bank on the liquidity management systems used by individual banks.


Capital provides an essential buffer to absorb losses that might arise in a banking business. Monitoring banks' capital positions is therefore a key task of bank supervisors. Since the 1988 Capital Accord, there has been a uniform approach internationally to calculating capital ratios and an acceptance that such ratios should not fall below eight per cent. All Australian banks comfortably meet this requirement. The aggregate risk-weighted capital ratio for Australian banks reached a peak of just over 12 per cent around the end of 1994 as banks repaired balance sheets weakened by the recession. More recently, banks have judged that capital ratios well above the minimum requirement were inconsistent with maximising returns on shareholders' funds and they have become more active in managing their capital positions. The aggregate ratio has fallen to a little above 10 per cent as banks have expended capital on acquisitions, introduced schemes for buying back shares in the market and enjoyed stronger asset growth. The Bank consults closely with any bank which proposes a capital reduction to ensure that its ability to comply with the minimum capital ratio is not prejudiced over the longer run.

Graph showing Banks' risk-weighted capital ratio – Average of all banks

Market risk

A major reform of the Capital Accord will become effective from the beginning of 1998, when capital requirements will be adjusted to capture market risk on banks' trading activities, that is, the risk of losses as a result of movements in interest rates, equity prices, exchange rates or commodity prices. The new guidelines are the product of consultation between banking supervisors and banks, domestically and internationally, over several years, under the aegis of the Basle Committee on Banking Supervision. The guidelines for Australian banks were issued as Prudential Statement C3 in January 1997. Their key feature is the scope for banks to use their own risk measurement models in the calculation of capital requirements, provided these models are technically sound and the broader risk management environment in which they are used meets stringent tests. The recent losses in derivatives activities experienced in the United Kingdom by National Westminster Bank are further testament to the consequences of inadequate risk control systems.

Each bank wishing to use its own risk measurement model for calculating capital must have that model recognised by the Bank. Some 10 to 12 banks plan to seek ‘internal model status’ by early 1998. The Bank's supervision staff will visit the trading operations of each of these banks to assess the adequacy of the models and the risk management environment. These visits will be complementary to the program of on-site reviews of market risk management, which began in 1994 and involved 18 visits to banks in 1996/97. The Bank's aim is to assess each bank's systems at least once every two years.

Credit risk

The Bank's other program of on-site reviews covers banks' systems for managing credit risk. These visits are designed to test that such systems meet acceptable standards and are being used effectively; they also provide opportunities to discuss, with specialist bank staff, where pressures in lending markets might be emerging. During 1996/97, 20 credit risk visits to banks were made.

Graph showing Banks' total impaired assets

Impaired assets of banks continued to decline in 1996/97, a reflection partly of the strict lending criteria imposed by banks in the wake of their asset quality problems in the early 1990s. It is the quality of loans being made now, however, which will determine the future scale of problem assets. Anecdotal evidence points to some lowering of lending standards in the past year or so, as competition for new business has whittled away interest margins and led to less onerous conditions on borrowers. Measuring lending standards is a more complex task than measuring the level of bad loans. In the housing and personal loan markets, simplistic measures such as loan-to-valuation ratios and comparisons between loan repayments and income can be used to assess standards. However, as loans increase in size, the range and complexity of loan conditions also increases and their appropriateness differs from loan to loan. While it is difficult to reach firm judgments, the Bank believes that some current lending practices do risk sowing the seeds of future credit quality problems, and it has cautioned banks to be conscious of this possibility.

External auditors

In May 1997, the Bank announced changes in its relationship with banks and their external auditors which provide a further discipline on risk management systems. Rather than looking to the external auditor for a general assurance about the systems operating in a bank, the Bank will now receive an annual attestation from the chief executive, endorsed by the board, that risks have been identified, systems designed to manage those risks are adequate and working effectively, and the descriptions of these systems held by the Bank are current.

The external auditors retain their responsibility to provide the Bank with assurances about each bank's observance of prudential requirements and about the reliability of information it provides. In addition, each year external auditors will review a particular area of banks' operations. In 1997, the focus is the systems used to keep a bank's chief executive, board committees and board informed about the management of credit, market, liquidity and operational risk. The auditors are expected to comment on matters such as:

  • the frequency and timeliness of the relevant information flows;
  • processes in place to check the accuracy and integrity of that information; and
  • the usefulness of the relevant reports for monitoring compliance with the bank's risk management policies.

Liquidity management

The PAR arrangements have required banks to hold a minimum level of Commonwealth Government securities, notes and coin and balances with the Bank. It was becoming clear that these arrangements could become the source of market tensions in coming years as the supply of Commonwealth Government securities diminishes. A similar problem had arisen in the late 1980s when the Government budget last moved into surplus; at that time the Bank reduced the minimum PAR ratio from 12 per cent of banks' liabilities (excluding capital) to 6 per cent. On this occasion (June 1997), the ratio was reduced to 3 per cent and the range of eligible assets widened to include Australian dollar-denominated securities issued by the central borrowing authorities of State and Territory Governments.

Prime assets are a source of liquidity for banks in an emergency. The reduction in the PAR ratio did not reflect any lessening in the need for a bank to be prepared for a run on liquidity; the PAR arrangements form only one element of liquidity management. As part of its annual cycle of consultations, the Bank discusses with banks their plans for meeting predictable day-to-day needs for liquidity, as well as for handling unexpected strains on their cash flows. The Bank will be placing greater emphasis on banks' internal management practices; in some cases, the Bank may require a bank to hold liquid assets (more broadly defined than for PAR) in excess of the PAR ratio. Its assessments will also take into account how banks manage their liabilities, including maturity structure, the wholesale/retail split and access to international markets.

Year 2000 problem

In addition to the risks discussed above, banks face a range of operational risks, many of which stem from increasing reliance on computers for customer servicing, information processing and control. One risk of growing prominence is the so-called ‘Year 2000 problem’, which arises from the fact that much computer software and hardware uses only two digits to represent calendar years (e.g. 97 for 1997) and will not be able to recognise the change to the new century. If not addressed, the consequence would be incorrect calculations and comparisons, destruction of data and the potential for serious disruption to the financial system. The Bank has sought assurances from Australian banks that they are giving the Year 2000 problem the high priority it warrants. Banks have been asked to complete a questionnaire on their progress in identifying the size of the problem for their operations, in drawing up a management program to fix the problem and in assigning the necessary resources. Banks will also need to ensure that their major customers are taking the appropriate corrective actions.

Institutional developments

Australia has 50 authorised banks, little changed from the previous year.

Authorised banks in Australia
August 1996 1997
Banks of which: 52 50
– Domestically owned 20 17
– Foreign-owned 32 33
locally incorporated 13 12
branches 19 21

During 1996/97, banking authorities were granted to the German bank, West LB, and to the Royal Bank of Canada to operate as foreign bank branches. The banking authorities of Bank SA, Challenge Bank and St George Partnership Bank were relinquished as a result of mergers, and that of Bank of Singapore following the transfer of business to a branch of the parent, the Oversea-Chinese Banking Corporation. The Australian branch of Bank of New Zealand will soon relinquish its authority following the transfer of all business to the National Australia Bank.

The takeovers of the Queensland Industry Development Corporation and Suncorp by Metway Bank, and Advance Bank by St George Bank, were consummated in 1996/97. ABN AMRO bought Lloyds Bank NZA, the Australian banking subsidiary of National Bank of New Zealand. Westpac's bid for Bank of Melbourne received official clearance in July 1997, and will be considered by Bank of Melbourne shareholders in September.

Legislation was enacted in the Tasmanian Parliament in 1996/97 to enable the corporatisation and eventual privatisation of Trust Bank.

Other Financial Institutions

Apart from banks, the Bank's only other direct supervisory responsibility is for authorising and overseeing foreign exchange dealers in Australia. At 30 June 1997, there were 73 authorised dealers, the same number as a year ago. The Bank meets regularly with ACI Australia (formerly the Australian Forex Association) to exchange information, discuss matters of mutual interest and keep abreast of issues relevant to the market from the participants' point of view. The Wallis Report agreed with the Bank's suggestion that the separate authorisation of foreign exchange dealers by the Bank should be discontinued.

Payments System

Real-time gross settlement

The Bank has been working with the finance industry over recent years to introduce ‘real-time’ settlement in the payments system. This important reform will make the system safer, more efficient and more competitive, and bring it into line with international best practice.

Under the current system of ‘deferred settlement’, each member of the payments system accumulates the various cheques and other payments received during the day, and it is only on the next day that the net balances are finally settled, using Exchange Settlement Accounts at the Bank. In the unlikely event that a member of the payments system was unable to meet its payments obligations, other members could face serious losses and many of the payments made on the previous day would be thrown into doubt. The problem could become serious enough to cause widespread financial disruption. The risks to the financial system are remote but the amounts involved are large. The total value of payments made between banks each day in Australia is a little over $90 billion, around 20 per cent of annual GDP.

The problem arises because there is a one-day delay built into the settlement system. To reduce this settlement risk, large payments will be settled individually, as they are made, in ‘real time’; hence the new system is called a real-time gross settlement (RTGS) system. High-value payments will be fed into the RTGS system continuously throughout the day, and each member operating in this system must have sufficient funds in its Exchange Settlement Account to meet payment obligations as they are processed. This new system has the great advantage that any problem would be quickly identified, before it could cumulate into a system-wide problem. It will improve the safety of the payments system and make it easier to achieve delivery-versus-payment in financial markets.

Real-time settlement already exists for some limited transactions between banks. The aim is to extend this further, giving priority to high-value payments, where the largest risks arise. These will include payments to settle trades in Commonwealth, State and private sector securities, the Australian dollar leg of foreign exchange transactions and large corporate payments. Large-value payments currently made by cheques, including bank cheques, and direct entry systems will be encouraged to migrate to the RTGS system. When RTGS is fully operational, planned for April 1998, around two-thirds of the total amount of interbank settlement risk will have been eliminated.

The project is a complex and ambitious one, and has required a large commitment of the Bank's resources and extensive co-ordination with the banking and finance industry. Within the Bank, the project has been managed by a Policy Board chaired by a Deputy Governor and involving several of the Bank's most senior officers. More than 50 Bank staff, from most of the Bank's functional areas, have worked on the project.

Implementing RTGS has involved the co-ordination of a variety of payment and securities settlement systems. To form the core of the new system, the Bank has built on the Reserve Bank Information and Transfer System (RITS), its existing system for settlement of Commonwealth Government securities. The Bank has also worked closely with Austraclear on securities settlements and with the Australian Payments Clearing Association, whose members will use a commercial financial message service (SWIFT, which has become, worldwide, the standard channel for international financial transactions) to deliver payments to the system. The Bank has also consulted the Australian Financial Markets Association on changes to dealing arrangements and system liquidity management. These changes were discussed earlier in ‘Operations in Financial Markets’. Aspects of this work have been co-ordinated through a Cross-Project Steering Committee chaired by one of the Bank's Deputy Governors.

This project has also required members of the payments system to make substantial commitments to upgrading their own systems. In particular, RTGS will require participants to have much more detailed control over their within-day liquidity. One important element of the project has been to ensure that all those involved are familiar with the demands which the RTGS system will place on them. Since July, when the core of the new system began operating, members of the payments system have been able to see the effect that transactions sent to the RTGS system would have had on their Exchange Settlement Accounts if they had been posted in real time, although settlement continues to take place the following morning. This ‘dry run’ or shadow system allows members of the payments system to understand their intraday payments patterns and likely liquidity requirements of operating in an RTGS environment.

The core development work for the new system has been completed and tested and some elements have begun to operate; the remaining parts will do so over the course of 1997. All of the relevant transactions are expected to have moved to the new system by February 1998. Limits will then be placed on the settlement exposures that can be generated. These limits will be progressively lowered; by April 1998, members of the payments system will be expected to run their shadow positions continuously in credit. Once that point has been reached, high-value payments between banks will be processed and settled in real time.

While the new system will require banks to keep their Exchange Settlement Accounts in credit in the face of a continuing flow of transactions, the system does include a number of features designed to help participants to manage their payments flows more easily. The Bank will provide a facility whereby members of the payments system can obtain liquidity during the day through repurchase transactions in eligible securities. Banks may use securities held to satisfy their PAR ratio in this way, provided they restore their PAR holdings by the end of the day. These transactions will not incur any interest charges and may be undertaken at the banks' discretion or by using an automatic facility.

The Government is considering legislative changes needed to underpin RTGS and other payments system reforms. The most important of these will remove the risk that RTGS could be rendered void by a ‘zero hour’ ruling that would date the insolvency of a bank from the midnight before it was declared. A number of other countries have introduced similar legislation to support their RTGS systems.

An important element in the process of introducing RTGS has been explaining to banks and their customers the background to the system and its likely impact on their operations. Senior Bank staff have spoken on these matters at a number of conferences and meetings, including some organised by the Australian Society of Corporate Treasurers, the Securities Institute, the Custodial Services Group and the International Banks and Securities Association.

The new system will not only strengthen the safety of the payments system; it also opens opportunities for more efficient payments by allowing customers the potential to arrange final payments to coincide exactly with critical points of their own transactions. An important change is that all institutions with Exchange Settlement Accounts will be able to provide real-time high-value electronic payments to their customers – in the past, this business has been dominated by a small number of large banks, and smaller banks have had to rely on agency arrangements with larger banks. All banks will now be able to compete on an equal basis for this business. The result should be more competition, better service and keener pricing for users of high-value payments services.

RTGS Cross-Project Steering Committee meeting, chaired by Deputy Governor Graeme Thompson and comprising representatives of the payments industry
RTGS Cross-Project Steering Committee meeting, chaired by Deputy Governor Graeme Thompson and comprising representatives of the payments industry

International payment and settlement system linkages

The introduction of RTGS will eliminate the risks arising because of the delay between clearing and settlement of high-value Australian dollar payments between banks. Similar risks arise in foreign exchange transactions, mainly because they are settled as two separate payments in their respective domestic payment systems, usually many hours apart. This gives rise to the risk that one party to a foreign exchange transaction will pay the currency it sold but not receive the currency it bought, because of the intervening failure of the counterparty. The Bank is encouraging Australian banks to achieve efficiencies in their foreign exchange settlements, including their arrangements with correspondent banks, so as to reduce the length of time they are exposed to such settlement risk. The Bank has recently surveyed a number of foreign exchange dealers in Australia, both banks and non-banks, about their foreign exchange settlement practices; the information provided will help to identify ‘best practice’ in this area.

The Bank is supporting a proposed amendment to the Corporations Law, drafted by the Companies and Securities Advisory Committee, intended to remove doubts as to whether the netting of transactions would be legally enforceable. This amendment would allow banks, with legal certainty, to offset obligations arising from their foreign exchange dealings, significantly reducing the magnitude of settlement risk. Demonstrating legal enforceability is also a precondition for a bank's admission to ECHO, a private sector company based in the United Kingdom providing an infrastructure for netting foreign exchange transactions. Two of the major Australian banks have formally signalled their intention to join ECHO once the necessary legal framework is in place. During the past year, the Bank provided facilities for representatives of ECHO and FXNet, another UK company providing netting services, to inform the Australian markets about their products.

A group of major international banks (the so-called G20) is developing a proposal for simultaneous, or near simultaneous, settlement of foreign exchange transactions across countries, to address the problem of different time zones. The G20 and the next tier of banks (the G40), which includes the major Australian banks, have also been discussing the pooling of resources on this project. An RTGS system for high-value payments is a prerequisite to participating in international solutions to foreign exchange settlement risk.

The Bank is building closer international links in securities settlement arrangements with the announcement by the Hong Kong Monetary Authority and the Bank, in April 1997, that the Central Moneymarkets Unit in Hong Kong will join RITS. This will facilitate cross-border settlement of transactions in money market and debt securities and provide the basis for exploring further reciprocal arrangements.

Supervisory Co-ordination

The Bank works closely with other agencies involved in the supervision of the financial system to ensure that it is able to carry out its broad responsibilities for financial system stability.

The focal point of high-level co-ordination is the Council of Financial Supervisors, which the Governor chairs. The other members are the Australian Securities Commission (ASC), the Insurance and Superannuation Commission (ISC) and the Australian Financial Institutions Commission (AFIC); together, these four main regulatory bodies oversee institutions managing about 97 per cent of financial system assets in Australia.

The Council has sponsored legislative amendments to facilitate information-sharing among its members, and, where appropriate, with other bodies such as overseas supervisory agencies. These amendments were passed in June 1997. They provide the basis, in particular, for a co-ordinated approach to supervising financial conglomerates. The Bank and the ISC, with Council endorsement, have developed proposals which would allow special-purpose holding companies to own financial institutions such as banks and insurance companies, subject to controls on the ownership of the holding company and the provision of access to group information. Under this approach one agency would act as ‘convenor’ or lead regulator for a financial conglomerate. The Wallis Report also recommended acceptance of holding company structures.

Co-operation with law enforcement agencies on matters connected with the Australian financial system is also a priority. The Bank is a member of the Australian Co-ordinating Committee of the Financial Action Task Force. Australia's anti-money laundering efforts received a favourable report from a team of international experts organised by the Financial Action Task Force, following a visit late in 1996. In addition, assistance was provided in the preparation of a report, for the Commonwealth Law Enforcement Board, on the development and law enforcement implications of electronic commerce. The Bank also contributed to the formation, in February 1997, of the Asia-Pacific Group on Money Laundering with initial membership of thirteen regional countries.

The Bank maintains extensive contacts with users as well as providers of payments and banking services. This is achieved through the Australian Payments System Council, which the Bank chairs, and through direct relationships with consumer and business organisations. The Bank is on the board of the Australian Banking Industry Ombudsman Scheme and of Tradegate ECA, an industry body promoting electronic commerce.

Internationally, close contact has been maintained with the Joint Forum on Financial Conglomerates, a group established in 1996 by the Basle Committee on Banking Supervision, in conjunction with the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors, to address regulatory problems posed by the emergence of large financial conglomerates. The Joint Forum met in Sydney in April 1997.

On a broader front, links with overseas bank supervisors and with the Basle Committee remain strong. During the past year, the Bank attended three meetings of a bank supervision study group formed by EMEAP (Executive Meeting of East Asia and Pacific Central Banks) and hosted a seminar on market risk for EMEAP countries in June 1997. The Bank has also participated in the payments activities of EMEAP and of the Committee on Payment and Settlement Systems at the Bank for International Settlements (BIS). It has been active in a joint BIS/IOSCO project to develop a disclosure framework for securities settlement systems. This culminated in the publication, in March 1997, of a questionnaire for system operators to complete and make public, with the aim of ensuring that participants understand fully the risks involved.

A program of secondments continued during the year, with staff placed with the Bank of England, the International Monetary Fund and AFIC, while an officer from the ISC was employed at the Bank.

Legal actions – Farrow group

The Bank had been drawn into a number of legal actions arising from the failure in 1990 of the Farrow group of companies, including Pyramid Building Society. It was a defendant or third-party defendant in various actions seeking recovery of losses by investors in the group. The Victorian Government had also initiated claims against the Bank seeking indemnity for claims from depositors and non-withdrawable shareholders of the Farrow group, as well as damages and costs. For reasons outlined in earlier Annual Reports, the Bank believed these actions were without foundation and intended to defend them. It had not been prudential supervisor of any companies in the group.

Late in 1996/97, the Victorian Government withdrew its action against the Bank; the other actions have also been withdrawn. There have been no findings of any liability against the Bank. Nor has the Bank made payment toward any settlement of these cases.