Reserve Bank of Australia Annual Report – 1989 Financial System Surveillance

The Bank is responsible directly for the prudential supervision of banks. It also has a general concern for the stable and efficient operation of the wider financial system, including the clearing and payments systems which link financial institutions within Australia and with the rest of the world. During 1988/89, it brought these functions together, within a newly-established Financial System Division.

Most groups of financial institutions showed moderate to strong growth in 1988/89, reflecting buoyant demand for finance and related services. Returns on assets of major banks increased sharply in the first half of the year; the large inflow of funds to these banks in the period immediately after October 1987 provided a relatively stable, low-cost funding base for the expansion of lending. Performance of smaller banks was mixed, and profitability of some non-bank groups was below levels of a few years ago. All groups of lenders increased their provisions for bad and doubtful debts, some by substantial amounts.

In some important respects, the share-market crash of October 1987 continued to have an impact on the financial system during 1988/89. While the sharp fall in share prices did not impair the overall stability of the financial system, repercussions are still being felt by some individual firms. Several money market corporations and associated companies failed during the year; lenders, including banks, have had to absorb losses as a result. The Bank kept in close touch with these developments, in co-operation with other regulatory bodies including the National Companies and Securities Commission.

During 1988/89, the Bank introduced new guidelines to assess the capital adequacy of banks. The aftermath of October 1987 further underlined the need for adequate prudential operating standards among financial intermediaries. Financial institutions other than banks are also paying more regard to the risk profile of their assets in assessing capital adequacy; some States are preparing amendments to legislation to formalise a risk-based approach to setting the minimum capital of building societies.

An important regulatory change in 1988/89 was the removal of the Statutory Reserve Deposit (SRD) requirement on trading banks. Trading banks had been required to hold SRDs with the Reserve Bank equal to a specified ratio of their Australian deposit liabilities. In recent years, the ratio had been unchanged at 7 per cent and banks were paid interest on these deposits at the rate of 5 per cent per annum. Under legislation presently before Parliament (see below), all banks (including savings banks) will be required to hold non-callable deposits with the Bank, not exceeding 1 per cent of their total liabilities in Australia (excluding capital). For some, particularly the large established banks, the level of required non-callable deposits is far less than the funds which were held in SRDs; the excess will be returned to these banks over a transitional period. For others, the effect is to increase required balances. The new arrangements are being phased in and are expected to be fully in place by September 1991.

The SRD requirement distorted the composition of trading bank balance sheets. Australian deposits were subject to SRDs; other liabilities, such as bank bills and offshore borrowings, were not. It also gave a competitive advantage, in fund raising, to non-bank financial institutions which were outside the SRD provisions. One immediate effect of the decision to wind down SRDs and replace them with the more widely-based non-callable deposits was to reduce the incentive for banks to rely on non-deposit liabilities as a source of funds. After the changes were announced, banks financed almost all credit extended to customers by raising Australian deposits. They also directed a greater part of their borrowing and lending operations through their own balance sheets rather than through non-bank subsidiaries.

The Treasurer announced in August 1988 that the legislative distinction between trading and savings banks would be removed. The requirements applying to savings banks were different, in a number of respects, from those applying to trading banks. Savings banks were not subject to the SRD requirement; they were required to observe a Reserve Asset Ratio similar, though not identical, to the trading banks' Prime Asset Ratio requirement; and they were required to invest the bulk of their funds in government securities or housing and other loans secured by land. The need for this regulatory distinction had become less relevant in recent years: the separation added to banks' costs, and many banking groups were being managed as though the distinction had relevance only for statutory returns and annual accounts.

In advance of formal legislation to change the Banking Act, the Banking (Savings Banks) Regulations under that Act were amended to give savings banks somewhat greater operating discretion. Thus, the “free tranche”, i.e. the proportion of their deposits for which savings banks already had wide investment discretion, was raised from 6 per cent to 40 per cent of deposits.

Banking supervision

Banking supervision has two prime objectives: to protect the interests of bank depositors; and to safeguard the stability of the banking system as a whole. It seeks to ensure that each bank's business is conducted with integrity, prudence and professional skill. The banking system has a crucial role in the community's financial affairs; banks are expected to follow management practices which limit risks to levels consistent with this position.

The Bank monitors banks' observance of agreed prudential standards relating to such things as capital adequacy and large exposures. In conjunction with banks' external auditors, it seeks to ensure that they have effective internal management systems to control risk. It consults regularly with each bank to review all aspects of its operations.

Most Australian banks have a variety of subsidiaries to conduct particular types of business, e.g. insurance companies, merchant banks, and finance companies. Clearly, the interests of a bank's depositors and the stability of the financial system cannot be adequately addressed by monitoring only the bank itself. Sensible supervision must take account of the consolidated group of which the bank is a part. For some years, the Reserve Bank has been assessing capital adequacy on a consolidated basis. This has now been extended to monitoring of large exposures to clients or related groups of clients.

Capital adequacy

New guidelines for assessing capital adequacy of banks were introduced in August 1988. These were the result of extensive consultations with banks and with supervisors in other countries. The previous guidelines related a bank's capital base to its total balance sheet assets; the new approach relates capital to all exposures giving rise to credit risk, whether on- or off-balance sheet. It recognises broad differences in the degree of risk attaching to different categories of balance sheet assets and off-balance sheet exposures. Risk weightings are assigned to the various categories and the aggregated assessed risk of the bank is then related to its capital. The higher the aggregate risk, the greater the capital required.

The new guidelines are consistent in all substantial respects with the framework agreed during July 1988 by the Basle Supervisors' Committee of the Bank for International Settlements and endorsed by the Fifth International Conference of Banking Supervisors, in which the Bank participated. Some minor adjustments have been made to reflect Australian conditions. The Basle framework provides for such local discretion. For instance, there are two levels of risk weight for certain claims on another bank, differentiated according to whether the debtor bank is incorporated in an O.E.C.D. country. The Reserve Bank is prepared, on a case-by-case basis, to extend the preferential weight to some banks incorporated in non-O.E.C.D. countries in the Asia-Pacific area.

The Basle Committee proposed that banks should be required to have a minimum ratio of capital to risk-weighted assets of 8 per cent; at least half of this capital should be “core” capital, defined as equity and disclosed reserves. Given the disparate capital positions of banks from countries covered by the Basle Committee membership, December 1992 has been set as the date by which these standards should finally be met. All Australian banks currently meet the minimum core capital requirement on a consolidated basis and all but a few satisfy the 8 per cent capital ratio. Transitional arrangements have been agreed with those currently below the 8 per cent ratio, under which they will reach that minimum no later than June 1990.

Banks have already begun to adjust to the new capital guidelines. Many have raised additional capital, particularly through issues of term subordinated debt in forms acceptable to the Bank. Raisings in 1988/89 which met the Bank's criteria for inclusion in capital were about $6¼ billion. There were also large increases in capital from internal sources, i.e. retained earnings, asset revaluations, general provisions, and dividend re-investment schemes.

In the light of the new capital guidelines, the Bank reviewed the Prime Assets Ratio (PAR) requirement. This requirement obliges each bank to hold in specified assets (predominantly Commonwealth Government securities) a stated percentage of its total liabilities, excluding capital, used to fund assets in Australia. Following the review, the PAR requirement was reduced from 12 per cent to 10 per cent at the end of September 1988. At the same time, savings banks agreed to meet the new PAR requirement in place of the Reserve Asset Ratio requirement under which they had held 13 per cent of their deposits in a specified range of assets.

Amendments to the Banking Act

In May 1989, a Bill was introduced to Parliament to amend the Banking Act to make more explicit the Bank's powers to supervise banks.

When enacted, the amended legislation would allow the Bank's prudential requirements to be specified by Regulation, permit the Bank (or its agents) to conduct investigations of banks and strengthen the Bank's powers to obtain prudential information from banks. The Bank sees these as reserve powers. It prefers, as far as possible, to maintain flexibility and informality in its supervisory role.

The proposed legislation would also remove the distinction between trading and savings banks and the SRD provisions of the existing Act, and provide for non-callable deposits, as discussed above. At present, the latter are held by agreement with the various banks.

International supervisory co-operation

The Bank keeps in close touch with banking supervisors in countries where Australian banks operate or where parent banks of foreign-owned Australian banks are located. It also has regular contact with the Basle Supervisors' Committee and is a member of the SEANZA Forum of Banking Supervisors. The latter draws its membership from south and east Asia, the Indian sub-continent and New Zealand, as well as Australia.

During the year, the Bank completed a Memorandum of Understanding with the Securities and Investment Board (SIB) of the U.K., in conjunction with three Self-Regulatory Organisations. Its purpose was to avoid the need for Australian banks to establish separately-incorporated subsidiaries to conduct securities business in the U.K. and to remove some duplication of supervision of such business. The SIB has entered into similar arrangements with banking supervisors in some other countries.

Ownership of banks

A number of changes occurred in the ownership of Australian banks during 1988/89. In four banks, which were among the foreign banks authorised in 1985, Australian minority interests were acquired by the major foreign bank shareholders.

State Bank of Victoria (SBV) was granted an exemption under the Banks (Shareholdings) Act 1972 to allow it to acquire temporarily 100 per cent of the voting shares in Australian Bank Limited (ABL). The understanding was that SBV's holding in ABL would subsequently be reduced to not more than 10 per cent. The purpose of the acquisition was to facilitate the purchase by ABL of SBV's wholly-owned merchant bank subsidiary, Tricontinental Holdings Limited. As that purchase is not to proceed, the Bank is reviewing with SBV the options for dealing with its ownership of ABL.

Metway Bank Limited began business in July 1988 following its conversion from the Queensland-based Metropolitan Permanent Building Society. In July 1989, Bank of Melbourne Limited commenced business following its conversion from the Victoria-based RESI-Statewide Building Society.

Other financial intermediaries

While the primary focus of the Bank's supervision is on banks, its concern for the efficiency and stability of the financial system as a whole leads it to take an interest in the structure and activities of non-bank intermediaries as well. In this, it does not seek to apply prudential standards as it does for banks, except where non-bank entities which are owned by banks fall within the consolidated supervision of their parents. However, the Bank does have particular responsibilities for operations in two specialised financial markets — the market for foreign exchange (see the preceding chapter) and the short-term money market.

The Bank supervises the activities of, and provides banking facilities to, authorised dealers in the short-term money market. The number of authorised dealers was reduced to eight in May 1989 when arrangements with First Federation Discount Limited were withdrawn. The company had ceased trading activities after its parent was placed in receivership in April. Also in May, the basis of the line of credit facility provided to authorised dealers by the Bank was altered from loans against Commonwealth Government securities to repurchase agreements based on those securities. At the same time, dealers' minimum capital requirements were increased.

The Bank has no other formal supervisory responsibilities for non-bank financial institutions. In the case of co-operatives, such as building societies and credit unions, this responsibility rests with State authorities. Other intermediaries operate under State and Commonwealth companies legislation.

Over the past couple of years, the Bank has expanded its contacts with State regulators and supervisors as well as with other Commonwealth authorities, including the National Companies and Securities Commission. It has regular discussions with senior management of a wide range of financial intermediaries and industry associations. These meetings have been particularly useful in helping the Bank to a better understanding of developments in the financial system and to assess problems which might be faced by intermediaries and their implications for financial system stability. The Bank very much appreciates the ready co-operation and assistance of the institutions and authorities concerned.

Payments systems

The Bank continues to be closely involved with developments in payments systems.

Its overriding interest is in efficient and competitive systems which enable the community to make payments securely, promptly and at low cost. This implies that close attention has to be paid to liquidity and credit risks of various kinds. Systems also need to keep pace with rising demand for payment services.

The Bank's interest in these areas is pursued in a number of ways: directly with the bodies using or controlling the various payments arrangements; through the Australian Payments System Council which is chaired by a senior officer of the Bank; and through other committees or task forces established from time to time for particular purposes. At present it is represented on a task force reviewing the operation of banks' clearing arrangements and some related issues.

Overseas, increased attention to clearing and settlement practices and standards in all financial markets was highlighted by a “Group of Thirty” Report which emphasised the value of common international standards for securities markets. The Report argued that these standards should encompass prompt matching of trades followed soon after by settlement, with simultaneous delivery and payment. It favoured development of central securities registries with broadest possible participation. The Bank's proposed new system for trading in Commonwealth Government securities (see page 40) and the existing Austraclear system covering other securities are broadly within the Group of Thirty's recommended standards.

Consumer issues

The Bank was a member of the Commonwealth-State Working Group on Consumer Financial Services which submitted its Report to the Commonwealth Government in June 1989, and it participated in a Commonwealth committee which reviewed the code of conduct for intermediaries providing electronic funds transfer services at the retail level. It also maintains informal contact with consumer groups and State and Commonwealth consumer affairs departments.

Over recent years, there has been a substantial increase in the range of financial services available to customers of financial intermediaries. That has undoubtedly benefited the community in general. However, the array of services, and the terms and conditions under which they are offered, can be confusing. This puts a heavy responsibility on the providers of financial services — banks and other intermediaries — to disclose fully and clearly their nature and the conditions attaching to them. Customers have a right to this information and to be made aware promptly of variations in interest rates and other charges, or in any other rights and obligations they might incur. The full benefit of deregulation for consumers of financial services cannot be realised without these elements.

Handling the nation's savings and payments is a very sensitive activity. Given the high volume of transactions, it is not surprising that disputes and complaints arise from time to time. The volume of disputes and complaints seems to have risen with the greater use of automated processes (through ATMs, EFTPOS, etc.). Equally, there has been some public dissatisfaction with the way complaints are handled. The Bank has encouraged banks to have well-defined procedures for settling disputes and to ensure that complaints are dealt with promptly and fairly. It welcomes the decision of the Australian Bankers' Association to establish an independent industry-based ombudsman.

The Bank sees advantage in moving towards nationally uniform credit legislation, currently being considered by the Standing Committee of (Commonwealth and State) Consumer Affairs Ministers. The issues involved were a major focus of the Commonwealth-State Working Group on Consumer Financial Services (see above). Consistency among States in consumer credit legislation would, of itself, be a valuable contribution to efficiency in financial markets. There would be further benefit if changes were made to allow more flexibility in design and pricing of financial services while improving standards of disclosure.

It needs to be recognised that there are costs involved in protecting consumer interests, both in monetary terms and also in terms of flexibility and efficiency of the financial system. In the final analysis, these costs will be borne by the users of the various services. It is important that the costs be identified so the community can judge whether they are worth paying.