Submission to the Financial System Inquiry 4. Assessment of Prudential Supervision Arrangements

Introduction

92. Since deregulation, the Australian financial system has been marked by expansion and innovation. It is much more sophisticated and open than systems in many larger countries. Take-up of new technology in payments and other areas has been rapid. Competition has been very strong in wholesale financial markets, and has been intensifying at the retail end more recently. At the same time, the financial system is sound and has a high level of community confidence. It suffered some instability early in the 1990s, but less than was experienced in many other countries at the same time. The recovery from that period of weakness has been quite rapid.
93. Against that background, several criticisms have been made of prudential supervision in recent times. These seem to be not so much about the quality of supervision as about whether it is organised efficiently or whether it is distorting competition. This Chapter examines some of those criticisms.

‘The supervisory system is out-of-date’

94. It is sometimes asserted that prudential supervision arrangements have fallen behind developments in the market. To some extent at least that will always be the case, and is no more than an indicator of the pace of financial innovation. It is, in fact, no bad thing that supervisory arrangements should be one (small) step behind the market, not so much in terms of understanding developments but in reacting to them. In the absence of perfect foresight, any attempt by supervisors to be pre-emptive risks inhibiting innovation and efficiency.
95. The RBA would reject any suggestion, however, that prudential arrangements have not evolved with the rapid change in Australia's financial system. Although the present regulatory structure is relatively young, there has already been considerable rationalisation and updating in the past decade. The RBA's Bank Supervision Department was established in 1984. The ISC was created from four separate regulators in 1987. The ASC took over from the previous Federal and State regulators in 1991, and AFIC was established to administer the Financial Institutions Scheme in 1992. Concurrently, the supervision of the major financial sectors has been enhanced. Meanwhile, reviews of the regulation of collective investments, friendly societies, trustee companies and derivatives markets are in train.
96. The most significant recent step has been the creation of the Council of Financial Supervisors in 1992 to formalise high-level liaison and co-ordination among the main agencies. This will be an increasingly important player, both for harmonising supervisory requirements and in the oversight of financial conglomerates. Building on a policy framework recently devised by the CFS for holding company structures, more formal lead regulator arrangements will be developed for all conglomerates.
97. In the RBA's area, there has been major evolution over recent years in the methods used in bank supervision, in response both to the increasing complexity in banking and lessons learnt from problems in the late 1980s. Capital adequacy standards covering banks' credit risks on and off balance sheet were introduced internationally in 1988. By the end of 1997 these standards will have been extended to cover market risks. The new standards have been developed with extensive industry consultation, internationally and domestically, to ensure that they are both relevant to banks' own risk management and consistent with the objective of minimising regulatory burdens. A key aspect is the ‘internal model option’ which allows banks to use their risk management systems for generating a regulatory capital charge (subject to their satisfying a number of qualitative and quantitative requirements). The RBA expects that, in future, other supervisory requirements will be based more on banks' internal systems, and will focus more on economic concepts of risk and capital.
98. This theme of evolution is also illustrated in the development of the RBA's credit and market risk visits, which commenced in 1992 and 1994, respectively. While other overseas supervisors had engaged in detailed examinations of banks' operations, the RBA was one of the first to recognise the value of targeted, high level visits to assess (and develop benchmarks for) risk management systems and methodologies. These are likely to be both more effective and less intrusive than prescriptive, rule-based supervisory methods. A number of overseas supervisory agencies, including the Bank of England and the US Federal Reserve, are now emphasising programs similar to those conducted by the RBA in their on-site work. These and other recent prudential standards – such as on securitisation and funds management – reflect the RBA's aim of finding an appropriate balance between supervisory vigilance and minimum interference with the freedom of banks to be innovative and efficient.

‘Everything is Blurring’

99. It has been asserted that a blurring of distinctions between financial institutions and products effectively undermines the current institutional focus of prudential supervision. Some of these issues were addressed in Chapter 2. In the RBA's view:
    • a valid distinction can be drawn between two broad categories of financial product – those which are ‘deposit like’ and those where the return is linked to the performance of a specified pool of assets. It is this basic distinction which establishes the need for different supervisory approaches to be applied to the different institutions offering these products; and
    • there has been some crossing over of products between the different types of institutions and some new finance providers have challenged traditional market boundaries. But that process is far from complete. Such innovations, nonetheless, can have implications for product regulation. The community presumably wishes to have the same information provided by all suppliers of products which are close substitutes – to assist with choice – and to have similar avenues of redress for complaints about poor service regardless of source. But these innovations do not have any automatic consequences for prudential supervision, which is concerned with institutional viability and financial system stability.
100. Under what circumstances might blurring in the latter, more narrow, sense have consequences for prudential supervision? First, the advent of new competitors in similar products could prompt a re-evaluation of the supervision requirements for established firms. It may be that there is a case to reassess the balance which has been struck between the costs (including effects on competitiveness) and the benefits of that supervision. This balance must periodically be reviewed by relevant supervisors, with any competitive impacts being one factor taken into account. Second, where the general activities of new providers raise the same concerns – for either the protection of investors' funds or for financial system stability – which motivate supervision of established firms, they should come under broadly equivalent prudential standards.
101. Are prudential supervision arrangements in Australia applied unevenly to similar activities which pose similar risks?

Credit institutions

102. The main deposit-takers are banks, building societies and credit unions. The RBA's prudential supervision of banks is very similar to AFIC's for the latter two groups, both being built substantially on the capital standards developed by the Basle Committee on Banking Supervision, with only minor variations in asset risk-weights. The main differences in supervision relate to ownership rules, prime purpose requirements and supervisory style which largely reflect the community-based origins, narrower scope and smaller size of the AFIC institutions. Some studies have also highlighted the additional costs involved in supervising building societies and credit unions because of its State-based structure, which involves some duplication of resources.
103. Merchant banks borrow in wholesale markets and are not subject to prudential supervision in their own right. Most are subsidiaries of foreign banks and are supervised indirectly on a global consolidated basis by their ‘home’ bank supervisor. They do not therefore have to observe local capital requirements, large exposure limits and PAR or lodge non-callable deposits with the RBA. On the other hand, they do not enjoy some of the advantages of branch status or direct access to the payments system. The fact that some such institutions have chosen to apply for a banking authority, while others who would qualify have chosen not to, suggests that the competitive advantages in the two categories are finely balanced and the net outcome depends a good deal on individual circumstances. (These institutions are discussed further in Chapter 5.)

Deposit-takers and life insurance companies

104. Banks (and other deposit-takers) and life insurance companies are both subject to capital adequacy rules, but these are constructed quite differently. In large part, however, this reflects the differing natures of the institutions – the risks they carry on and off their balance sheets and the contracts which they strike with investors or savers. One consequence of these differences is that insurers pose less risk to financial system instability than banks do, and it would not be inappropriate for them to be supervised to a different standard. Even so, it is not apparent that varying supervisory requirements do create competitive advantage in relation to the small set of savings products which are similar between banks and insurance companies. The Council of Financial Supervisors has commenced an assessment of the scope to align capital standards more closely, but this seems likely to be limited.

Funds managers and the others

105. All funds managers (other than the special case of superannuation funds) operate in a common framework of product regulation under the ASC. Where a funds management operation has a bank parent, the RBA has certain requirements to emphasise to investors the separateness of the two, but these place no particular constraint on the funds management activity itself. As described in Chapter 3, funds managers are not prudentially supervised in the way capital-backed institutions are. Nor should they be – attempts to do so would constrict the spectrum of risk for investors and alter the funds management role fundamentally.
106. The RBA's view is that there are no major instances of supervisory requirements contributing to an ‘unlevel’ playing field, without a justification in the different nature of the institutions involved.

‘Supervision should be based on functions, rather than institutions’

107. Again, it is not always clear what is meant by this view. If functional supervision means simply that all deposit-takers should be supervised alike, all insurers should be supervised alike, and so on, there is nothing exceptional in that. As noted above, Australia is very close to having such a system.
108. In other cases, functional supervision seems to mean that each type of financial asset – a government security or a housing loan, for instance – should be assigned a capital charge which would, in turn, be invoked whenever and wherever that asset occurred in the financial system. That this makes no sense is obvious if one contemplates the manager of a unit trust with a portfolio of government securities having somehow to hold capital equivalent to that required of a bank with securities on its balance sheet. As outlined in Chapter 2, the concept of a capital charge only has meaning when applied to an institution with a standard balance sheet or which incurs exposures in its own name. Even among deposit-takers it might, in principle, be quite appropriate for different capital charges to apply to similar assets. The community may want its investments with one group to be very secure while, with another, it is prepared to accept more risk in return for higher earnings.
109. Implicit in the argument for ‘functional’ supervision is the view that any capital charges should be calculated as the sum of all the individual components of risk. But prudential supervision has to assess the risk in an institution as a whole, taking into account possible geographic or industrial concentrations of exposure and, possibly, correlations (positive or negative) between different risks within the portfolio. Modern supervisory practice is moving increasingly in that direction. In this sense, the notion of supervising functions or products could be viewed as a rather outmoded approach to what is a complex and rapidly-evolving supervisory process.

‘Supervision is too costly’

110. While it would be surprising if supervision did not entail costs for supervised institutions, the relevant questions are about the net costs for individual institutions – taking into account the lower funding costs and other advantages which come with greater public confidence – and for the financial system in the broad. The gross costs for the latter include restraints on innovation and efficiency; these need to be set against the benefits of a more stable and reliable financial system. Even at the institutional level it is difficult to measure objectively the net benefits or costs. It is virtually impossible to do so in the broader sense.
111. One approach which can be indicative is to look at outcomes. Focussing on the banking system, with which the RBA is most familiar, it would be hard to sustain an argument that prudential supervision is unduly onerous. It certainly does not appear to have hindered expansion and change there. In contrast with some other countries, Australian banking groups have considerable choice in business activities – from ‘traditional’ banking to derivatives trading, and on to insurance, funds management and superannuation. The banking sector currently has its highest share of financial system assets since the mid 1970s, as well as accounting for the vast bulk of transactions in the securities, foreign exchange and derivatives markets. Funds management subsidiaries of banks have increased their market share in recent years, now having around one-quarter of the total compared with a fifth in 1990. The only significant regulatory requirement bearing on banks' funds management and insurance activities is that they are conducted in separate legal entities. This ensures, as far as is possible, that the deposit business of the bank and the capital supporting it are insulated from those other activities. However, this ‘separation’ of activities imposed by supervisory requirements is probably no greater than would have arisen naturally within a banking group given the different legal, financial and risk characteristics of these businesses and the different skills required to manage them.
112. The RBA's main balance sheet requirements – leaving aside the NCD impost which has no prudential supervision purposes – relate to capital and holdings of prime assets (PAR). Neither appears to entail significant costs for banks because, on average, they hold more capital and more prime assets than the RBA requires. Currently, the capital ratio of the banking system is 11.6 per cent. Based on the standard minimum of 8 per cent, this translates to ‘excess’ capital of about $15 billion. This is not, of course, to say that the requirements will not bite from time to time. If they did not, they would be serving no purpose in curbing risky behaviour.
113. Bank profitability has also remained high, on average, which is at odds with prudential constraints bearing heavily on operations. While recent high levels of profitability are now being challenged, this is more the effect of new competitors with lower operating costs than the banks have. The ability of mortgage securitisers to gain a significant slice of the housing finance market, at the expense of the banks, is perhaps the best recent example of that process. Although banks have a funding advantage over the mortgage securitisers their lending rate is higher. Even assuming (unrealistically) that banks would hold no capital and no prime assets in the absence of supervision, supervision costs for housing lending account for only 60 basis points of the bank margin.
114. There has been strong response to the further opening of foreign bank entry arrangements since 1992. Together with the conversion of building societies to banks, the number of banks has increased substantially – from 28 in 1980 to the present total of 52, and there is a handful of applications in the pipeline. (Only one foreign bank has left the Australian banking scene in that time.) This increase is not consistent with supervision being onerous or discouraging.
115. The RBA's overall assessment is that the supervisory burden on Australian banks is not excessive – and probably much less than in countries such as the US, Japan and Singapore. Even so, the RBA is conscious of the costs which undoubtedly come with supervision and aims to minimise these, consistent with its statutory obligations. Its on-site visit program, for example, is helping it to assess the relevance of data collections and to consider moving to new information which would be more useful and less costly to collect. In some instances, banks themselves have encouraged the RBA to collect and publish more aggregate data on their activities and risk exposures. With prudential requirements based more on banks' internal management systems and, where possible, harnessing the disciplinary forces of the market through encouraging better financial disclosure by banks, supervision should become more effective while also involving lower compliance costs.

‘Regulations overlap and conflict’

116. Complaints are commonly made about overlaps or lack of co-ordination in supervisory requirements. As with ‘blurring’, however, the substance in these complaints can be hard to pin down.
117. Overlaps involving prudential supervision could arise in two or three ways. The first is where an institution is subject to both prudential supervision and product regulation which will have it answerable to two agencies. This may be an irritant, but it is unavoidable just as it is unavoidable that financial institutions will be subject to the Corporations Law, to taxation law, privacy standards, anti-discrimination law, and so on. Because the agencies' objectives are different, their requirements should not be duplicated to any great extent or be inconsistent.
118. Another area of overlaps arises with conglomerates, where the individual entities within the group have different supervisors. Again, it is inevitable that when a conglomerate is composed of different types of institutions – deposit-takers, insurance, funds management – different standards and reporting requirements will fall on those specialised entities. Generally these requirements will not overlap but in some cases they will – for instance, with intra-group exposures. It is an ongoing objective of the Council of Financial Supervisors to see that the responsible supervisors – two, in most cases, with Australian conglomerates – do not get in each other's way, requesting the same information from different parts of the group or imposing requirements in relation to group behaviour which are inconsistent. The proposed adoption of more formal lead regulator arrangements will help here, as the lead regulator could assume responsibility for group-wide data.
119. It has been suggested that the creation of a single prudential regulator may go some way to remedying problems of this type. A more extreme variant of this argument is that all regulatory agencies (prudential and otherwise) could be merged in order to improve co-ordination of financial regulation and supervision. There is, in fact, little evidence to support the contention that combining supervisory or regulatory agencies leads to any rationalisation of supervisory requirements or that co-ordination would be made easier by reorganisation of agencies. This is explored in more detail in Chapter 5.

‘Capital requirements for banks are arbitrary’

120. Banks have argued from time to time that regulatory capital charges applied to individual or groups of exposures are not well aligned to actual (economic) levels of risk. The most commonly cited example is the 4 per cent capital charge applied to the bulk of banks' residential mortgage holdings, when there is strong evidence that the true risk in such assets is much less. More generally, it can be been claimed that the application of a standard 8 per cent capital charge on all corporate and related exposures takes no account of the wide spectrum of credit risk within the corporate sector. There are other examples.
121. One implication of the use of rule-of-thumb regulatory capital charges is that it may disadvantage banks with relatively low-risk corporate loan portfolios but work to the advantage of banks with higher-risk portfolios (since, other things being equal, both institutions face the same capital charge). The argument is that regulatory arrangements should not bias asset portfolio choices of institutions, as this leads to regulatory-induced competitive advantages and disadvantages which work against efficient resource allocation both at the macro and micro level.
122. The challenge of ensuring that supervisory capital charges are well aligned with actual risk is a difficult one, involving choices between accuracy and simplicity. Supervisory capital structures work best when they are relatively simple – the ready acceptance of the international Capital Accord in 1988 owed much to its simplicity. Such simplicity does not aspire to measure risk accurately on an exposure-by-exposure basis. Only a dedicated methodology based on concepts of economic capital can fulfil that requirement. Banks have only recently begun to turn their attention to the measurement of their capital needs on this basis.
123. The new market risk guidelines referred to above take a step in this direction by recognising banks' own risk management models as the basis for a capital charge. The RBA is looking (over the longer term) at ways of incorporating more accurate risk measurement systems into other capital requirements. Major changes here will depend in part on developments internationally and the result would tend to be a much more complex system than the present one. Meanwhile, the broad approach to risk measurement does not preclude reassessments of particular risk weightings if it were clear that these had clearly become inappropriate from a prudential perspective. (Risk weights on housing-related exposures is one possible example, as is the recognition within the risk weight structure of insurance.) Such issues are discussed regularly with banks.

‘Supervision is not ready for the future’

124. It has been argued by some that developments in communications and technology may render the present financial and prudential structure irrelevant. Implicit in this is the view that supervisors have not recognised the potential for change. In part, the argument is an elaboration on the blurring thesis discussed above. In part, it also reflects a concern about how existing financial institutions and their supervisors will cope with uncertain financial developments ahead.
125. In considering such concerns, it should be recognised that the Australian banking sector has not only retained market share but increased it significantly over the past decade. Banks have also been among the most active in utilising new technologies to transform the nature of their businesses and move into those newly expanding fields of electronic, branchless, computerised and telephone banking. The Australian community has become a relatively intensive user of such sophisticated technology. Prudential supervision has not constrained the capacity of banks to respond to, and harness, these innovations (most of which offer novel methods of service delivery for existing products, rather than new products). The challenge for banks will be to forge effective alliances with specialist technology suppliers. Ultimately these are commercial and competitive, rather than prudential, issues.
126. Non-finance firms have not intruded significantly into traditional banking areas. While some large overseas corporations have developed extensive card networks abroad, they have not impinged upon the intermediation or market-related activities of banks. Very importantly, they do not constitute part of the payments clearing and settlement system. Currently, all activities of such institutions require the presence of a bank to carry out any necessary clearing and settlement functions. It is impossible to come to definitive conclusions on where this broad issue of potential involvement of non-finance entities in the financial system may be heading It is conceivable that, in time, technological developments could see ‘banking’ activities conducted over international computer networks, bypassing traditional credit institutions and conceivably becoming part of the payments network. This possibility is discussed in Chapter 8.
127. The main point to make is that to the extent that any new players succeed in building a financial business which poses similar risk to savers and to the financial system as do banks, they would have to be supervised in the same way. These are issues for consideration by supervisors globally; they are not unique to Australia.