Speech The Reserve Bank's Role as it Impacts on Business
Talk to the 1996 National Institute of Accountants New South Wales Congress, ‘Maximising Your Business Opportunities’
The Reserve Bank – unlike many of the other organisations making presentations to your Congress – does not have a great deal of direct dealing with the general business community. Our activities do, nevertheless, have significant pervasive impacts on Australian businesses and individuals. Indeed, the Reserve Bank Act gives us a very broad charter, requiring us to ensure that our monetary and banking policies contribute toward the economic prosperity and welfare of the nation.
I will discuss our activities under three main headings:
- monetary policy;
- financial system stability and bank supervision; and
- services for Governments.
The RBA determines and implements monetary policy, which is one of the main arms of economic policy, and, through the influence of monetary policy on economic conditions, the RBA's activities affect all Australian businesses.
The particular focus of monetary policy is on keeping inflation low, although not to the point of pursuing an inflation objective regardless of other economic aims such as growth in employment and production. Indeed, a totally blinkered focus on inflation would be inconsistent with our broader charter.
The RBA's main monetary policy instrument is the overnight cash rate in the short-term money market, which is influenced by our buying and selling of Commonwealth Government securities. Movements in cash rates flow through to interest rates on deposits and loans by banks and other financial institutions. These rates, in turn, influence decisions to spend and to save, and affect the general environment in which wage bargaining and price setting takes place. In this way, interest rate changes work indirectly to influence the inflation rate.
Speaking generally, business is always in favour of easier monetary policy and faster economic growth. Experience shows, however, that pushing an economy forward beyond the ‘speed limits’ set by growth in productivity and work force inevitably forces up inflation and/or the deficit on current account of the balance of payments.
Eventually, difficult economic adjustments become necessary when inflationary pressures have to be subdued – higher interest rates, falling sales and profits, business failures and job losses. We should recall the boom period of the late 1980s and its painful aftermath; what we want is sustainable growth.
Our monetary policy objective is to hold underlying increases in the consumer price index to an annual average of between 2 and 3 per cent over the course of the business cycle. For the aficionados, there are many subtleties in how inflation targets are expressed by central banks. I do not want to dwell on these here – the important general point is that a target conveys the central bank's commitment to effective price stability – to keeping inflation at a level where concern about a rising price level does not intrude significantly into the decision-making of companies and households. We think we will have achieved this aim in Australia if we can look back over reasonable periods of time and calculate an average for underlying inflation of ‘2-point-something’ per cent.
Over the past five years, during which national production has grown by a robust 17½ per cent, underlying inflation has averaged 2½ per cent. In the year to March, the underlying inflation rate was 3.3 per cent, slightly above that 2–3 per cent range. We expect that inflation will be back within the range in the second half of 1996.
If this is how things pan out, monetary policy will have passed an important test, and the public announcement of our objective for inflation will, I think, have played a useful part in that. It seems to have provided a valuable anchor for price expectations when inflationary pressures built up during the period of rapid spending growth in 1994. Our commitment to the objective was, of course, demonstrated by the three increases in interest rates in the second half of 1994. The prospective return of inflation to below 3 per cent should emphasise the message to wage- and price-setters that we are determined to keep inflation under control.
What does business get out of lower inflation?
Economies work better when inflation is low. In an environment of low and predictable inflation, consumers, investors and businessmen are less likely to be driven by ‘short-termism’ – the obsession with quick capital gain. New investment decisions are based more on assessments of enhanced productive capacity, less on short-term speculative potential. Profitability, in turn, is more likely to reflect output and sales rather than simply the inflation of prices.
In this way, maintaining low inflation supports sound business management. Low inflation minimises the distortions in the tax system which, when inflation is high, tend to favour debt finance (potentially to an imprudent extent) at the expense of equity. More generally, an inflationary environment makes it all too easy for poor management to be disguised. And I suspect that accountants might be among the best placed to appreciate the unproductive – though not necessarily unprofitable – financial machinations which become worth pursuing in an inflationary environment.
Finally, low inflation, if sustained, will result in lower interest rates, which should in turn reduce hurdle rates of return for new investment. When inflation is high and variable, lenders build a risk premium into their interest rates.
Interest rates have been much lower in the current economic upswing than in the early phase of the recovery in the mid 1980s, due largely to the much improved performance on inflation. (See Graph 1.) This has translated into strong profits growth, especially on an after-interest basis. (See Graph 2.) Keeping interest rates low – with these beneficial effects on profits and cash flow – is largely a question of keeping inflation down.
In sum, a monetary policy which delivers low and reasonably steady inflation creates the environment for better all-round economic performance.
Financial System Stability and Bank Supervision
In common with all central banks, the RBA has a responsibility for the stability of the financial system. The financial system plays a critical role in the economy – particularly in channelling savings to productive uses – and its health is as important to the nation's welfare as is a low rate of inflation. The two objectives are, of course, interrelated: a stop-start inflationary world is hardly conducive to stable financial institutions, as was also demonstrated by experience in Australia and many other countries in the late 1980s and early 1990s.
Accordingly, the RBA takes a keen interest in any developments which might impinge on financial system stability. Of course, prevention is the best cure, and the most important way – though not the only way – in which we seek to pursue this objective is through our role as prudential supervisor of Australia's banking system.
In this connection we have two related responsibilities. The first is to supervise banks to encourage and promote their sound and prudent operations – to ensure, as far as practicable, that banks conduct themselves in ways which do not cause or promote instability in the financial system.
Our second task is to protect the interests of depositors in the event that a bank gets into serious difficulty. We are empowered, in such circumstances, to take control of the bank and manage it until its health is restored or its depositors repaid.
To the extent that our prudential supervision is effective, we have a very important indirect impact on Australia's business community. A sound banking system makes three major contributions to the health of business.
First, it provides a low-risk avenue for investment of liquid balances and working capital.
Second, it is the major source of debt funding for business. Banks currently provide about one-third of aggregate debt outstanding of the corporate sector. Small and medium-sized companies which do not enjoy direct access to the capital markets rely even more heavily on bank finance.
Third, banks operate the payment system which is the lifeblood of commercial activity in any advanced economy.
The RBA's supervision of banks comprises a number of elements:
- requirements for a spread of ownership;
- collecting and monitoring regular information on their operations;
- consultations with bank management at various levels;
- regular reports from external auditors;
- on-site visits by RBA supervisors; and
- imposing, and monitoring compliance with, various prudential standards.
Prudential standards cover such aspects as a bank's capital ratio (which is, in simple terms, the ratio of its shareholders' funds and reserves to the amounts susceptible to credit risk on and off-balance sheet), its liquidity, large exposures to individual clients, foreign exchange exposures, securitisation activities and associations with non-banks. Capital requirements are currently being extended to take account of market risks, which are the risks of loss due to fluctuations in interest rates, exchange rates and prices of equities and commodities. Increasingly, we are also taking a close interest in the management systems used by banks themselves for day-to-day measurement and control of the risks in their operations.
While our requirements no doubt make banks safer institutions, less likely to become insolvent or illiquid, they also impose some costs on banks – the costs of extra capital, form-filling and so on – which are ultimately passed through to customers in various ways.
It is the perennial balancing trick of the prudential supervisor to tread the line between meeting the community's need for (and its expectations of) a safe banking system, and regulating so conservatively that the capacity of banks to be innovative and to compete with less closely supervised institutions is unduly impaired. While businesses are keen to have a sound and reliable banking system, they also want to be served by banks which are efficient, responsive and cost-competitive.
One way in which supervision can be made somewhat less prescriptive and detailed is through putting more onus on financial markets to exercise their own oversight and discipline of banks. Within limits, we think there is merit in this approach and have been encouraging improved standards of disclosure by banks in their published statements – particularly in respect of their impaired assets and their derivatives activities.
Here, of course, the accounting profession can make a major contribution by helping to produce public information which facilitates comparisons of the performance of different banks, and by devising standards which deal effectively with the growing complexity of banking business, including the large volumes of transactions which are off-balance sheet. We have been pleased to work with the accounting profession on such issues, a current example being the development of ED63.
A combination of new technology and new players, who are less heavily supervised than banks, is currently putting pressure on some areas which have traditionally been important sources of bank profits – the most notable example being housing loans. This process is bringing a sharper edge to questions about the balance between the safety and the competitiveness of banks – and about the pros and cons of extending bank-like supervision to players who compete with banks in certain products, but whose overall mix of activities means they do not pose the same risks for the stability of the broader financial system.
Another major focus of the RBA's concern with financial system stability is its work with banks and others on payment system reform, in particular to reduce interbank settlement risk.
An efficient and reliable payments system is vital to the everyday conduct of commerce. Businesses and individuals tend to take for granted their ability to make payments routinely by cheque, EFTPOS and other means, but this confidence relies on close and continuing attention being paid by the RBA and commercial banks to the complicated plumbing which underlies the system. A blockage can have wide and disruptive consequences.
Another reason for paying careful attention to the payments system is that it creates a network of linkages among financial institutions – mainly banks – through which a problem in one could be communicated more broadly.
At present, payments among banks on their own behalf or on behalf of customers are accumulated through the day and settled, via payments across their accounts at the RBA, on a net basis the following morning. This leaves a receiving bank exposed to the possibility (albeit remote) that a bank due to pay becomes unable to meet its obligations. If this happened the problem of that paying bank would quickly become a problem for other banks, and there would be major disruption to those bank customers wishing to access their accounts to make payments or those anticipating receipt of funds.
Working with the banking industry, the RBA is currently introducing a system in which high-value payments processed electronically between banks will be settled irrevocably at the same time that the payment instructions are sent. When using this system – known as ‘real-time gross settlement’ or RTGS – business customers will have assurance that, as soon as their banks process a payment instruction, it is final and irreversible. We plan to have RTGS operating by end 1997.
While talking about the payments system, it would be remiss of me if I neglected to mention our responsibility for printing Australia's currency notes, and our pioneering work in introducing notes on polymer which are both more secure and more durable than their paper predecessors.
Services for Governments
As I have outlined, the RBA has a deep policy interest in the payments system and is banker to the commercial banks. We are also a participant in that system as banker to governments – the Commonwealth and some State Governments. This is another way in which the RBA's activities affect the business sector.
I should emphasise that the RBA does not have this government business as of right – we have to keep our customers as any bank does, by providing a high standard of service at competitive prices. In these days when governments themselves are under pressure to control costs and manage their business efficiently, our government banking division has to operate very much on a commercial basis. By concentrating on systems dedicated solely to government needs we are able to be a competitive supplier of transactional banking services.
We aim to recover fully the costs of these services, largely through charging fees. This puts us in an unusual position vis-à-vis our private sector competitors who, as you know, generally cover only a proportion of costs with fees and earn the rest of their income from the spread between interest on deposits and loans. Our interest spread with our main client, the Commonwealth Government, is zero – we pay on deposits what we earn on assets.
As banker, we've been particularly active in helping to move government payments from paper-based to electronic means. (Cheques processed and posted to customers' accounts by the RBA in 1994/95 totalled 51 million items, compared with 69 million five years earlier.) This is having efficiency payoffs all round, with payments being made at lower cost, more quickly and more reliably. Businesses transacting with governments are now much less subject to the vagaries of the cheque-clearing system and the costs of ‘batch’ payments via magnetic tape.
The RBA's Direct Entry System (GDES) allows direct credit and direct debit transactions. It was initially designed for the passing of high volume direct credits – such as social security payments – to the community through financial institutions. Subsequently, some government agencies have taken advantage of GDES to manage better their payments cycles. GDES utilises RBAnet, a network providing direct data links between our customers and over 600 financial institutions. In 1994/95 GDES delivered around 200 million direct credits, an increase of 6 per cent over the previous year. These transactions amounted to about 50 per cent of all bulk electronic credit payments exchanged among financial institutions.
More recently, a direct debit facility in GDES has helped businesses to keep better control of their payments to government. One example is the system used by the Department of Customs which allows customs agents to clear incoming goods faster and at significantly lower cost than under the former paper-based system. The facility is also far more efficient for making tax payments, particularly payroll, PAYE and company tax instalments, and has done away with costs associated with manual payment records and reconciliation processes.
The RBA has also been doing pioneering work with the Commonwealth Government on Electronic Data Interchange (EDI). With EDI a single transmission can carry both payment detail for banking purposes and remittance detail for updating payees' account receivable records. Further efficiencies may be gained by interfacing EDI directly with current payment systems, and fully automating the payment cycle. EDI can pass payment details to a bank account and remittance information to a merchant immediately via fax or a direct link between the bank and the business.
Our financial EDI service is now used mainly to make payments among Commonwealth agencies and for regular disbursements to State governments, but further development of the Government's electronic commerce initiatives, coupled with the eventual development of a common EDI format by all Australian financial institutions, will allow the business community to take greater advantage of this technology. (Over 83,000 EDI transactions were processed in 1994/95, about 25 per cent more than in the previous year.)
Those interested in Commonwealth Government securities would be aware that the RBA also runs the registry and electronic settlement system for that market. Five years ago we introduced an on-line, real-time computerised system for the electronic transfer of securities and cash called RITS (Reserve Bank Information and Transfer System), which delivered:
- a significant reduction in settlement risk, as all transactions in CGS on the system are effected on a delivery-versus-payment basis, with the cash component of each transaction irrevocably guaranteed by RITS members' participating banks;
- greater ability for banks to monitor and control their exposure to clients; and
- improvements in the management of members' trading portfolios and funds, and in the efficiency of their back offices.
In recent years we have used RITS to streamline further trading in CGS, with the main enhancements being:
- ‘9am Settlement’, which required all interbank obligations arising on a day to be settled before the commencement of the next day's business;
- a facility for the settlement of net interbank payment obligations for transactions created in the Australian Stock Exchange's CHESS system; and
- electronic bidding facilities for CGS tenders.
Currently over 95 per cent of the turnover by value in CGS passes through RITS, over $91 billion of stock is held in the system, and average daily turnover is around $15 billion.
As I mentioned earlier, we are in the process of introducing a RTGS system for high-value payments between banks. This is to be based on the RITS infrastructure.
I hope this short tour of our responsibilities and interests gives you an appreciation of the many channels through which the RBA's activities have impacts on Australia's business world.
I might conclude by noting that there is talk from time to time of narrowing the RBA's focus, so that it would have only one or two ‘core’ responsibilities.
In my view such a move would be misguided. There are significant synergies in having the responsibility for both price stability and financial stability in one place. Banking supervision is integral to our financial stability role, and provides information on market and institutional conditions which is helpful to monetary policy. Meanwhile, our operational activities in securities markets, in the payments system and in conducting banking services give us some ‘hands-on’ experience in, and a better understanding of, pressures and constraints in the business world. This, in turn, contributes to the better-informed conduct of our broader policy functions.