Speech Financial Regulation and the Financial System Inquiry
Talk to the ‘Trends’ Luncheon organised by Advance Bank
Today I would like to share a few thoughts with you on some of the regulatory issues that will confront the Financial System Inquiry.
I want to say at the outset that the Reserve Bank has supported the notion of an inquiry into the financial system. After a decade of financial deregulation and rapid technological change – one manifestation of which is the globalisation of financial markets – it is time to review how well current regulatory arrangements are working, and how they might be improved to meet future challenges.
It is a tall order, and the timetable is very tight. There will, therefore, be pressure on everyone involved with the Inquiry to concentrate on actual problems, and to resist the temptation to dwell on things which are not really ‘broke’.
‘Regulation’ is to be the main focus of the Inquiry. That label covers many subjects, including policies on competition and consumer protection; supervision of financial institutions; and rules governing behaviour in capital markets. Important issues arise in each of these areas.
In the area of competition and mergers, for example, regulation raises issues which affect the costs of financial services. The banks have recorded generally good profits in recent years, but they remain relatively high cost, high margin providers of retail financial services. This high margin business is under permanent threat of being competed away, as the mortgage originators have been doing; they now have 8 per cent of the new housing loan market, compared with virtually nothing 18 months ago.
To maintain profitability as margins decline in these areas, banks will have to reduce their costs or increase their fees. Rationalisation of branch networks is one way of reducing costs, but the scope for further cost saving through this channel will depend in part on competition policy. In particular, it will depend on whether changes are made to current policies which preclude mergers among Australia's four largest banks, and which make the absorption of regional banks by major banks conditional on the presence of a substantial fifth player in the relevant market.
The Inquiry can be expected to assess the extent to which these policies are inhibiting bank rationalisation (and, therefore, cost and margin reduction through that process), as well as the implications of possible changes for bank customers. I think these are among the most challenging questions likely to come before the Inquiry; my own hunch is that, subject to certain safeguards, scope does exist to ease these policies without reducing competition.
These issues cannot be pursued today but, whether or not competition policy is changed, I assume that the Australian Competition and Consumer Commission (ACCC) will remain the agency responsible for regulation of competition and mergers in the financial sector. I assume also that the broad principles adopted by the ACCC in relation to the financial sector will be consistent with those applicable to other sectors. This regulation related to competition should be distinguished from prudential regulation; although one form of regulation can have implications for another, each has its own objectives which necessitate different approaches and can justify different administrative structures.
My focus today is on regulation directed towards maintaining prudent institutions, and fair and informed market activities, in the financial sector. In respect of this regulation, I want to make a very important but not entirely satisfactory distinction between ‘prudential’ and ‘other’. ‘Prudential’ regulation aims to ensure the prudential soundness of financial institutions and is, by definition, institution-based. It is the failure of institutions, not particular products, which poses the greatest threat to those who seek maximum security for their savings and, at the macro level, to stability in the financial system. Such regulation can be distinguished from other regulation directed more towards the integrity and even-handedness of financial markets and products.
This distinction will figure prominently in my talk. I think we need both institution-based and product-based regulation. I believe also that a certain amount of tension between the two – that is, between promoting the prudential soundness of institutions and achieving comparable treatment of similar products across institutions – is inherent in all financial systems. How this tension is handled will depend largely on how effectively the different regulators co-ordinate their activities. But that is jumping ahead.
Current Prudential Regulatory Arrangements
Currently, the ‘prudential’ and ‘other’ regulators in Australia comprise the Reserve Bank, the Australian Financial Institutions Commission (AFIC), the Insurance and Superannuation Commission (ISC), and the Australian Securities Commission (ASC). Each has some characteristics of both categories of regulation, but the Reserve Bank and AFIC are the most prudential in the sense defined, while the ASC is the most ‘market’ focussed regulator of the four. Together, they constitute the Council of Financial Supervisors (COFS) and ‘cover’ institutions with over 95 per cent of the total assets of all financial institutions in Australia.
How might this regulatory framework be improved, viewing ‘improvements’ as changes which would lead to a more dynamic and innovative – but still fair and stable – financial sector? To answer this question properly, we should first be clear about the shortcomings in the current framework. Things can always be done better, but many of the usual criticisms appear to me either to lack a lot of substance, or reflect problems which are not capable of being corrected simply through changes in regulatory regimes. They are along the lines that:
- current arrangements are outdated and have not kept up with recent, let alone prospective, developments;
- they are too costly and intrusive;
- and, as a consequence, they are frustrating the strategies and ambitions of banks and other financial institutions.
I would like to make a few comments in response to these kinds of criticisms, mainly from the perspective of a banking supervisor.
‘Current arrangements are outdated’
Practitioners know that regulatory arrangements in the Australian banking sector have not stood still over recent years:
- risk-weighted capital adequacy requirements were introduced in the late 1980s as a buffer against credit risks, and these are in the process of being augmented for market risks;
- Reserve Bank teams have been visiting banks to review credit risk management systems since 1992, and market risk management systems since 1994;
- foreign banks have been free to establish branches (as well as subsidiaries) since 1992;
- guidelines on banks' involvement in funds management and securitisation were issued in 1992 and revised substantially in 1995 in the light of market developments;
- new arrangements for banks to report and monitor asset quality were introduced in 1993;
- in 1995 banks were permitted to take limited equity positions in small to medium businesses; and
- work is on track to move high value inter-bank payments from the present deferred net settlements basis to a real-time gross settlements basis (RTGS) by the end of 1997.
Other sectors also have undergone some substantial changes. AFIC, for example, was established in 1992 to lift the standard of prudential supervision of building societies and credit unions. The Council of Financial Supervisors was also established in 1992, to help plug gaps and avoid overlaps and inconsistencies in the approaches of different regulators. New insurance company legislation was passed in 1995.
In part, the assertion that current arrangements are outdated probably reflects a perception that regulators have not kept up with the ‘blurring’ which has occurred in the roles and products of different financial institutions. We see this blurring in, for example, mortgage originators and insurance companies offering home loans, and in funds managers offering deposit-like investment products. It is the outcome of a dynamic financial sector and it does not appear to have inhibited unduly financial institutions pursuing their corporate stratregies. Banks, for example, have been able to establish their own funds managers and insurance companies; when these are included, banking groups have actually increased their share of total financial assets from 52 per cent in 1984 to 59 per cent at present. (It has been government taxation and superannuation policy – rather than prudential regulation – which has prevented banks from offering retirement savings accounts on their own balance sheets; as you know, this policy is about to change.)
I think it is significant that this blurring of different activities and products has not ‘merged’ to the point where they are all being offered on the one balance sheet. The fact that some products (eg bank deposits) require capital backing, while others (eg unit trusts) do not, effectively requires the establishment of separate entities to conduct the different activities. This facilitates their supervision by different regulators, although it also puts a premium on co-ordination among regulators when the different activities are grouped under common ownership in conglomerates.
‘Current arrangements are too costly and intrusive’
This is another, generalised criticism often levelled at current arrangements. For some, of course, any regulation is innately too costly and burdensome. But a degree of supervision is the quid pro quo for deregulated markets; without it, deregulation would not find reasonable community acceptance. Markets are usually more efficient than the alternatives, but they can operate in ugly ways – and sometimes not operate at all – justifying official intervention.
It has been suggested that consumers and regulators should rely on disclosures by financial institutions about their affairs, rather than expensive inspections and form filling. In practice, disclosure and ‘hands on’ supervision can both be important, with disclosure perhaps being of greater value in relation to, say, funds managers than deposit-taking institutions like banks. Disclosure by banks of their financial standing is a prominent feature of bank supervision in New Zealand, although reports of the extent of that country's ‘hands off’ regime are often exaggerated; banks in New Zealand are subject to essentially the same capital adequacy rules as banks in Australia.
Personally, I do not believe regulators can rely on disclosure, especially in the case of the vast numbers of ordinary customers of banks and other deposit-taking institutions. These customers have effectively delegated the task of monitoring the financial health of these institutions to the prudential regulator. In these circumstances, reliance on disclosure is unlikely to constitute an unassailable defence in the event of an authorised bank getting into difficulties. The Reserve Bank has even found itself being sued in relation to some failed building societies – institutions which it has never authorised or supervised. And I fear we are becoming more litigious, not less. In my view, the Bank's best all-round defence is to do all it can to make the institutions under its wing look after themselves properly – and then a bit more as well.
Some of the costs which bank executives complain about most have little or nothing to do with prudential supervision as such. The costs to the banks of compliance with prudential regulation would be swamped, for example, by the costs of their uneconomic branch networks. (As I noted earlier, the latter owe something to the obstacles to branch rationalisations implicit in current competition policy, as well as to community and political opposition to branch closures.)
Some of the costs of arrangements intended to protect consumers, such as Uniform Credit Legislation, codes of practice, the Banking Ombudsman Scheme and other financial sector complaints mechanisms are also distinct from costs of prudential regulation. This is not to say that none of these arrangements involves excessive costs; some probably do, but the door is open for the Inquiry to propose cheaper and more rational arrangements.
The sub-commercial rate of interest now paid on the non-callable deposits (NCDs), which banks are required to hold with the Reserve Bank, can be viewed similarly. The cost to the banks (and their customers) is around $185 million annually. Although it has been presented as being in the nature of a payment for the ‘benefits’ which come with bank authorisation and supervision, it is essentially a budget revenue raising measure.
The capital adequacy requirements which banks have to meet are usually seen as a regulatory cost. This is a prudential matter, but it reflects international standards in what is increasingly a global industry. There is not much Australia acting unilaterally can do about these standards, even if we wanted to. Indeed, any move by Australia to ‘go it alone’ and depart from the standards could prompt negative reactions by counterparties, ratings agencies and regulators in other countries. The fact that the average risk-weighted capital ratio for banks in Australia is currently about 11½ per cent – well above the Bank for International Settlements (BIS) minimum of 8 per cent – suggests that, at this stage at least, the minimum capital requirements themselves are not imposing a major cost burden.
These comments are not meant to imply that current regulatory arrangements cannot be made more cost effective. But we do need to be more explicit in identifying shortcomings than we have been to date. The Bank supports the weeding out of unnecessary processes and avoidable compliance costs, although what is ‘unnecessary’ and ‘avoidable’ is not always clear-cut. The Inquiry provides an opportunity for industry participants, consumers and regulators to think afresh about what constitutes the ‘right’ balance of interests.
New Regulatory Structures
Talk of changes to the regulatory structure seems a little premature until the problems in the present structure are better identified. I would like, nonetheless, to speculate in general terms on some broad options for change.
(i) Evolutionary change
One option is to allow the present structure of prudential and other regulation to continue to evolve in response to technological and other changes. This option is not without attractions. Australians suffered from the excesses associated with the early years of financial deregulation but, unlike many other communities, we did not have to dig into the national budget to prop up the financial sector. In fact, our institutions dealt with their problems quite expeditiously, assisted by five years of sustained economic recovery; they are now generally in good health, and customers are at last seeing the benefits of deregulation, in the form of more innovative and competitively priced products.
It is not a ‘do nothing’ option. Prudential regulation is an evolutionary process and, as noted earlier, many changes have occurred in recent years in the way financial institutions are regulated. Many of today's regulatory structures – including AFIC and COFS – are barely a few years old. In other words, within the existing framework, we can expect change to be a constant. And, as also noted earlier, this framework does not appear to be unduly inhibiting financial sector developments.
All regulators worth their salt attempt to anticipate developments in the market place. Occasionally, they may seek to head off a particular development, but their more usual role is likely to be one of trying to accommodate market developments. This seems to me to be the right position for regulators to take up – in trotting parlance, to be ‘one out and one back’. It is a ‘market friendly’ position. An innovative financial sector requires ample scope for private initiative, and for banks and other financial institutions to perform their important risk-taking function. If they want to get out in front and try something new, they should do so in a prudent way but they should not be reined in by pre-emptive regulations. By sitting a little to one side, regulators are well placed to balance risk-taking and stability, market incentives and regulations.
A particular illustration of this important general point is the emergence of stored value and other ‘smart cards’. These seem destined to grow in significance over time, and banks and others – including non-financial players – are jockeying for positions. The Reserve
Bank is monitoring various trials of different cards, and assessing their policy implications. We would be getting ahead of ourselves, however, if we were already promulgating new regulations to govern their issue and use. Sometimes it is better not to be pre-emptive!
Where different institutions are linked by ownership or offer some similar products, effective co-ordination of the activities of different regulators is clearly important. The Council of Financial Supervisors is a good base to build on here. It has had a low profile to date – partly because it has not had to contend with any major problems – but it has been working quietly in several areas on contingency plans for managing serious situations. Steps have been taken to remove obstacles to information sharing among regulators (which, in some instances, are entrenched in legislation), and to developing procedures for ensuring that financial conglomerates and holding companies are effectively supervised. (The latter are moving towards the ‘lead regulator’ model, where one member of the Council would have responsibility for overseeing a particular conglomerate or holding company.) More work remains to be done to develop the Council's role, but it is shaping up as a workable approach to the problem of co-ordination.
Notwithstanding the attractions of this evolution option, time will tell whether the Inquiry will be so bold as to recommend it.
(ii) Reshuffle the pack
A second option is to reshuffle the pack of financial institutions and regulators. The resultant number of regulators could be the same or greater than at present, although there seems to be a presumption in favour of it being smaller.
This option too has its attractions, in principle, but we have to remember that we are not starting with a blank sheet of paper. We need always to ask whether a different structure of regulation would work better than the present one, and at what cost. There is no value in forcing everything into a couple of simple moulds just for the sake of tidiness, or looking for a reduction in the number of regulators unless this made for better arrangements.
One reshuffle would separate banks and other deposit-taking institutions from the rest. This could be argued partly on the grounds alluded to earlier, namely the large number of ordinary customers who hold the highest expectations regarding the security and eventual return of their deposits with those institutions. Such institutions should, therefore, be subject to rigorous prudential regulation, including capital requirements. In the case of other products (eg unit trusts), where investors understand that greater risks are involved and they stand to make losses, the same kind of prudential regulation is not required; such products do not need to be capital-backed because the investor bears the risk of loss.
The other important part of the argument for distinguishing banks in this way is that they are the institutions which are most relevant for stability of the financial system, and for the smooth operation of the financial intermediation process, which is vital to the macroeconomy.
The neatest group of deposit-taking institutions comprises the banks, building societies and credit unions. Banks are supervised by the Reserve Bank, while the others are supervised by AFIC in conjunction with State government agencies. All are perceived to be at the safest end of the risk spectrum, and are subject to similar prudential requirements these days; the average risk weighted capital ratio for building societies and credit unions (14 per cent) is currently above that for banks (11½ per cent). The building society and credit union industries, and the States, might have views on being combined with the banks, but it could be a practical option if rationalisation of regulatory structures was seen as a significant issue.
If building societies and credit unions were to share a common regulator with the banks, they would be perceived to be even more akin to banks, and subject to similar degrees of public ‘protection’. This perception need pose no insuperable problems, particularly given the degree to which prudential requirements have been harmonised in recent years. Most, if not all, building societies and credit unions – along with many banks – would be too small to give rise to systemic problems if they were to fail, but it would be hard to argue for a different prudential regulator for a sub-group of these institutions based on size.
The issue which next arises is whether the rest of the financial sector could be covered adequately by a separate regulator with an emphasis on products and disclosure arrangements, rather than institutions and capital requirements. Activities like unit trusts and investment advice would seem to fit neatly enough, but others might not – some insurance products, for example, are not unlike deposit products in that they entail contractual obligations and are capital-backed. Should institutions offering these latter products also come under the prudential regulator? What about superannuation funds? What should we do about merchant banks and finance companies?
Just to raise these few questions is sufficient to illustrate that there can be no clear-cut division of existing (and changing) financial institutions and products. It would be difficult, for example, to devise a sensible two-part division if we start with banks, building societies and credit unions as one part. Tests like the riskiness of investments, and the implications for financial system stability are helpful, but they still leave a lot of fuzzy edges.
(iii) A mega regulator?
Another option, which has attracted some airplay, is to have a single, mega regulator for all financial institutions (but not competition or consumer policy).
Frankly, I have some doubts about this, mainly because of the point I have laboured already, namely the need for both institution-based and product-based regulation. In theory, a mega regulator could be totally product-based, with risk-related regulatory requirements determined and assigned to each financial product. But not only is there no practical basis for doing anything like that, the theory neglects the institutional basis of prudential regulation.
I understand that Denmark, Sweden and Norway have single regulators for their banking, insurance and securities industries, while Canada has a single regulator for banking and insurance. Again, however, I think the relevant question for us is not whether such a model will work, or is working elsewhere, but whether it will work better than our existing arrangements or some other alternative.
A mega regulator along the lines of Scandinavian models – covering all major institutions – would need to establish separate divisions with different skills and regulations to handle different industry and risk categories. In these models, the co-ordination role which the Council of Financial Supervisors is currently developing would be ‘internalised’. Perhaps with everything under the same roof, decision making and problem resolution would be more efficient, and level playing fields more easily maintained. But that is far from clear, to judge from the large coordination tasks which already confront most regulators. I have said before, only half facetiously, that the main problem with super regulators is that there are too few supermen (and women) to run them.
Having responsibility for everything from the safest deposit to the riskiest investment under a single regulatory umbrella could raise public perception – or ‘moral hazard’ – problems. The community might come to the view that no financial institution would be allowed to fail. This would not be a healthy state of affairs, given the risk-taking role of financial institutions; prudential regulators exist not to eliminate risk-taking, but to see that this is properly managed. Whatever the large and fine print might say, people who lose money in financial institutions will always seek to implicate the regulators – by its nature, a mega regulator is likely to be an easier target than a ‘specialist’ regulator.
My scepticism about mega regulators would remain, incidentally, even if the mega regulator were to be the Reserve Bank. The more usual thought, however, seems to be that the responsibility for bank supervision might shift from the Reserve Bank to another regulator; this could give rise to a separate set of concerns. Perhaps I am tilting at windmills here, but I would like to register a few points nonetheless.
To begin with, the Reserve Bank is vitally interested in the soundness of the banking system for the reasons mentioned already – depositor protection, overall financial system stability and the financial intermediation process. The latter refers to the critical role banks play in supplying finance to business, and particularly to small business. If the failure of a bank were to lead, through ‘contagion’, to a weakened banking system, this could have potentially disastrous consequences for new bank lending and for the real economy. Even the temporary freezing up of the intermediation process could have serious consequences – much more so than the failure of, say, an investment manager.
Following on from this point, banks have access to lender of last resort facilities from the Reserve Bank. Only a central bank can provide additional liquidity quickly in the event of threats to an individual bank or to the broader system (of the kind which loomed, for example, at the time of the October 1987 share market shake-out). The knowledge which comes from its supervisory responsibilities would assist the Reserve Bank in assessing the seriousness of possible threats of these kinds and, if necessary, responding quickly. The Bank would ‘check’ with the mega regulator if that were to be the new situation but, because the Bank would be providing the support, it would want to make its own assessment and back its own judgment. This helps to explain why overseas central banks which do not formally supervise banks still devote significant resources to shadowing developments in the banking sector.
The banks are also major players in the payments system. Every day transactions totalling more than $100 billion pass through the payments system, with those exchanged between the banks ultimately settled on exchange settlement accounts which the banks maintain with the Reserve Bank. Though it is largely unseen, a secure and efficient payments system is vital for the smooth functioning of the economy. The planned move at the end of 1997 from the current system based on deferred net settlements of inter-bank payments to a real-time gross settlements system for domestic high value payments will reduce the risk of major problems in one bank being spread through the payments system. Even then, however, about a third of domestic payments will continue to be settled on a deferred basis, as will cross-border payments.
Some central bankers without responsibility for bank supervision argue that this separation avoids conflicts of interest with anti-inflationary monetary policies; others are happy to avoid the risk of bad odours from regulatory problems flowing over to their monetary policy role. Most central bankers with responsibility for bank supervision will concede that the ‘reputation damage’ argument might have some substance, but they see little force in the conflict of interest argument. If any such conflicts did arise, these would have to be resolved irrespective of whether the supervisory function rested with the central bank or another agency. (And my hunch is that, in such a situation, the avoidance of instability in the financial system would win out over price stability.)
In practice, we see more synergies than conflicts in the pursuit of financial stability and price stability objectives. Monetary policy works largely through financial institutions and markets, and the Bank's hands-on involvement in its regulatory functions helps with its macroeconomic responsibilities, and vice versa. The hands-on experience and close proximity to banks and financial markets also help to get central bankers out of their ivory towers.
- Finance is a global industry these days and, consequently, prudential regulation has a large and growing international dimension to it. Central banks have been in the thick of international harmonisation and coordination efforts, especially through the BIS, which is the hub of thinking on capital standards, derivatives, safer payments and settlements systems, and mechanisms for supervising financial conglomerates. Non-central bank regulators could always pick up the reins in these areas, but there would be some costs involved.
I hope my remarks today will not be construed as an attempt to protect the Reserve Bank's patch. That has not been my intention – in a couple of months my interest in financial regulation will be confined to how well it is serving the needs of users!
There is no doubt that all areas of regulation affecting the financial sector – competition, consumer protection and prudential supervision – can be improved, some more than others perhaps. The Reserve Bank will detail its views on some possibilities in its submission to the Inquiry. My remarks today are more in the nature of a primer on some of the questions that should be asked, and the complex issues they raise. We are not starting with a blank sheet of paper, and we should not overlook the transitional costs that would arise in moving to a radically different regulatory framework.
The short gestation period for the Inquiry to report also emphasises the need to focus on real problems and practical solutions. With that focus, the Inquiry has an opportunity to make important renovations to the existing regulatory structure. But if it wants to completely demolish that structure and construct something new in its place, it would need to look at a confinement not of nine months but several years.