Reserve Bank of Australia Annual Report – 1988 Financial System Surveillance

Over recent years, central banks in many countries have been assessing what further needs to be done to foster stability in the financial system. Previously adequate ways of gauging the “stability” of financial institutions have become outmoded with developments in communications, the rapid pace of financial innovation and the ease of “cross-border” finance traffic. The nature of intermediaries' balance sheets has changed considerably. Increasingly, business is being written in a form which moves it off the formal balance sheet.

Financial markets, previously seen as distinct, have become intimately related until they are now parts of one broad market place. The connections between markets for equities and those for options, futures and debt issues were highlighted by the October share-market crash, as was the ultimate dependence of those markets on liquidity provided by the banking system. Closer international financial relationships have added a further dimension.

It was a common experience around the world that many of the newer financial instruments and corporate practices which seemed to work well in buoyant economic conditions were severely tested by the events of October. Prompt and firm responses by the authorities and by market participants themselves were required.

In Australia, the stability of the financial system was not seriously threatened in October. With some minor exceptions, market institutions weathered the set-back, despite the fact that share-price falls in Australia exceeded those abroad.

Though some of their clients took heavy losses, banks themselves were not greatly affected. Many had lent to finance share-market transactions including take-overs and other company reconstructions, the fate of which was influenced by share-market conditions. However, in general, they appear not to have lent excessively on the security of shares. As well, Australian banks do not hold extensive portfolios of shares in their own right. In the event, any potential cash-flow problems for banks were ameliorated by the large shift of deposits to them in the wake of the crash.

Other groups of financial intermediaries emerged largely intact, although in some individual cases the extra pressures revealed serious underlying weaknesses. Failures have been few but some intermediaries' net worth and profitability were reduced; some had to take quick steps to restore their capital positions.

Outmoded stock-exchange settlement procedures had led to large backlogs of paperwork and overdrafts necessary to finance this build-up had become a matter of concern in the months prior to the share-price fall. Though the crash hit the industry hard, subsequent falls in trading volume allowed backlogs and overdrafts to be reduced.

Several major financial entrepreneurial firms experienced cash flow problems. While the market was buoyant, the necessary cash flow to finance some take-over offers was expected to be derived from asset sales. When share prices collapsed, some entrepreneurs found cash flows severely disrupted. In some cases, problems were resolved, though at substantial cost, by changes in company structures, including mergers and acquisitions and the divestiture of assets.

During the period of uncertainty associated with the stock-market disorder, the Bank kept in close touch with the financial markets and with other supervisory authorities, both at the state and national level.

While the Bank had a particular interest in the condition of the banks, it also recognised a broader concern for the health of the financial system generally. The share-market crash has influenced the Bank to seek to expand its understanding of the operations of financial intermediaries beyond the banks. It has also kept itself informed of developments, particularly in the United States and the United Kingdom, in the regulation of the securities industries.

In consequence, the Bank's internal structure has been altered to bring closer together the various strands of its supervisory and surveillance activities. Details are shown on page 72.

Banking supervision

The Bank's supervisory work during 1987/88 continued to be based on:

• collection and analysis of statistical data;
• monitoring the observance of agreed prudential standards;
• assessment of the adequacy of individual banks' management systems for controlling exposures and limiting risks; and
• periodic consultation with the management of each bank to review its operations.

This was aided by reports by each bank's external auditor on the bank's observance of prudential standards and other requirements set by the Reserve Bank. The Bank also had frequent discussions with individual banks on specific aspects of their operations and on initiatives being undertaken by them.

The Bank keeps closely in touch with banking supervisors in countries where Australian banks operate and where parent banks of foreign-owned Australian banks are located. It also has regular contact with the Basle Supervisors' Committee.

The Bank participates in the regional development of efficient supervisory systems through its membership of the SEANZA Forum of Banking Supervisors. This includes supervisors from South-East Asia, the Indian sub-continent, Korea, China, Japan, Iran, New Zealand and Australia. The Bank hosted a meeting of the Forum in Sydney during March 1988 attended by member countries, the Chairman of the Basle Supervisors' Committee and representatives of supervisory authorities in the United Kingdom, the United States, Hong Kong and Macau. The Forum provides opportunity for discussion of prudential developments in individual countries and current international supervisory issues.

Convergence of international capital standards for banks

In last year's Report it was noted that the Bank had been discussing with banks technical aspects of a risk-ratio approach for measurement of capital adequacy. Discussions have gone much further in 1988. The Bank has circulated a set of specific proposals which take account of comments received from banks and other interested parties. They are consistent with proposals of the Basle Supervisors' Committee of the Bank for International Settlements but with some adjustments for local conditions and practices.

Under present arrangements, Australian banks observe a minimum capital ratio based on total balance-sheet assets. This approach however does not distinguish between the various risks carried on the balance sheet, nor does it take account of off-balance-sheet business. The gross size of Australian banks' off-balance-sheet business is now around two and a half times their balance-sheet aggregates.

The risk-ratio approach relates a bank's capital to its total credit risks. All exposures giving rise to credit risk, whether on or off-balance-sheet, are taken into account. The higher the aggregate risks, the greater the capital resources that are required.

The Basle Supervisors' Committee has proposed that international banks should be encouraged to achieve, by the end of 1992, a minimum ratio of capital to risk-weighted assets of 8 per cent (of which “core capital” — defined as equity and disclosed reserves — should be at least 4 per cent). The Bank accepts this minimum requirement. Transitional arrangements have yet to be decided.

The risk-ratio approach deals only with broad credit risk and not with interest rate risk or other factors which can bear on capital adequacy. It must necessarily be a somewhat subjective and broad measure if reasonable simplicity is to be retained.

A number of Australian banks already use a risk-based framework for assessing the cost of capital funds and in pricing services and banking facilities. The Bank's guidelines are likely to call for an increase in capital for some banks. There will be a phasing-in period. That is expected to commence in 1988/89.

Overseas operations of Australian banks

Australian banks have continued to expand their overseas operations in terms of both the size of activities and the number of points at which they are represented. In aggregate, the overseas assets of the major banks were about 37 per cent of their total assets at March 1988 compared with about 24 per cent in June 1983.

The international claims of Australian banks are predominantly against borrowers in major industrial countries. Exposures of Australian banks to countries experiencing debt-servicing problems are relatively small. Nevertheless, during 1987/88 the four major banks increased provisions against exposures to debt-rescheduling countries to levels fully comparable with those of major international banks.

Banking structure and ownership

Australian banks' capital ratios generally compare well with those of banks overseas. During the year, several banks took steps to augment their capital bases, influenced by actual and prospective business growth and presumably with the new capital requirements in mind.

There were also several substantial changes in shareholdings in a number of banks. Some shareholders raised their holdings close to the 10 per cent limit set by the Banks (Shareholdings) Act 1972. In one case, an exemption was granted under the Act to permit an acquisition up to 15 per cent of the voting shares. It was subject to an understanding that the shareholder would not attempt to exercise an undue measure of control or influence over the policies or operations of the bank. Two foreign banks increased their ownership share of Australian bank subsidiaries.

Two new banks commenced operations. Tasmania Bank, formed by amalgamation of the Launceston Bank for Savings and the Tasmanian Permanent Building Society, began operations as a State bank in September 1987. Metway Bank Ltd began business as a savings bank on 1 July 1988, following its conversion from the Queensland-based Metropolitan Permanent Building Society.

Banks which have begun operations since 1985 have grown at differing rates. Overall, they have provided extra competition in the financial system, but have not captured a substantial share of banking business. An important factor has been the difficulty in developing an Australian dollar deposit base in competition with the longer-established banks. The Statutory Reserve Deposit requirement has been an impediment in this. It raises the cost of borrowing for all banks but tends to bite harder on the newer banks than on those with a more developed and diverse customer base. In the result, the newer banks have funded the bulk of their customers' needs for credit through bills and offshore borrowings.

External auditors

During 1987/88 the Reserve Bank received the first reports by banks' external auditors covering a full year of operations. The reports cover observance of prudential standards, the reliability of statistical data submitted to the Reserve Bank and the adequacy and observance of internal management systems to limit exposures and control risks. The Bank's understanding of banks' systems has been greatly enhanced by these arrangements with banks and their auditors.

During the year, the Australian Auditing Standards Board issued an “Auditing Guidance Release” to help auditors in reporting to client banks on prudential matters. The Bank co-operated with the Board in preparation of this document.

Other developments in the financial system

In April 1988, legislation was enacted permitting the establishment of offshore banking units. The units will be exempt from interest withholding tax, but earnings from offshore activities will be subject to normal Australian income tax.

The Proceeds of Crime Act 1987 was proclaimed on 5 June 1987. It provides mechanisms for law enforcement agencies to trace, freeze and confiscate proceeds of crime. The Act places statutory requirements on financial institutions to provide specified information to law enforcement agencies and to retain relevant records for seven years. The Cash Transactions Reports Act 1988 became effective in July 1988. The Act requires financial institutions to report cash transactions over $10,000 and foreign currency transfers of more than $5,000. The Act also establishes new procedures for verification of the identity of customers opening accounts.

The Bank continued to be closely involved with developments in the domestic payments system, in part through its membership of the Australian Payments System Council. The Council's work over 1987/88 was mainly on issues concerning the efficiency of the Electronic Funds Transfer (EFT) system. In this context attention was paid to consumer education and protection, and the pricing of payment services. The Standards Association of Australia has continued to develop technical standards for electronic funds transfer to cover communications between components of the system; these include message structure, content and authentication of messages and security.

Electronic payments systems continued to develop quickly during the year. The linkages between the electronic funds transfer at point of sale (EFTPOS) networks of the major and State banks were largely completed during the year. Building societies, credit unions and some of the smaller banks have arranged access for their customers to some of these networks. By June 1988, there were around 9,000 terminals in retail outlets. Transaction volumes now exceed 40 million per annum.

Computer-based systems to facilitate the settlement of transactions in commercial securities and the transfer of high value funds between banks also continued to expand.

Arrangements for processing payment orders through the banks' clearing system have been completed. A payment order is a financial instrument, provided for under the Cheques and Payment Orders Act 1986, which may be drawn on prescribed non-bank financial institutions.

The set-back to world share markets in October demonstrated the importance of a soundly operating system of international payments and showed the strains that could quickly come upon it. Australia, as a significant participant in the system, has a deep interest in its stability. The Bank therefore keeps in close touch with developments.

The Bank also continues to take a close interest in the consumer implications of developments in the financial system. It maintains contact with various consumer organisations, and seeks to encourage a balance between consumers' interests and market efficiency.