Reserve Bank of Australia Annual Report – 1990 Financial System Surveillance

Overview

The Bank has specific statutory responsibilities for the soundness of the banking system. It also has a responsibility for stability of the financial system as a whole. The Bank monitors developments affecting non-bank financial intermediaries, and takes a close interest in the efficient working of the payments system.

The year past has been a difficult one for the financial system, with sharply reduced demand for credit and increased bad debts stressing a number of intermediaries. Towards the end of 1989/90, and continuing into the present financial year, several financial institutions came under severe liquidity pressure. Problems were concentrated in, but not confined to, Victoria. Several non-bank financial groups were unable to withstand heavy withdrawals of funds, making suspension of normal operations — and in a couple of cases, closure — inevitable.

These various strains have to be seen against the background of several years of strong growth in financing, much of it based on rising prices of property and other assets; increases in numbers of lenders; and new financing techniques and products. Competitive pressures had also compressed interest rate margins, although they have widened somewhat in 1990. Financial institutions with heavy exposures to highly leveraged companies, and to commercial property, have been most affected. Those concentrating on consumer business, and others pursuing relatively modest corporate lending goals, have generally fared better.

With profits under pressure, intermediaries have been reviewing their credit assessment and other operational procedures, as well as their overall business strategies. Many are restructuring their businesses and implementing cost cutting measures. Major domestic banks are either formally absorbing the operations of many of their financing subsidiaries or at least integrating their managements more closely, to achieve operational efficiencies and improve management controls. Among foreign-owned banks and especially merchant banks, there is more focus on finding specialised market niches. Only a few intermediaries have quit the Australian market altogether. Some smaller co-operative institutions are being merged for competitive and/or prudential reasons, while a large building society group in Victoria is in the hands of an administrator.

With the financial system experiencing something of a roller-coaster ride in recent years, fingers have been pointed at deregulation as a major destabilising factor. Deregulation unleashed some powerful forces in the second half of the 1980s but it is much too simplistic a view to ascribe all current stresses to that factor.

Deregulation certainly increased the number of lenders and intensified competition among them. In this environment, many of the newer — as well as some of the established — financiers felt impelled to build balance sheets and drive hard for market share. In the process credit became more readily available and, in hindsight, standards of risk assessment in some institutions were clearly compromised. Some institutions also appear to have failed to monitor adequately their borrowers' financial positions. In many instances the credit risk associated with a borrower increased after funds were advanced because of changes in ownership or in the quality of assets held as security; moreover, borrowers often increased their gearing by taking on additional debt.

Deregulation of the financial system was not, however, the only factor in these developments. Demand for funds would have been strong in any event, given rapid growth in the economy and incentives (such as escalating asset values) for borrowers to take on more debt. Moreover, the more recent deterioration in quality of many loans has been an inevitable consequence of the necessary slowdown in economic activity and the reversal of earlier jumps in asset prices. It is also the case that more prudent decision-making by lenders was not helped by the development during the 1980s of creative accounting practices and complex corporate ownership structures. Added to this has been evidence of serious failures on the part of some company directors to meet their obligations fully, together with deficient disclosure of financial transactions. Even so, some lenders have been excessively complacent about the likelihood of deceptive behaviour by borrowers.

The experience of the past few years has provided a stern reminder of the risks involved in any single-minded pursuit of market share. The difficulties in 1989/90 should also remind lenders and borrowers of the folly of behaving as if rapid economic expansion and asset price inflation can proceed indefinitely. Many other lessons have no doubt been learned which should make for a better financial system over the longer term. Institutions are now more appreciative of the importance of careful credit assessment and monitoring, and of reliable documentation. More emphasis is being placed, in lending decisions, on establishing the adequacy of borrowers' cash flows and assets and on the competence of management and boards.

Events of the past year have also pointed to the need for tightening prudential supervision of many groups of financial institutions. In addition, the general public needs to be better informed about the nature of, and risks attaching to, different kinds of financial investments.

Many of the pressures on intermediaries have still to work fully through the system. Falling asset values and lower levels of economic activity will continue to place strains on the value of intermediaries' assets. Highly-geared businesses, especially those which have borrowed against assets (such as commercial real estate) whose values have fallen, continue to pose particular dilemmas for lenders; they realise that precipitate action to reduce exposures by selling assets held as collateral or by declining to refinance loans as they fall due are likely to add to business failures and bad debts.

Although some parts of the financial system have been affected by a loss of confidence in recent months, the most acute problems have been localised. Most financial institutions remain sound and well-managed. Improved prudential arrangements are likely to come from various reviews currently underway.

Bank Supervision

As part of its responsibility under the Banking Act to protect the interests of bank depositors, the Bank conducts prudential supervision of banks. The ultimate responsibility for sound management of a bank resides with that bank's board and management but, in consultation with banks, the Bank maintains a framework of prudential standards within which a bank must operate. The standards cover a bank's capital, liquidity management, large credit exposures and various other aspects of its operations.

Supervisory powers

Amendments to the Banking Act late in 1989 gave explicit powers to the Bank for prudential supervision of banks and enable regulations to be made for this purpose. They also provided the Bank with greater power to seek information from banks for prudential purposes and to investigate, either directly or through an agent, the affairs of banks. The Bank's preference remains that supervision of banks be relatively informal, flexible and consultative; the changes to the Act are seen as providing reserve powers to underpin current practice.

Other important amendments to the Banking Act removed distinctions between trading and savings banks, and formally detailed the arrangements for Non-callable Deposits which have replaced Statutory Reserve Deposits.

Banks owned by State governments are not subject to the Banking Act. However, they comply voluntarily with Reserve Bank requirements. Early in 1990, the Government of Victoria decided to give a formal undertaking to the Bank that the State Bank of Victoria (SBV) would observe the Bank's supervisory requirements. The Bank agreed that, as part of this more formal arrangement, it would meet from time to time with representatives of the Victorian Government and the board of SBV, to discuss supervision issues.

Supervision in 1989/90

In the relatively disturbed conditions of 1989/90, the Bank consulted more frequently with banks on their performances, including the adequacy of systems to monitor and control credit risk. Particular issues concerned the making of realistic provisions against bad and doubtful debts, and the maintenance of adequate buffers of capital to protect against unexpected losses. Transitional arrangements, under which those few banks not meeting a minimum capital ratio of 8 per cent were given time to do so, expired in June 1990. In many other countries the 8 per cent standard is not required to be met until the end of 1992.

Australian banking groups raised capital, in various forms, of $41½ billion during 1989/90. On the latest information available the capital ratio of the banking system as a whole (including consolidated subsidiaries) was around 9.3 per cent, compared with 9.1 per cent in mid 1989.

To help improve its monitoring of potential loan losses and the possible need for more capital, a new statistical collection covering banks' non-performing loans was introduced by the Bank in June 1990.

As noted earlier, changes were announced in February in the Prime Assets Requirement (PAR) under which banks hold a proportion of their liabilities in high quality, readily cashable assets such as Commonwealth Government securities, balances with the Reserve Bank and notes and coin. In consultation with the Bank, a bank could liquidate these assets (or borrow against them) if it were to encounter serious liquidity difficulties. Under the revised arrangements the PAR ratio was reduced in steps from 10 per cent in February to 6 per cent from 1 May. At the same time the range of eligible assets was changed to exclude Non-callable Deposits held with the Reserve Bank; this effectively redefined the starting point ratio from 10 to 9 per cent. The reduction in PAR was consequent upon developments in some other aspects of prudential supervision. These include the risk-based capital adequacy guidelines and closer supervision by the Bank of banks' liquidity management.

As part of a general nervousness about financial institutions in Victoria, the Bank of Melbourne experienced abnormally heavy withdrawals of funds over several days in July 1990. (The Bank of Melbourne had commenced operations as a bank on 1 July 1989, following its conversion from the RESI-Statewide Building Society.) The Reserve Bank issued a statement on 16 July to indicate the supervisory arrangements applicable to the Bank of Melbourne and to reassure depositors that their funds were protected. Soon after, depositor withdrawals subsided.

Issues in bank supervision

Banks' associations with other financial institutions figured prominently in issues considered over the past year. This theme has become more common around the world as banks have become more involved in activities not traditionally associated with banking, such as insurance, funds management and stockbroking.

The Bank has long been concerned that problems in a bank's subsidiaries should not jeopardise the health of the bank itself. With this in mind, the capital adequacy requirements introduced in 1988 were applied both to the bank and to the bank consolidated with its subsidiaries. In August 1989 limitations on large exposures were extended to apply to consolidated bank groups as well. In general, subsidiaries of banks will continue to be consolidated with their bank parents for supervisory purposes whenever practicable.

The ANZ Banking Group's proposal to acquire a controlling interest in National Mutual Life Association (NML) prompted a review of policy on insurance companies and other subsidiaries which are not consolidated with the bank. (It is not considered appropriate to consolidate banks and life offices for supervisory purposes because of the different nature of their assets and liabilities and the role of a separate insurance supervisor.) In light of that review, the Bank announced that, from June 1990, a bank's investment in such non-consolidated subsidiaries, or in associated companies effectively controlled by the bank, would be deducted from its capital and assets before assessment is made of the adequacy of capital to support its other assets. This approach, which is consistent with international practice, limits the potential for multiple use of the same capital in different parts of a bank group. Such investments had been treated previously as if a loan had been made to the subsidiary; this treatment did not properly recognise the different obligations and risks attached to equity and debt.

On-going government policies to encourage savings for retirement are directing funds not only to life insurance companies but also to other institutions engaged in long-term funds management. Banks, understandably, have been developing their involvement in this business. In its approach to this issue, the Bank has aimed to separate clearly the banking business of the bank and its funds management activities. The Bank has also sought to make clear that investors in the latter bear the risks associated with changes in asset prices and poor performance by the funds manager, and that funds from a related bank cannot be relied upon to support managed funds. At present there is no requirement that banks managing funds under trust arrangements hold capital against these funds.

Nevertheless, the potential remains for banks to carry some residual risk from their funds management activities. This is especially so where a bank's name has been used prominently in marketing that business. With banks' involvement in funds management likely to grow, the Bank is reviewing its policies in this area, in consultation with the banks.

Somewhat similar issues are raised by the securitisation of bank assets. This process, by which assets are packaged, sold and thereby removed from a bank's balance sheet, is partly a response to capital adequacy requirements as banks seek to economise on capital. In part it is also a response to the increasing demand for suitable assets by funds managers.

Banking supervisors around the world are agreed that banks can avoid the need to hold capital against securitised assets only where there is a “clean sale” of such assets, i.e. there is clearly no residual risk attaching to the selling bank. The definition of “clean sale” can, however, raise some difficult issues in practice. In securitisation schemes, banks often continue to administer the assets involved, collecting repayments, keeping the accounts and renegotiating doubtful debts as if they were still the owners of the assets. In these circumstances, and depending on how schemes are structured, investors might expect that the originating bank will make good any losses. Even though the bank has no legal responsibility it might feel a “moral” or commercial obligation to do so.

In response to these concerns the Bank is developing, in consultation with banks, a policy on securitisation which is compatible with the capital adequacy requirements for banks.

The ANZ/NML proposal also prompted a reassessment of the Government's policy on full ownership of banks by life insurance companies. Arising from this, the Treasurer announced in May that the Government was not opposed, in principle, to a non-mutual life office owning a bank provided various criteria were satisfied, including that the life office should demonstrate sufficient financial strength and have a diverse share register consistent with provisions of the Banks (Shareholdings) Act.

The Treasurer also specified that a life office owning a bank would be required to accept supervision of itself by the Reserve Bank to the extent necessary to ensure the integrity of its associated bank, and stability in the overall financial system. (The Insurance and Superannuation Commission would continue to exercise its supervisory and other responsibilities for the life insurance and superannuation industries.) Legislative changes will be necessary to implement this policy.

The Bank believes that banks' equity investments in non-financial businesses should not be substantial. This is because a bank's soundness, and public perceptions of its soundness, should not depend to any significant extent on the fortunes of associated non-financial enterprises. The risks to a bank from being a shareholder in a company are greater than those involved in lending since any losses fall first on shareholders' funds. In listed companies the market value of shareholders' funds at any point in time is also affected by sharemarket conditions. However, the Bank understands that in “working out” problem loans it can sometimes be in the best interests of both bank and borrower for the bank to exchange some part of debt for equity. With this in mind, the Bank is prepared to administer its policy with due consideration of particular circumstances.

The risk-based capital adequacy requirements aim primarily to provide a buffer against losses from credit risk, e.g. on lending. However, banks face other risks, most notably “market risks”. These include the risks of loss to which banks might be exposed through fluctuations in exchange rates, in equity or commodity prices and in interest rates.

Supervisors worldwide are currently examining how such market risks should be treated. Possibilities include: incorporating such risks into banks' capital requirements; limits on exposures; or a vetting of banks' internal monitoring of, and controls over, those risks.

The Bank currently receives from banks descriptions of their management systems for monitoring and controlling foreign exchange risk; it also imposes a limit on banks' overnight foreign exchange positions in Australia, as it does with all authorised foreign exchange dealers. Australian banks have not tended to hold substantial equity or commodity positions.

Against this background the Bank is currently paying attention in the first instance to banks' interest rate risk — the potential for banks to incur losses as a result of unfavourable changes in interest rates. This can arise through, for instance, differences in the frequency with which interest rates can be reset on a bank's liabilities and the comparable frequency for its assets.

The Bank has sought to obtain a better reading of the way banks monitor and control interest rate exposures. Banks have been asked to supply detailed descriptions of their current management systems for controlling global, consolidated exposures to interest rate movements; this information is currently being assessed.

Institutional changes

The National Mutual Royal Bank (NMRB), jointly owned by Royal Bank of Canada and the National Mutual Life Association, was acquired by ANZ Banking Group on 2 April. The operations of NMRB are to be integrated with those of ANZ. In July 1990, ANZ announced that it had offered to acquire the Perth-based Town and Country Building Society, for which it would seek a banking authority.

During 1988/89 the State Bank of Victoria (SBV) was granted temporary exemption under the Banks (Shareholdings) Act to allow it to acquire 100 per cent of the voting shares in Australian Bank Limited (ABL). The intention was that SBV's holding in ABL would subsequently be reduced to not more than 10 per cent and ABL would purchase SBV's merchant bank subsidiary, Tricontinental. In the event, ABL did not proceed with the acquisition of Tricontinental. SBV is considering options for either disposing of ABL or absorbing it.

Civic Advance Bank acquired the basic building society business of Canberra Building Society on 1 August 1990. This combined operation is called Canberra Advance Bank.

Australian banks have continued to expand their international banking operations through acquisitions. During 1989/90 National Australia Bank purchased the United Kingdom based Yorkshire Bank PLC. The Commonwealth Bank of Australia purchased, through its subsidiary (Auckland Savings Bank), the Westland Bank Ltd in New Zealand. The State Bank of South Australia acquired the New Zealand-based United Building Society which converted to corporate status and was granted a banking authority in New Zealand.

The ANZ Banking Group acquired the Papua New Guinea bank, Niugini-Lloyds International Bank, through its existing Papua New Guinea subsidiary, ANZ (PNG) Bank Ltd. In addition, the ANZ acquired Bank of New Zealand's 100 per cent shareholding in BNZ Fiji and its 50 per cent shareholding in the Bank of Western Samoa. Westpac Banking Corporation purchased the banking and finance company operations of Banque Indosuez in New Caledonia and French Polynesia.

The State Bank of New South Wales was given corporate status in May 1990. The Western Australian Government has foreshadowed a similar change for the Rural and Industries Bank of Western Australia. Both banks remain wholly owned by their respective State governments.

International co-operation on supervision

The Bank has regular contact with overseas banking supervisors and in particular with the Basle Committee on Banking Supervision.

In April the Basle Committee issued a paper on “Information Flows Between Banking Supervisory Authorities” as an adjunct to the 1983 Basle Concordat dealing with supervision of banks' overseas operations. The aim of the paper's recommendations, which the Bank supports, is to improve supervision of cross-border banking through better sharing of information by supervisors.

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. During 1990 senior officers of Bank Supervision Department visited banking supervisors and senior management of Australian banks in Japan, South Korea, Hong Kong and Singapore.

The Bank also participates in regional discussions on bank supervision through membership of the SEANZA Forum of Banking Supervisors. This includes supervisors from South East Asia, Japan, South Korea, China, the Indian sub-continent, Iran, New Zealand and Australia. In May the Bank was represented at a meeting of the Forum in Bombay to discuss developments in individual countries and international supervisory issues. The Bank has assisted in a number of training programs for banking supervisors conducted in the Asia/Pacific regions.

Non-bank Financial Intermediaries

At present the Bank keeps itself informed of aspects of the operations of non-bank intermediaries, consistent with its broader objective of maintaining an efficient and stable financial system. However, apart from its special responsibilities for authorised money market dealers and dealers in the foreign exchange market, the Bank has no specific responsibilities or powers for supervising non-bank financial intermediaries. Building societies, credit unions and friendly societies are supervised by State authorities. The Insurance and Superannuation Commission is responsible for life offices and superannuation funds, while merchant banks, finance companies and various trust-type investment institutions operate under Commonwealth and State companies and securities legislation.

The Bank substantially upgraded its monitoring of non-bank intermediaries following the 1987 stockmarket crash. Contacts with industry bodies and senior management of intermediaries have been expanded. The Bank also consults regularly with State and Commonwealth authorities with responsibility for various groups of non-bank financial institutions. This helps the Bank to keep abreast of developments and provides the opportunity for exchanges of views on prudential standards.

The debate in recent months about the soundness of some non-bank financial intermediaries, and the adequacy of current regulatory arrangements for them, has raised the question of greater involvement by the Bank. This whole issue is now being examined by relevant industry groups and Commonwealth and State regulatory bodies.

The Bank believes there is value in having a range of financial institutions with diverse product and risk characteristics, and that it is neither necessary nor desirable to seek to force all financial intermediaries into a banking mould. The most important requirement is that supervisory arrangements be effective, whether they apply at the federal or State level. The Bank's resources will remain concentrated on protecting the integrity of the banking system but the Bank will assist in the supervision of non-bank intermediaries where this will contribute to more effective arrangements.

While there have been improvements in recent years, the Bank believes that resources allocated to the task by those bodies responsible for prudential supervision of non-bank intermediaries have not generally kept pace with the increased volatility and complexity of financial markets, nor with expectations of the community. There are acknowledged differences in the quality of State-based supervision which are at least partly attributable to differences in the availability of good resources for the purpose.

When non-bank institutions experience difficulties, as occurred on occasions in the past year, the Bank's main interest is to assess implications for the stability of the financial system, including the possible need to supplement its liquidity base. It is not the Bank's role to provide direct assistance to institutions which it does not supervise. However if banks decide, on the basis of their commercial judgements, to provide short-term liquidity support to a non-bank financial institution in need and in so doing run short of liquidity themselves, the Reserve Bank would fully support those banks. While the Bank does not expect banks to provide support to others against their own commercial judgments, it does expect them to respond sympathetically to requests for liquidity assistance from otherwise soundly based institutions; this has been longstanding policy. The Bank has reminded banks of this position in recent months when some building societies in Victoria came under pressure.

The Payments System

Central banks have traditionally taken a close interest in the efficiency and dependability of the domestic and international payments systems. As these systems and associated clearing arrangements around the world have changed rapidly in the past decade, central banks' interest and involvement have become closer. This has reflected an increased appreciation of the inherent risks in electronic payments systems where problems can flow quickly throughout financial markets. Risk monitoring is being upgraded to protect the payments system from costly disruption and inconvenience. More attention has been given also to deficiencies in systems for trading securities.

In Australia, there has been continued development of payments services and particularly strong growth in electronic payments systems, both retail and wholesale. However, payments clearing arrangements have grown in a somewhat ad hoc manner and are in need of reform if they are to ensure sound development in the 1990s. Historically, payments arrangements in Australia have depended on the stability of a small number of large players to guarantee their integrity. The changing financial environment, including the participation of a wider range of institutions, means that more attention now needs to be given to the design of payments systems and specific prudential aspects of institutions' involvement in them.

The need for change was recognised by the Australian Bankers' Association (ABA) when it reported early in 1990 on the outcome of a review of aspects of the payments clearing system. The Bank participated in that review, which also considered submissions from non-bank financial intermediaries and the Trade Practices Commission.

The ABA recommended a restructuring of payments clearing arrangements and establishment of an overseeing organisation to co-ordinate operational arrangements. Its proposals were designed to increase the transparency of clearing arrangements, to improve the access of non-bank financial intermediaries to the payments system, to suggest principles to govern access and cost-sharing, and to help control settlement risks.

The Bank endorses the broad thrust of the proposed reforms. It is now chairing a Steering Committee (including representatives of banks, building societies and credit unions) to implement the recommendations. The Steering Committee reports regularly on its work to the Australian Payments System Council, which the Bank also chairs, and to other interested parties.

Central banks overseas have been working with banks to encourage them to recognise and price payments settlement risks. Central banks operating payments networks are beginning to explicitly price daylight overdrafts afforded to banks.

Another important theme has been the development of privately-funded arrangements to underwrite the integrity of high-value payments systems. Central banks and the operators of high-value payments systems in most countries are moving to incorporate more safety devices in their systems or to install new systems with inherently lower risk.

In Australia, traffic on high-value payments systems continues to grow quickly. The Bank has held discussions with banks on the risks involved and ways in which these should be managed. It is keen to see that systems for monitoring and limiting inter-bank and customer settlement risk are given proper attention as payments technology becomes more sophisticated.

Consumer Issues

The view is sometimes expressed that consumers are not treated as well as they should be by banks and other financial intermediaries. While available statistical evidence suggests that the number of grievances is tiny relative to the volume of transactions, the Bank is keenly interested in the efficiency and fairness with which financial services are provided to consumers and in the mechanisms established to resolve disputes. However, it does not become involved in disputes between individual customers and financial institutions. A range of options for consumers to resolve such disputes is available, short of action in the courts; these include approaches to senior management of institutions, State consumer affairs departments and the recently established Banking Industry Ombudsman. The Bank expects that the Banking Ombudsman will make a significant contribution to resolving disputes and improving banks' services to their customers. The Bank is represented on the Board of the Ombudsman scheme.

The Bank has been involved, through the Australian Payments System Council, with several projects to enhance safeguards to consumers using electronic funds transfer (EFT) services. In the first, the Council has been carrying out a study of security in EFT systems. The study is intended to help institutions to better assess the security of their systems and to provide consumers with reassurance about standards.

In mid 1989 State and Commonwealth governments endorsed a revised Code of Conduct governing EFT transactions. The Payments Council is monitoring institutions' compliance with this Code to ensure that customers benefit fully from the protection it offers. The Council has also monitored institutions' compliance with new standards for design of automated teller machines.

The Bank believes the potential benefits for consumers from deregulation in financial markets will not be realised unless intermediaries disclose fully the terms and conditions on which services are offered. To further this objective, the Bank is represented on a Standards Australia committee developing a consistent manner of disclosing interest rates and other borrowing costs. The Bank also presented a submission to officials of the Standing Committee of Consumer Affairs Ministers working on the Draft Bill dealing with consumer credit. The Bank argued for uniformity of requirements across States and full and consistent disclosure without unnecessary restrictions on flexibility in pricing and design of services.

During 1989/90 the Bank maintained an interest in two particular areas involving difficult judgments about consumers' rights to privacy and the broader public interest. These are credit reference reporting and monitoring of financial transactions for possible connection with crime. As to the former, the Bank accepts the value of credit reference facilities in aiding the credit assessment process and reducing the prospect of high bad debts (and, therefore, borrowing costs). However, any such facilities need to ensure that improper or unauthorised access to information about an individual's or company's credit commitments does not occur and that the public is confident of that.

Further provisions of the Cash Transaction Reports Act came into operation in 1990. From 1 January 1990 financial institutions and other cash dealers have been required to report to the Cash Transaction Reports Agency any suspicious transactions and from 1 July 1990 all transactions in cash over $10,000. From February 1991, stringent identification checks will be required to be made by financial institutions when opening new accounts. As a result of discussions between financial institutions and the Agency, steps have been taken to ensure that the community benefits of this Act are achieved at least cost and inconvenience to their depositors.

“The very acceptance by government of a higher, though hopefully steady, inflation rate would influence expectations in such a way as to make prices rise more rapidly and less steadily In short, the case for accepting steady inflation fails to recognise both the imperfect capability of public policy and its influence on price expectations.”

Arthur M. Okun
The Mirage of Steady Inflation, 1971