Reserve Bank of Australia Annual Report – 1996 Development of the Financial System

On 30 May, the Treasurer announced the terms of reference of the first major inquiry into the Australian financial system since 1981. Among other issues, the Inquiry will consider the extent to which existing regulatory arrangements meet the objectives of efficiency, stability, market integrity and fairness, and how those arrangements might be improved to cope better with current and prospective developments.

Deregulation and technological change have promoted growth, diversity, innovation and extensive change in the financial sector over the past decade and a half. Regulatory structures and techniques have responded, with increased market freedoms for financial institutions balanced by requirements for prudent behaviour, public disclosure, and more attention to consumer needs. Some of the forces driving these developments and regulatory responses are outlined in this chapter.

Structure of financial system

The Campbell Inquiry surveyed a financial system with many legacies of the period of postwar reconstruction. Limits remained on interest rates, lending volumes, maturity structures and bank ownership. One effect of this regulatory framework was to undermine steadily banks' dominance of the financial sector; non-bank intermediaries expanded to fill the vacuum. The Campbell Committee, which reported in September 1981, recommended the removal of virtually all government intervention which restricted the “efficiency and flexibility of the financial system”.

Financial institutions

(Percentage share of financial system assets)

June	Banks	Non-bank financial intermediaries	Funds managers and insurers
1956	62	11	27
1966	51	17	32
1976	45	29	26
1981	41	33	26
1986	41	29	30
1991	45	21	34
1996 (e)	46	16	38

Much of the Committee's advice was accepted. In 1982, the Commonwealth Government introduced tenders for government bonds. Subsequently, price and quantity controls and captive market arrangements were abandoned. Interest rates on deposits, as well as loans, were deregulated. The Australian dollar was floated and exchange controls removed in December 1983. Restrictions on the establishment and ownership of merchant banks were eased in 1984, and 15 foreign-owned banks were authorised in 1985/86. Policy on foreign bank entry was eased further in 1992. Building societies and credit unions gained increasing access to the payments system. State governments removed lending and interest rate controls on building societies and abolished captive market arrangements for workers' compensation and third-party motor vehicle insurance. Many State government-owned financial institutions were corporatised and then privatised, although in several cases not before enormous losses had been incurred.

Ownership of Australian financial institutions
Per cent owned by:

Deregulation has brought major changes. To begin with, the financial sector has expanded dramatically; after changing little relative to GDP for 20 years, the ratio of assets of the financial sector to GDP nearly doubled following deregulation. The market shares of banks, funds managers and insurers have increased while non-bank intermediaries have lost ground. In spite of several mergers, new entrants (foreign banks and former building societies) have pushed the number of banks to around 50, compared with 25 in 1980. Another 40 or so foreign banks operate in Australia as merchant banks. The share of funds managers and insurers has benefited particularly from high earnings on investment-linked products, which have attracted household savings away from bank accounts, while government retirement incomes policy has channelled growing sums of compulsory savings into tax-advantaged superannuation funds.

The impact of this increased reliance on market forces had two distinct phases. Initially, competition among financiers produced some unwelcome side-effects as intermediaries battled for market share and lost sight of adequate credit standards. This caused losses both for the financial institutions directly involved and for the community at large. The response of prudential supervisors to this period was to tighten requirements on individual financiers to moderate their capacity for imprudent behaviour but, in retrospect, it is clear that supervisors – as well as the institutions – were not as well prepared for the shock of deregulation as they might have been.

Flows of household* savings
(Percentage of total)

In the second phase, the expected benefits of increased competition – innovation and more keenly priced products – have started to appear. A better balance of flexibility and prudence has allowed the deregulated financial system to demonstrate its ability to generate new and better ways of meeting community needs. The innovative behaviour of market participants has posed challenges for the existing regulatory framework but it is adapting to change without stifling innovation.

The combined effects of competition and technology have encouraged many financial institutions to offer products traditionally provided by others, blurring former distinctions in the process. Insurance groups offer short-term savings facilities and home loans, although only in modest quantities; in fact, around 95 per cent of deposit-type funds are lodged with intermediaries, and this proportion appears to have been little changed over recent years. More significant blurring has occurred with the growth of financial conglomerates such that banking groups can offer funds management, superannuation and life insurance through special-purpose subsidiaries. All but four of Australia's largest 25 financial institutions – which control around two-thirds of financial system assets – have expanded beyond their traditional business boundaries to form financial conglomerates; most have a bank or insurer as the dominant operating entity.

Financial system assets

(Percentage of total)

	1980	1996
Major bank groups	38	36
Banking groups	53	60*
Insurance groups	18	18
Other	29	22
* Includes The Colonial Mutual Life Assurance Society Limited and its subsidiaries

Despite perceptions of the blurring of traditional functions and products encouraged by such developments, financial institutions continue to offer two conceptually distinct sets of liabilities:

• deposits (including transactions balances), some life insurance policies and annuities, where institutions undertake to repay a specified nominal sum at some future date. In the normal course the institution, not the customer, assumes the risks associated with earning a return on its assets; and
• investment-linked products, such as unit trusts and accumulation superannuation funds which are managed by financial institutions on a “best endeavours” basis. Customers bear the risks of declining investment values but reap the benefits of higher returns.

The risks faced by institutions undertaking these two types of business, and the risks faced by their customers, are fundamentally different, and are subject to two distinct supervisory regimes (see below). Given that the risks and regulatory requirements are different, institutions offering a range of these products are generally obliged to do so in separate financial entities, even when they are part of a financial conglomerate. This facilitates their supervision by different agencies.

Technology and innovation have allowed products which were traditionally linked – such as deposits and loans – to be separated, as well as previously separate products – such as part fixed/part floating-rate loans – to be offered jointly. Complex financial products, such as derivatives, have allowed companies to manage risks better by splitting them into components. This “unbundling” of financial services has allowed specialists to make inroads into sectors of banks' traditional markets, as is well illustrated by the recent success of mortgage originators (and securitisation schemes) in the residential mortgage market. Advances in technology are also opening up possibilities in the payments system. The development of stored-value cards and the use of the Internet to make payments raise a number of policy issues which were touched upon in the previous chapter.

As superannuation assets continue to accumulate, the demand for securitised loans and other marketable securities can be expected to increase, providing further opportunities for specialist lenders with low distribution costs and a strong customer focus. The banks will face increasing competition for funds, and will be under ongoing pressure to contain their costs, but they do have specialist abilities for assessing credit-worthiness and designing financial products to meet particular customer requirements.

Evolution of regulatory arrangements

The regulatory regime of the 1950s through to the 1970s, based on direct controls, has been long dismantled. The present system, based largely on market disciplines, seeks to promote efficiency and stability while serving the interests of consumers. The arrangements summarised in the following table have evolved out of legislative and other changes over the past decade or so with those various objectives in mind.

Financial institutions, like other businesses in Australia, have to conform to a range of basic business standards, such as the accounting standards, public reporting requirements and prospectus requirements specified by the Australian Securities Commission (ASC). The Australian Competition and Consumer Commission regulates various restrictive agreements and aims to protect consumers from unfair trade practices under the provisions of the Trade Practices Act. Both these authorities play active roles in the financial sector, reflecting that sector's importance in the overall economy, the significance of disclosure to investors and retail customers, and the extent of merger and takeover activity in the sector.

On top of these are supervisory and regulatory regimes designed to protect savers and safeguard the stability of the financial system. Here the focus traditionally has been on the supervision of banks, given that bank deposits represent the major obligations of financial intermediaries to the public and banks are the major source of funds for small and medium-sized businesses. Banks also play the dominant role in the payments system, which is a potential source of transmitting instability in the financial system. More recently, the supervision of building societies, credit unions and life insurance companies, which also involve obligations to repay contracted nominal amounts to the public, has attracted increased attention.

Protection of holders of claims of this type requires supervision of the institution issuing them, because the value of the claims depends on the solvency of the institution. Prudential supervision of this sector is, therefore, mostly institutionally based; reducing the risk of insolvency of an institution provides a degree of protection to both individual depositors and the system more generally. Supervision of these institutions has concentrated on encouraging prudent behaviour, including minimum requirements for capital and liquidity, sound internal management systems, and clear understandings by managements and boards of their obligations.

The Bank is engaged in this type of prudential supervision, along with the Australian Financial Institutions Commission (AFIC) and the Insurance and Superannuation Commission (ISC). Since its establishment in 1960, the Reserve Bank has had responsibility for the banking system. Its modus operandi has progressed as deregulation progressed. In 1984, a Bank Supervision Department was established which, over the following years, has issued a series of prudential requirements to which banks must conform. One of the most important of these was the introduction in 1988 of consolidated, risk-weighted capital requirements based on international standards. In 1989, the Banking Act was amended to give the Reserve Bank explicit responsibility and related powers for the prudential supervision of banks. More recently, following the difficulties experienced by many banks in the early 1990s, the Bank has standardised requirements for reporting impaired assets, valuing security and determining provisions. It has also introduced programs of on-site visits to banks to assess portfolio quality and risk management systems.

Until the early 1990s, building societies and credit unions were regulated under a range of regimes administered by the States and Territories. Competitive pressures and a number of well-publicised collapses demonstrated the need for prudential standards to be raised and applied uniformily across Australia. In 1992, the States passed template legislation establishing AFIC; AFIC sets prudential standards for building societies and credit unions which are implemented on a day-to-day basis by State supervisory authorities. AFIC's prudential framework is very similar to that followed by the Bank in its supervision of banks.

The ISC, which supervises the insurance and superannuation industries, was formed in 1987 from the offices of the Life Insurance Commissioner, the Insurance Commissioner, the Occupational Superannuation Interim Group and the Australian Government Actuary. The supervisory frameworks for both life offices and superannuation funds have been upgraded substantially through the Life Insurance Act 1995 and the Superannuation Industry (Supervision) Act 1993. The ISC sets and monitors standards for the solvency of life and general insurance companies and the management of superannuation funds but puts responsibility for the prudent management of funds on the financial entities themselves. To this end, it requires insurance companies and superannuation funds to maintain adequate risk management policies and internal controls.

Market-linked financial investments, such as public unit trusts and certain life office products, are managed on a “best endeavours” basis where the return reflects the value of the underlying assets (eg equities, property). The value of these products can fall without entailing the failure of the managing institution. In other words, an institutionally based prudential regime is generally not appropriate for this sector; rather, the emphasis is on standards of disclosure and behaviour to assist investors to make informed choices. Unlike the Reserve Bank and AFIC, the ISC also oversees consumer protection measures related to disclosure and codes of practice. The ASC oversees disclosure by public unit trusts.

Financial regulators in Australia, along with their counterparts in other countries, have been criticised both for failing to foresee and forestall failures (“lax supervision”), and for imposing unwarranted burdens (“excessive supervision”). Complaints are also heard of inconsistencies and overlaps, which is not surprising. Some “overlap” of responsibilities is inevitable, given the range of products and services now offered, the extent of the markets in which they are traded and, on top of that, the emergence of financial conglomerates. Some perceived inconsistencies probably reflect, in part, the different degrees of risk which investors wish to assume; where investors are prepared to accept investment risks themselves, there is no need for institutions to hold capital as a buffer against loss. Australia's regulators and supervisors have been alert to the problems of unintended gaps and overlaps in a rapidly changing environment, and have been guided in their responses by emerging international practices.

The Council of Financial Supervisors, established in 1992 following a recommendation by the 1991 Parliamentary Inquiry into Banking and Deregulation (the “Martin Committee”), was a direct response to the need for better co-ordination of financial supervision, including in respect of financial conglomerates. The Council is a non-statutory body whose members, the Bank, AFIC, the ISC and the ASC, have authority over institutions managing around 97 per cent of the total assets of the Australian financial system. To date, the Council has concentrated on improved co-ordination and understanding among its members: ASC and ISC product regulation is being harmonised under the Council's auspices, and it is co-ordinating proposals for the regulation of derivatives. Guidelines for the supervision of conglomerates have been agreed, and the Council is seeking legislative changes to allow restricted information to be exchanged among its members.

Although it has had a relatively low profile to date – partly because of the absence of major problems in the financial sector – the Council has been quietly laying the groundwork for effective co-ordination arrangements to respond to any crisis which might arise. Its flexibility and relative informality have been helpful features in this regard.

Financial institutions are also subject to general consumer protection requirements applicable to other Australian businesses. The particular complexity of many financial products and services has led to a situation where financial institutions also have to conform to additional Commonwealth and State government requirements, as well as a number of codes of conduct. These additional requirements and codes have focused on the areas of disclosure, behaviour and dispute resolution.

All credit-providers will be affected by the disclosure provisions of the Consumer Credit Code, which is now expected to come into effect throughout Australia on 1 November 1996. This Code, which has been many years in the making, will replace the the separate provisions currently in force in each State. Most banks, building societies, and credit unions will also formally adopt their industry codes of practice on 1 November; these require full and effective written disclosure of all fees and charges, along with details of repayments and any restrictions or penalties. The ISC requires life offices to disclose all fees and charges (including agents' commissions) in a “Key Features Statement”. The general insurers' voluntary code of practice aims to promote disclosure of information, and to facilitate comparisons of different products. ISC disclosure requirements for superannuation funds also have been upgraded. The industry codes of practice set minimum standards of behaviour in a number of areas, including in relation to variations in terms and conditions.

One aspect of the ongoing relationship between financial institutions and their customers which has attracted particular attention in recent years has been the imposition of fees and charges on transaction accounts. In its inquiry into fees and charges imposed on retail accounts by banks and other financial institutions in 1995, the Prices Surveillance Authority concluded that while regulation was not required, banks should align their pricing in this area more closely with their costs. Responding to this conclusion, most banks over the past year have introduced accounts which provide limited transactions at low cost for customers with small balances.

Given the growing complexity of financial products, it is almost inevitable that misunderstandings and disagreements will arise between financial institutions and their retail customers. The codes of behaviour of the banks, building societies and credit unions provide for internal processes to handle disputes, as well as providing for customers to have access to an impartial external dispute resolution process free of charge. Complaint handling systems are also operated by both the Commonwealth Government and industry bodies for customers of the insurance and superannuation industries.