Conference – 1991 Banking Deregulation – A Virtue or a Necessity? Rob Ferguson[1]

1. Introduction[2]

For much of the 1980s, the conventional wisdom was that banking deregulation was a wholly-virtuous process. Now in the 1990s, with the destabilisation that has resulted from the asset boom and bust, this conventional wisdom is being challenged. This challenge highlights four key issues that require answers.

  1. To what extent was it accepted by banks and the community that deregulation required a new overt form of banking supervision and regulation?
  2. Were the banking problems of deregulation predictable?
  3. Was our supervision and regulation adequate for the task? Did the checks and balances of auditors, directors and shareholders of banks fail to fulfil their role as complements to the supervisors' role?
  4. Is the oligopolistic structure of banking in Australia a benefit or a disadvantage?

2. From Covert to Overt Supervision

(a) The Covert Supervision of the Old System

It is worthwhile defining deregulation in the context of the banking industry. To the community at large, deregulation implies no supervision or regulation, which is, of course, far from the truth. Talk about deregulation in the community tends to confuse two separate but related events. The first was the complete deregulation of interest rates, which occurred in a number of steps, but was largely completed by the early 1980s. Next came the need to replace the system of banking supervision and regulation that was embedded in the controlled interest rate environment with a new system of banking supervision and regulation. This came somewhat later.

The control of interest rates was the cornerstone of banking supervision and regulation in the post-war period. Interest rate controls rationed the availability of credit. Banks had a certain amount to lend and this tended to be allocated to the best clients. Typically, these were the clients with the best credit standing. Deregulation of interest rates eliminated credit rationing. In its place came the market mechanism which moved the price of credit up or down via changes in interest rates. Thus the borrowing queue was dispersed and instead borrowers, subject to minimum creditworthiness conditions, were now free to bid on the price they would pay for a loan. For many borrowers who had come to regard inflation at the high levels of the 1970s as a permanent feature of the landscape, the price of loans was overwhelmed by the prospect of asset inflation on the scale of the 1970s. The high real interest rates that should normally have been a major deterrent to excessive bidding for funds was heavily discounted by those who extrapolated the past into the future.

The bidding process for credit catered to the reckless borrower. Such borrowers were typically poorer credits. If they had more at stake, they would have conformed more to the principle that “it is unwise for an individual to risk losing what he has and needs in an effort to gain what he doesn't have and doesn't need”.[3]

(b) Competitive Pressures and Market Share

The countervailing force to the enfranchising of borrowers who were previously forced to exist at the fringe of the financial sector should have been the natural conservatism of our banks. But intense new competition had been introduced to the erstwhile club environment of banking. This competition took two forms. First, the major banks were encouraged to compete amongst themselves for market share. In the regulated environment, given the difficulty in differentiating product by price, it made little economic sense to compete aggressively for market share. Lifting this constraint through a series of regulatory changes including the abolition of most interest rate ceilings in 1980, and culminating in the elimination in June 1982 of quantitative bank lending guidance, was thus a revolutionary step. The next step in the unleashing of competition was the February 1985 invitation to sixteen foreign banks to accept banking authorities.

The domestic banks had been primed for foreign bank entry and were determined to hold their ground against this competitive onslaught. Furthermore, they were keen to expand internationally both to follow customers overseas but also to demonstrate to the world the quality and skill of Australian banks and bankers.

This enthusiasm for competing head-on with new banks in Australia and reaching out to the rest of the world was reflective of a mood that went beyond the Australian financial community. It was also heavily influenced by a worldwide belief that banking was a business that was readily transferable internationally without significant deterioration in one's competitive position. What the 1980s has shown is that only very specialised parts of banking are truly global businesses. It has become clear that the strength of most banking institutions is largely domestically based in their commercial and retail franchises. Banks tend to be strong at home and weakened when abroad. For the Australian banks in the early 1980s, their obliviousness to this truth meant they overestimated their ability to compete internationally but equally they overestimated the capacity of foreign banks to make an impact in the Australian market. This meant they competed in Australia for their customer base against foreign banks with a ferocity that was unnecessary. Likewise their efforts to make ground overseas, with the exception of the NAB, was disappointing.

Once the incumbent Australian banks were released to compete against each other and the world, they sought market share in wholesale banking as their measure of success. For some industries, some of the time seeking market share is an appropriate strategy, but for wholesale banking, most of the time this is a fundamentally flawed strategy. In retail banking, the need to build retail liabilities to fund retail assets acts as a partial discipline on a market share approach to retail banking. The consequence of this rush to compete for wholesale market share was the catapulting of our previously conservative banks who via the rationing system of the regulated era needed to think only minimally about corporate credit risk issues into the dangerous world of high interest rate lending.

The high interest rate lending market had always existed outside the banking system but the weaknesses of the credits was offset by the scepticism of the lenders. This scepticism reflected a lifetime of lending experiences. For the unleashed banks, these experiences were yet to come. The lack of experience in the major banks of high interest rate lending is curious given that most banks owned finance company subsidiaries that in the 1974 recession had experienced significant loan problems. It seems that many of the subsidiaries were very separate organisations with distinct cultures and therefore the benefits of these experiences tended not to be recorded in the folklore of the parent companies despite the fact that they footed a large part of the bill. Given the poor lending experiences of some bank-owned finance companies in the current cycle, it appears the lessons of 1974 did not prove enduring even within those organisations.

In this era of high interest rate lending, at the extreme, loans were advanced to borrowers who put up little in the way of equity. The borrowers were taking an option bet with the bank's money. Heads I win a lot, and you win a bit; tails you lose. The banks thought they were making loans but often they were investing in equity with a return capped at the loan rate. Many of today's problems relate to this era of equity banking in the mid to late 1980s – an era that reflected the unleashing of a comfortable oligopoly which not only aggressively competed amongst itself for the first time but also took on most banks that passed by its sights.

(c) Why Regulate?

It is worthwhile pausing to ask “why is it that banks should be supervised and regulated”? There is, of course, an argument for no bank supervision and regulation. To succeed, such an approach would depend on absolute reliance on the disciplines of the marketplace with no safety net or “too-big-to-fail” concepts. Banks in this model, small or large, would be allowed to fail, irrespective of the harm done to depositors and the impact on the real economy. Most would argue that this model, while theoretically possible, is socially unacceptable. As Wojnilower (1991a) has written, “the financial system ultimately is a conduit as fundamental to our well being, via production and employment, as that of electricity and water. Standards, access and behaviour, therefore, should not be left entirely to market forces”.

It seems our society has concluded that, in a modern industrial economy, banks have a special role and responsibility. They are holders of public funds and have huge liabilities, most of their assets are illiquid and their capital is small relative to other business. Thus the need for some supervision and regulation.

3. Were the Banking Problems of Deregulation Predictable?

(a) The Initial Resentment of Prudential Supervision

The above approach is the way society thinks today but what was the view when deregulation began? Was there a belief that the banking system could and should stand on its own two feet? Certainly such a view is consistent with the free market attitudes that seemed to peak in the early 1980s. Self-regulation and competition were frequently linked as being the way to cope with the new environment. Deregulation was expected to produce “efficiency, competition and innovation” with no mention of any negatives. Such attitudes meant that deregulation of the currency, interest rates and the introduction of new competition into banking tended to be seen by the community and industry participants as a wholly-virtuous process. The incumbent banks were, after a post-war period of constrained competition, very strong financial institutions. There was little thought of the possibility of this strength being diminished but rather an emphasis on the benefits of the new era. Among those who favoured this new environment were the supervisors. At the Reserve Bank, the task of coping with an inadequate set of regulations led the supervisors to recognise the necessity of change. However, there is a big difference between reacting to a necessary process, and turning that process into a virtuous one.

I believe all of us suffered from that fault. Being starry-eyed about the benefits of deregulation meant that we tended not to focus on the downsides of the new era. There was little debate on the disadvantages of the new environment and in particular little discussion on the need for banks to continue to be supervised and regulated but in a different way.

Probably the worst offenders in this process were the incumbent banks. Supervision and regulation is a balance between privilege and burden, but by the early 1980s the incumbent banks were chaffing at the extent of the burden. Banks, as the ruling financial class, had seen their share of the cake diminish over the post-war period and thus saw deregulation as an opportunity to claw back what they had lost. The incumbent banks felt most competent to handle the new environment and were bolstered in their confidence by their relative financial strength compared to many international banks still suffering from their LDC exposures. Our banks, more as a function of their cloistered environment than good management, had largely avoided LDC damage, but this had not stopped them from basking in the glory of this fact.

There is a tendency for any long-term holders of privilege to not concede or appreciate the advantages of that privilege. The incumbent banks suffered from this in the early 1980s. Consistent with the free market mood of the time, they pushed for as much freedom as possible and, as very strong financial institutions, resented the need for overt prudential supervision.

In the regulated environment, prudential supervision was simply a by-product of macro-economic policy, but given that banks engaged in very little risk taking, the benefits of the by-product were not obvious. So from the banks' point of view, the incoming system of overt supervision was a new hindrance and a reactionary move – re-regulation. Thus, the then Managing Director of Westpac, Mr Bob White, denounced the Reserve Bank move to use external auditors in their supervisory activities as “re-regulation”. (He now regards the process as perfectly proper.)[4]

(b) Were the Banking Problems of Deregulation Predictable?

So what of the turmoil we encountered post deregulation – was our experience unique and therefore unpredictable or could we have had some inkling of the outcome? I think it is true to say that virtually all of the Australian discussion failed to foresee the potential for banking problems, or at least greatly underestimated them. Participants in financial markets were keen to be free of the old regulated system, and like their colleagues in the economic profession had great faith in the power of the free market to produce optimal outcomes.

Of course, if you looked hard enough, there were some early doubters (see Wojnilower (1980) and (1985)). Another example was Andrew Graham, a visiting Oxford academic, who said in 1984 to the Economics Committee of Cabinet, “If Australia goes ahead with deregulation of interest rates, maturity structures and market entry then this will need to be accompanied by greater not less supervision. In the absence of increased supervision, what will happen is quite clear. First, the tight regulation that has been in operation in Australia has acted as a substitute for bankers' caution. So if regulation is removed, the system will expand – though not necessarily immediately. This expansion will be particularly swift in a situation in which the virtues of competition are being especially espoused. The tendency towards expansion will also be decisively re-inforced by the presence of new entrants … At the same time the more competitive environment will put pressure on profit margins. The result of this process will be that the system will eventually overextend itself, unjustified risks will be taken and when the optimistic expectations break individual institutions will be found in trouble – trouble that will bring with it demands for greater investor protection and increased supervision”.[5]

Graham's correct prediction of events was largely ignored, presumably because he was seen as an old-fashioned regulationist, but also because his solution, direct controls on lending that are changed “every so often”, seemed and is impractical. The other issue that Graham clearly was aware of was “in attempting to control the quantity of money, central banks have had to rely on controlling the demand for money by influencing the whole structure of interest rates. However, in the situation I have described, it becomes rather a forlorn hope to expect that it will be possible to move gently along a stable demand for money. Either expectations of expansion will continue undeterred (in which case demand for credit will appear very inelastic), or expectations change and there is overkill. This – the difficulty of controlling the quantity of money through price – is the major argument for direct controls”.

(c) The Asset Price Boom: Should it have been Predictable?

As noted earlier, the inflationary mentality of the 1970s and its apparent transformation to habitual mode of behaviour in the 1980s, despite the obvious warning signs of high real interest rates and insufficient cash flow coverage, was an unexpected factor. To what extent was this a major contributing element to the banking problems that showed up at the end of the decade?

We have seen throughout history waves of expansion and contraction in credit that in retrospect were irrational. Often they started for good reason but simply got out of control. This reflects the “predictable irrationalities among people as social animals. It is now pretty clear (in experimental social psychology) that people on the horns of a dilemma … , are extra likely to react unwisely to the example of other people's conduct, now widely called ‘social proof’. So once some banker has apparently (but not really) solved his cost pressure problem by unwise lending, a considerable amount of imitative ‘crowd folly’ relying on the ‘social proof’ is the natural consequence”.[6]

In the 1980s we had good initial grounds for the boom in borrowing. “Equity prices received a substantial boost … from the cyclical recovery in profits and the structural increase in profit share of GNP resulting from the fall in real unit labour costs under the Accord. Thus the first couple of years of strong growth in share prices was attributable to real, rather than financial, factors”.[7] This prompted a situation whereby there was “a willingness to assume liabilities structures that are less defensive and to take what would have been considered in earlier time, undesirable chances …” At the same time the bankers, “those who supply financial resources live in the same expectational climate as those that demand them. In the several financial markets, once a change in expectations occurs, demanders, with liability structures that previously would in the view of the suppliers have made them ineligible for accommodations, become quite acceptable. Thus the supply conditions for financing the acquisitions of real capital improve simultaneously with an increase in the willingness to emit liabilities to finance such acquisitions”.[8]

Equally, the equity market is ruled by the same “expectational climate” as banks and borrowers. Thus, ANZ, NAB and Westpac were able to raise substantial amounts of new capital over the 1980s. By 1990, their combined shareholders' funds amounted to $17.4 billion, compared with $2.6 billion at the start of the decade (see Table 1). New capital, including dividend re-investment plans and raisings for acquisitions, amounted to over $6 billion (see the Appendix).

Table 1 Bank Shareholders' Funds
As at 30 Sep. ANZ NAB Westpac
1981 928 591 1,107
1982 1,063 918 1,488
1983 1,195 1,046 1,652
1984 1,781 1,354 1,903
1985 2,214 1,970 2,439
1986 2,736 2,193 2,780
1987 3,143 2,848 2,986
1988 3,911 4,229 5,499
1989 4,009 5,676 6,351
1990 4,323 6,251 6,871
Mar. 1991 4,403 7,540* 7,100
* Includes recent rights issue of $1,050 million

Another factor inducive to the ultimately irrational lending and borrowing of the 1980s was the attractions provided by the tax system to borrow. Over the whole post-war period, the tax system had contained many irrationalities. These included the lack of capital gains tax, the double taxation of dividends and taxation and deductability of nominal interest rates rather than real interest rates. The lack of capital gains produced the inevitable distortions in behaviour as did double taxation of dividends. When inflation ignited in the 1970s the gearing mania was unleashed, but the overall constraint on lending provided a crude but, in retrospect, effective cap on the exploitation of the tax system. By the 1980s, with this cap gone, the pent-up demand for tax minimisation, which typically features some form of gearing, exploded. There is a clear lesson here in terms of the timing of deregulation. To date, the view has prevailed that the best way to start deregulation in our economy was to begin with the financial system. Given our present knowledge of the capacity of a deregulated financial system to exploit tax anomalies, it is clear that it would have been better if the partial levelling of the tax playing-field that came during the second half of the 1980s had been done prior to financial deregulation.

Ironically, at the time of the elimination of double taxation of dividends (a laudable step), the ANZ, Westpac and NAB, as the stock market major beneficiaries of this move, experienced a sharp once-off rise in their share prices thus reducing their cost of capital and allowing them to raise, and gear against, $2.3 billion in equity. These capital raisings occurred in the period May-July 1988. The timing of this access to new equity was unfortunate. Here was a case of the market providing funding over and above their view of the “expectational climate”. Of course, the gearing available had the effect of lifting that “expectational climate” another few pegs especially as it was soon after the Reserve's Bank's, now acknowledged, period of excess monetary ease in the calendar year running up to the October 1987 stock market crash.

4. Was Supervision and Regulation Adequate?

(a) The New Overt System of Regulation

The deregulation of interest rates and the introduction of new competition prompted the need for changes in the way our banking system was supervised and regulated. This was recognised by the establishment in 1980 at the Reserve Bank of an “embryonic supervision group which began thinking about what statistics might be useful for assessing a bank's health”. (Thompson (1991))

During the 1980s “as deregulation gathered pace, the Bank's supervisory activities expanded” (Thompson (1991)) to the point where prudential standards covered:

  • capital;
  • liquidity management;
  • large credit exposures;
  • foreign exchange exposures;
  • associations with non-banks;
  • ownership of banks.

These issues are covered by a series of regulations requiring statistical returns and formal consultation with Reserve Bank supervisors. The credibility of these returns and effectiveness of management systems is subject to verification by the external auditors of the banks who give separate reports to the Reserve Bank. This post-deregulation model of bank supervision and regulation is based on the fundamental principle of ensuring that banks have sufficient capital at risk so that they behave as if they have a lot to lose by imprudence. Thus, so long as banks keep within the regulations set down, prudence is largely left as a management issue.

The question is, was our new overt system of bank supervision a sufficient substitute for the old covert system of supervision?

(b) Was the Overt System an Adequate Replacement for the Covert System?

The answer to the above question is anything but straightforward. First of all, it requires an examination of the broad monetary policy implications of deregulation and the tools available to the Reserve Bank in this environment, and secondly it requires a look at the use of these tools.

The main implication of interest rate and currency deregulation from the monetary authorities' point of view was that by eliminating direct lending controls it took away the capacity of the supervisors to control credit without sustained periods of excessively high interest rates with the destructive effect this involves on the real economy. To be sure, in the regulated era, interest rates in less regulated markets were highly volatile, as in 1961 and 1974, but combined with the rationing effect of credit controls acted very quickly to counter excess demand.

The problem the regulators faced progressively through the post-war period was the erosion of the central bank's credit rationing capacity and the need to offset this with the blunt instrument of interest rate changes. While it has been argued that the supervisors could have extended their reach beyond the banking system to offset this leakage that occurred via the growth of the unregulated sector, it is apparent that technical and financial innovation would have always been a step ahead. “In the mid 1970s a widening of the regulatory net in the form of the Financial Corporations Act of 1974 was contemplated, but in the end the Act was not used for that purpose. Once again it was recognised that as each new set of financial institutions was brought within the regulatory net, another set could be expected to emerge outside that net”. (RBA (1991))

The floating of the dollar and the elimination of exchange controls put this issue beyond doubt. If the supervisors sought to control non-banks via the Financial Corporations Act, then overseas banks would fill the vacuum. So the supervisor was faced with an inexorable loss of direct power over the post-war period culminating in the deregulation of interest rates and exchange rates.

Thus, the difficulty the supervisor faced after deregulation was that any increased supervision and regulation of banking while possible would tend to push the demand for credit to the domestic unregulated sector or overseas where it would ultimately be satisfied. This meant the supervisor was forced to use interest rate policy as the major mechanism of demand control.

What are the critics of the supervisors concerns? First, they seem to be saying that the asset boom that the Reserve Bank presided over spilled over into the real economy and interest rate measures designed to mollify the financial boom have been excessively damaging to the real economy; second, the critics argue that the Reserve Bank should not have allowed the banks to lend so excessively to the “entrepreneurs”. Third is the criticism that competition did not bring much in the way of price benefits to retail customers who effectively part-subsidised the wholesale lending splurge. Finally, they seem to be saying that the Reserve Bank should not have let the banks lose so much money.

If there is no alternative in the post-deregulation world to the interest rate mechanism as the major weapon of monetary policy, it is hard to see what else the Reserve Bank could do but ensure that monetary policy was sufficiently tight. It has been conceded that this was not so during much of 1987/88, but there are few that argue that over the decade monetary policy was too loose.

As to the question of loans to entrepreneurs, the first defense the supervisor has is that it would have been difficult to anticipate this trend. Secondly, even if it had been anticipated, the banks, reflecting the climate of the time, would have aggressively resisted Reserve Bank efforts to limit lending to this sector. Even under the regulated system in its heyday, the Reserve Bank did not specify to banks the customers that they should not lend to. There is a further argument that says that successful constraint by the Reserve Bank of lending to entrepreneurs would have forced the demand out into the non-regulated sector of the financial system as well as overseas. While this argument may have some validity, it is likely that the volume of funds provided to entrepreneurs under these circumstances would have been substantially reduced and thus the eventual negative impacts reduced.

Bank retail and small business customers may argue that they, via cross-subsidisation, should not bear the cost of the banks' corporate losses. We can see that there has been a period of lagged recognition of falling interest rates by banks at the retail and small corporate level designed to rebuild damaged bank equity. The effect of this is, at least in the short term, to inhibit the intent of monetary policy and cause parts of the community, rather than the shareholders, to bear the brunt of bad lending decisions.

The cross-subsidisation problem is likely to diminish over the current cycle as banks focus on the fact that retail is their core business, but it is apparent that this problem is a reflection of the oligopoly structure of Australian banking which has its greatest power in the retail sector. In the United States, where the ability of the banking sector to rebuild equity by oligopolistic behaviour is rare, the Federal Reserve “has elevated bank profitability into a de facto operation target for monetary policy and has reduced money market yields in order to improve bank lending margins and lowered reserve requirements to bolster the yield on bank assets”. (Hale (1991))

As to the issue of banks “being allowed to lose so much”, it is a fundamental principle of the current supervisory regime that the Reserve Bank's job is to ensure banks are sufficiently well capitalised and properly managed so that losses are contained to shareholders' funds and do not involve resorting to the safety net implied by the “depositor protection” words in the banking legislation. It is clear that despite the banking losses incurred, the safety net has not been even close to being used. The owners of banks have had to put their hand in their pockets for additional capital; the federal supervisor – the Reserve Bank – has not had to reach for the cheque book.

(c) Did the Checks and Balances of Auditors, Directors, Shareholders of Banks Fail to Fulfil their Role as Complements to the Supervisors Role?

Beyond the supervisors role and the competitive structure of the industry, the necessary checks and balances by directors, auditors and shareholders are the least appreciated part of the regulatory model that is required in today's deregulated environment. The supervisor, at the time of deregulation, would have had a reasonable expectation that these checks and balances would have acted as a very important complement to his activities. In fact, the supervisor was let down badly by the performance of the checks and balances.

In the regulated banking world, control on interest rates was so efficient in limiting competition (and thus its excesses) that the traditional checks and balances disciplines withered. Despite the lack of checks and balances, banks tended to make satisfactory and largely risk-free returns. Thus, these sources of management discipline became more or less superfluous as supervisory aids.

Today it would be hard to find a bank director or auditor who is not acutely aware of his responsibilities. At the same time, some bank managements appear to have a remarkable ability to rely on the excuse that everybody made bad loans and therefore it was the Government's high interest rate policy (or immoral borrowers) which caused their problems. There continues to be an obliviousness in some quarters to the dangers of seeking market share in banking. A 1991 Chairman's address by a major bank said, “Any bank that sits still is doomed. We … had to match, where practicable, what was being offered in the market in order to protect the business we had built up … Otherwise, we had to be prepared to allow the business to disappear. No-one would have thanked us if we had not sought to maintain our share of the growth of the Australian economy.”.

What they are really saying is that they should not be blamed for getting caught up in the “group think”. It was “group think” that made immoral borrowers appear virtuous and, thus, how can the banks be blamed?

Once again we are back at the issue of community expectations of a higher standard of behaviour by banks given their privileged position at the low-risk end of the risk spectrum. It is here where the shareholders of banks have a clear role to voice their non-acceptance of a management attitude that argues that they were not alone in their folly. Management is employed to differentiate not duplicate. Their role is to add value to the existing franchise, not as in the 1980s subtract value. Yet they have emerged seemingly unscathed and extremely well rewarded for their contribution in the 1980s. Likewise, boards have little to be proud of. Why have there been no consequences for management? Is it that with oligopoly, management, board and shareholders do not pay the full price – customer pays, management stays!

It is institutional shareholders who have the voting strength on banks' share registers, but they are far less vocal than the individual shareholder. The individual shareholder seems to regard his ownership relationship with his investments as relatively long term. Institutions, for all the well-known reasons, are still very short term in their views. There are early signs that this is changing. For the cyclical concentration of institutional funds to endure as a secular phenomenon, large institutions will need to be more strident to the managers of their businesses. They have no other alternative given the lack of liquidity they face.

In terms of the role of directors in the banking industry and other industries, it is clear that the lack of vigilance of some directors in the 1980s reflected their conflicted role. Often a board seat was in response to other business being done between directors' organisations and the bank. This raises the broad issue of the relatively low level of directors fees and the often very high level of other income that a director of a company can participate in. It is my conclusion that these conflicts are too difficult to be left to directors to grapple with and therefore no director of any company should, beyond a shareholding, gain any financial benefit from his position as director except from directors fees.

As to the role of auditors in the 1980s, the courts, in several major damages cases, are in the process of deciding some measure of punishment for the shortcomings auditors have displayed. Undoubtedly, this punishment will produce enduring lessons for the profession. The fact that management can effectively hire and fire auditors (due to the dispersed shareholding of most listed companies) means that we may need to find a new mechanism for auditor appointments that overcomes this weakness. This implies the need for the supervisors of corporates, banks and insurance companies to be more involved in this process.

(d) Can the Regulations be Improved?

Formal banking regulations in Australia are a conservative adaptation of the Bank for International Settlements (BIS) guidelines for banking regulation. These regulations are very comprehensive. The most important element of these is the minimum capital requirements. To quote Dr Wojnilower again, “very much like the old interest-rate ceilings on deposits, which largely prevented regulated institutions from bidding higher rates to acquire market share, mandatory capital controls also restrict banking growth … The effect is to re-introduce in a different guise prudential guidelines that lapsed with deregulation”.[9]

While capital controls make a contribution towards restraining balance sheet growth, their intention is clearly prudential rather than as an element in monetary policy. Indeed, they are of very limited help during an upswing characterised by asset price inflation. In Australia, equity was supplied plentifully to banks throughout the 1980s in response to expanding profits and the “expectational climate”. Capital availability tends to exert a pro-cyclical, rather than anti-cyclical, influence. In the more typical cycles where the real economy rather than the financial economy dominates, capital controls may well be counter-cyclical rather than pro-cyclical. Their role is the still very important one of putting the banks at risk ahead of the safety net.

So in asset price inflation cycles, we have a set of regulations, including capital controls, which are essentially static. It is variations in interest rates which provide the governor, albeit slowly and crudely, on the inevitable waves of enthusiasm and despair that all market-based economies experience in credit demand.

In addition to capital controls, there are the various returns covering large credit and foreign exchange exposures and liquidity for banks and their non-bank subsidiaries. In hindsight, it seems that these returns were not particularly effective at the outset of deregulation in giving the Reserve Bank a clear picture as to what was going on in banking. An obvious example of this is with large exposure reports. These were introduced in June 1986 but were not required on a consolidated basis so far as the lender was concerned until 1989. As to the issue of aggregating large exposures to related groups, this was initially loosely defined thus allowing loans to non-consolidated groups of related borrowers to not be aggregated. The danger of this anomaly was clearly reflected in the Adelaide Steamship Company situation where control rather than consolidation was the appropriate criteria for deciding to aggregate exposures. While most banks for internal risk reporting would have applied a control principle to this group irrespective of consolidation, many did not report to the Reserve Bank on this basis until the regulations were clarified in 1989.

A continuing weakness in reporting is the lack of attention to categories of lending apart from the very broad categories of Governments, Banks and Non-Banks. Nor is there adequate reporting on type of lending. So, for example, property-related exposures are only identified in an Australian Bureau of Statistics report which collects information on monthly increases in exposure on a non-consolidated basis but has no provision for identifying repayment of loans by industry type. Therefore, it is not possible to get a net picture of current outstandings to any one industry sector. Furthermore, apart from large exposures over 30 per cent of capital, individual client names are not identified at all. From a banker's point of view, it is hard to imagine the picture the supervisor gets from the returns provided. The supervisor is in a unique position to get a bird's eye view of the crowd behaviour going on below, but the information provided seems to do little to achieve this.

This seeming indifference to type of borrowers, especially in the corporate sector, reflects BIS weightings which, from a capital adequacy viewpoint, rates all corporates as equal. Behind this approach is a portfolio approach to credit rather than an individual credit risk approach. While this may be an acceptable approach as a broad-brush approach to capital adequacy, it would seem relevant that the supervisor at least gain some impression of the relative quality of the corporate lending portfolios of the banks.

In addition to the particular value of information on types of corporate borrowers and types of assets lent against, there is the general informational advantage of gathering such material. If banks were made aware of a surge in borrowings by particular areas and types, this may prompt some caution. Furthermore, from a macro-economic viewpoint, this information, with its resource allocation impact, should be useful.

A possible way to accommodate the collection of such information would be via the provision of credit ratings of all rated assets combined with names of borrowers and asset lent against/beyond a certain level of exposure.

Such an approach should help the Reserve Bank to differentiate between banks it supervises. At Bankers Trust we have observed the tendency of supervisors to look at form over substance. This shows up in banks being treated as if they were all similar, rather than recognising each bank as unique and therefore in need of an understanding of how each operates instead of a standardised approach. It is in the interests of the supervisor not to rely solely on regulatory compliance to judge the health of a bank. The supervisor should establish an understanding of the individual banks under its charter so that changes in a bank's business direction, or rapid growth, can be put into proper perspective and supervisory eyebrows raised or alarms sounded, independent of regulatory compliance.

One warning sign that regulatory returns do identify, but which does not seem to have been fully appreciated, is the growth of lending. If market share seeking is a potential recipe for imprudence in the banking industry, then those banks which grew much faster than the average during the 1980s should have received special attention. It is not clear that this was the case.

It was clear that several State banks were growing very rapidly during the 1980s and yet they seem little constrained by supervisory pressures. Perhaps the regulator was aware and voicing concerns, but the impotence of his role in relation to State banks may have meant it was difficult to follow up with decisive action. If this was so, the supervisor was in a no-win situation, and should have resisted from the start a regulatory role that lacked the necessary powers.

Another area where supervision, in hindsight, seemed inadequate relates to foreign banks. Out of the sixteen foreign banks listed in Table 2, four (Standard Chartered, Hong Kong and Shanghai Bank, Barclays Bank, and Lloyds NZA) effectively lost all of their starting capital plus retained earnings plus an additional $303 million, while two others (Chase AMP and NatWest) lost all but $22 million of $393 million in initial capital and retained earnings (see Table 2).

$ million
1986   1987   1988   1989   1990 Initial Capital Plus Profits Minus New Capital
Beginning Capital Profit/Loss Capital Injection Beginning Capital Profit/Loss Capital Injection Beginning Capital Profit/Loss Capital Injection Beginning Capital Profit/Loss Capital Injection Beginning Capital Profit/Loss Capital Injection
Barclays Bank 119.05 0.88 0.00   119.93 6.54 7.11   133.58 6.76 25.00   165.07 −79.79 130.00   215.27 −117.00   −73.1
Chase AMP 194.15 −2.58 0.00   191.15 0.18 0.00   191.74 5.31 100.00   296.90 −29.89 0.00   267.01 −149.50 80.00 17.67
Hongkong Bank 150.00 −12.14 0.00   137.86 5.92 0.0   143.78 10.75 52.25   206.79 −81.56 47.75   172.97 −199.50 250.00 −126.53
Lloyds NZA 79.65 3.57 0.00   83.21 10.65 0.00   93.86 8.92 0.00   102.78 −27.72 0.00   75.06 −61.90 40.00 −23.53
NatWest Australia 193.34 −51.12 0.00   142.23 −9.12 50.00   199.90 −32.16 0.00   167.75 −3.34 12.00   172.30 −93.00 100.00 4.6
Standard Chartered 74.97 7.40 54.00   136.32 11.20 0.00   147.50 8.33 −4.60   151.20 −54.19 0.00   97.00 −61.00   −80.15
Note: Capital injections are net of dividends paid Minority interests are excluded 1990 results are based on press releases

What was the problem here? Were the regulations inadequate, or did the supervisor not apply the regulations? It is probably a combination of both factors. Or was it reasonable for some banks to lose money on this scale? It has recently been acknowledged by the Reserve Bank, “that we have not been well served by our early-warning system on the extent of some bank problems in the past year” (Thompson (1991)). One suspects that in fact what the supervisor was doing was relying very heavily on one element of his regulatory armoury that related to the strength of ownership. Thus, even though these banks lost most of their capital, it did not matter from a systematic viewpoint as the owners subscribed enough capital to make up the shortfall.

The foreign banks' experience suggests that the supervisor was actually supervising as if these banks were branches rather than subsidiaries. It is certain that if these banks had not had the benefit of overseas ownership and had still suffered these losses, the systematic consequences would have been extremely serious. In effect, the foreign banks demonstrate the benefit of a banking oligopoly from a safety of the system viewpoint. The foreign banks had no franchises and no ability to cross-subsidise as did the domestic banks, therefore there was no buffer beyond their capital to cover their catastrophic losses.

The preceding criticisms of the Reserve Bank's approach to supervision place a lot of emphasis on the influence of the “expectational climate” in the community post deregulation that saw deregulation as wholly virtuous. The Reserve Bank, as a member of the community, also suffered somewhat from this mind-set, but given the confidence and aggressiveness of the incumbent banks towards their supervisor, it is not clear how successful the Reserve Bank would have been in achieving community acceptance of a tougher stance if it had wished to enforce such a stance.

It should be noted that the Reserve Bank did not get explicit legal power to supervise banks until the Banking Act was changed in 1989. This might lead some to argue that uncertainty over legal powers was a major influence on the supervisory track-record of the Reserve Bank in the 1980s. This may be so, but it is hardly an excuse. As with the specific issue of supervision of State banks, there is no point taking on a role if you are not confident of your powers. It was always the responsibility of the Reserve Bank to ensure it was comfortable with its powers to carry out the supervisory role that remained implicit in the Banking Act until 1989.

The community attitude has now changed. In part it reflects an emotive concern that Australian banks should not be so driven by the “expectational climate”. This is a very subtle issue and in part gets back to the special role banks have in our society. As the providers of the low-risk end of the household savings spectrum, they are expected to act with more prudence than they did in the 1980s. It may be that it was their shareholders who bore some of the cost, but the fact that the community, via cross-subsidisation, shared in this cost gives the views of the community greater force.

This community attitude is epitomised by the indignant response that seems to generally arise at the revelation that the supervisor “was not even inspecting the books” of banks. The Reserve Bank has acknowledged that it will respond to this issue by building a small team to initiate this added element of supervision. I suspect this response by the Reserve Bank is political rather than based on a belief in the need for such a group. If this is so, it should not be pursued. The community's concerns for more prudence can be accommodated by greater use of the information potentially available from current regulations, and a tougher attitude towards the policing of these regulations may be needed.

5. Is the Oligopolistic Structure of Australian Banking a Positive or Negative?

As noted earlier, our oligopolistic banking structure has contributed to cross-subsidisation at the expense of retail bank customers as well as reducing the effect of monetary policy. Oligopoly is normally regarded as an undesirable feature of an industry but, given the utility elements of banking and the systemic issues, oligopoly is, on the whole, not an undesirable condition for a banking industry. Our oligopoly, while presently revealing its negatives, greatly assisted our supervisors through the 1980s in limiting the extent to which they needed to intrude into banking. The extent of supervision required in banking is to a large extent influenced by competitive structure of the industry. The more fragmented an industry, the more likely is there to be strong competitive pressure and vulnerable financial institutions.

In the normal course, competition is in the best interests of customers. In banking, customers can be borrowers or lenders. Customers who are depositors enter into a fiduciary relationship with their bank. For these customers, too much competition can surely hurt. In the 1980s, our banks seemed to assume they were selling a good, just like a fast-food vendor, and thus should not be responsible for the damage that sale may do to the customer. Banking is lending not selling. The bank's role is to assess the customer's capacity to repay. Banks ration credit. Caveat emptor does apply to banking, yet in a highly-competitive environment the selling mentality tends to dominate the lending mentality.

In Australia, as in the United Kingdom and most parts of Western Europe, we have a highly-concentrated national banking industry structure: an oligopoly. In the United States, by contrast, with more than 14,000 banks, excess competition has long been a major corrosive force, offset ineffectively by excess regulation.

As noted previously, a highly-competitive system, as in the United States, inhibits the establishment of banking franchises. Without a franchise, a bank's stake in the game, ahead of the safety net, is less. With less to lose, the more likely is it that the official safety net will have to be resorted to.

In Australia in the 1980s, our banking oligopoly put normal oligopoly behaviour on hold, especially in the wholesale area. It competed amongst itself and with all on-comers. This self-defeating behaviour is now obvious to all. We are now in a phase of competition that reflects a return to normal oligopoly behaviour. This will mean the major banks are likely to realise that it is in retail banking where their main oligopoly power resides. This will mean a greater concentration on this area at the expense of wholesale activities by the major banks. This is because in wholesale markets attempts by banks to use muscle are ultimately disciplined by the risks taken.

The anti-competitive tendencies of oligopolies mean the supervisor has a conflicting role. The community expects competition with safety, but what has happened is too much competition, now followed by too little competition with the consumer footing a large part of the bill of the excesses.

How should the supervisor respond to this dilemma? This raises the issue of the privileged position banks have in Australia, which at present seems unrecognised if one can judge by the actions of the banks. Deregulation reduced the community's awareness of that privileged position and now the disappointments after five years of deregulation prompt a need for greater recognition of the need for trade-offs. Another related issue is the danger of the “big four” re-asserting their dominance of the financial system, thus restoring powerful elitist banking group at the cost of “efficiency, innovation and competition”.

Over time, the supervisor can at least alleviate these tendencies by encouraging competition in financial services between our two major financial oligopolies; banking and insurance. This competition needs to be vigorous and based on grass-roots entry into each other's turf. If mergers between members of these two oligopolies with their anti-competitive rationale are allowed, the opposite effect will be produced. The recent trend towards distribution alliances (AMP-Westpac, MLC-State Bank) being formed by insurance and banking groups, while a clever development from their standpoint, does not bode well for competition. The second way to avoid excess oligopoly power and the clogging up of the capital formation process is to always make available a role for the smaller specialist banks. Their role is to stimulate competition, creativity and efficiency at the margin.

It is likely the stimulative effect of small banks will diminish for some time in a cyclical response to the environment. The Reserve Bank should ensure this does not assume secular proportions by being more sympathetic than heretofore to some of the competitive disadvantages suffered by small and especially foreign banks but also by keeping open the possibility of new bank entry. While little action on the entry front is likely in the short term, an open door (subject to the normal entry standards) rather than a closed door is more likely to attract visitors.

A related issue is the role of tax subsidisation and official encouragement of broad community involvement in superannuation. The merit of this approach in a macro sense is undoubted given the expected effect on the savings ratio and the fact that over time it should have a net positive fiscal effect. In an industry structure sense, the effect of the relative growth of superannuation should be to stimulate competition between banking and insurance, thereby encouraging creativity that would not exist in a more static total assets environment.

Another benefit of the expected growth in superannuation is that there are lower barriers to entry in superannuation funds management than in banking. It is conceded that at present there are cyclical tendencies to industry concentration in superannuation. Over time, it is likely the highly-competitive nature of superannuation funds management, which reflects the degree of disclosure and lack of cross-subsidisation, will ensure an appropriate allocation of market share which is based less on barriers to entry and more on skill.

6. Where to from Here?

It is clear that we do not have the luxury of choosing to revert to the relatively straightforward environment we had when interest rates were determined by the bureaucracy. This regime is now unacceptable to a real economy that is trying to cope with its involvement in the open world economy. So we have no alternative but to try to develop the far more diverse and complicated regulatory framework that we are left with. Undoubtedly, the cost of this will be occasional bouts of financial instability.

In retrospect, this new regulatory infrastructure was far from fully operational when the system changed. This contributed to the cost of our recent experience. These are the costs of injecting competition into an environment with a withered set of checks and balances and bank supervisors learning on the job. It also reflects the whole community's view of the virtue of deregulation, instead of the recognition that the necessity that drove us to deregulation posed as many dangers as opportunities. We are dealing here with the pendulum of regulation. When the negatives of regulation build to the point of the destruction of a system that has lost credibility, it is part of human nature to excessively discount the virtues of the past. In Eastern Europe we are seeing this phenomena being played out again.

While there are plenty of reasons for misgivings as to the management of the post-deregulation regulatory structure of bank supervision, an oligopolistic competitive structure and the checks and balances of auditors, directors and shareholders, it is clear that the basic infrastructure is in place. What is required is an attitude change. First this involves a greater acknowledgment in the community, amongst the banks and by the supervisor, that the financial environment we live in is far more complicated and volatile than the past, and for the system to hang together the supervisor's role must be elevated from the diminished role of the 1980s. Much of this diminished role probably reflects the fact that supervision was achieved pre-deregulation as a mere by-product and therefore was non-intrusive.

It is an unfortunate fact post deregulation that supervision has to be intrusive. This was not obvious at the outset of deregulation, thus the animosity of banks and the tepid use of power by the supervisor. We all now know why intrusiveness is needed. Furthermore, this intrusiveness will require the supervisor from time to time to try and ameliorate the negative effects of oligopoly, in the retail area, via adjudication of the balance between privilege and burden.

An attitude change is going on amongst directors, auditors and shareholders but some would argue not fast enough. The supervisor will need to monitor this as in the ultimate any shortcomings here increase the supervisor's burden.

The severity of our problems in the 1980s means that the lessons that have been learnt by all participants in banking from management to directors to creditors to supervisors are long-living ones. We have had many recessions in this century that began in the real economy but only two that started in the financial economy. The other was in 1929. The memories of the first financial-driven recession lived long. Possibly the memories of the 1980s will not live so long given they are unlikely to be re-inforced by the depression of the 1930s.

What is clear is that the complexity of our banking system requires our supervisors and policymakers to perform a delicate balancing act. First, they have to be sure they have enough knowledge of what is really going on amongst banks. Second, they and shareholders must be vigilant to ensure that the checks and balances are really working. Finally, they should see that despite its undesirable competitive cost the preferred system of competition, oligopoly, is in place to ensure that in future financial manias, the banking system is strong enough to replenish its reserves.


Managing Director, Bankers Trust Australia Limited, Sydney. [1]

This paper is based on a shorter paper prepared for the 1990 Bankers Trust Australia Ltd Annual Report titled “Banking in the 1990s”. The title is from Jones (1991). [2]

Westco (1990). [3]

Quoted in Suich (1991) [4]

Graham (1984). [5]

Westco op. cit. [6]

Macfarlane(1991). [7]

Minsky (1982, page 121). [8]

Wojnilower (1991). [9]


Graham, A. (1984), “Deregulation, Competition and Supervision”, Economic Papers, 3(2), June, pp. 77–87.

Hale, D. (1991), “Will the Weakness of the US Financial System Prevent an Economic Recovery in 1991?”, Kemper Financial Services, April.

Jones, E. (1991), “Banks a Decade After Campbell: Promise and Performance”, Submission to the Inquiry into the Australian Banking Industry (Martin Inquiry), 6, pp. S1389–S1439.

Macfarlane, I. (1991), “Lessons for Monetary Policy”, this volume.

Minsky, H.P. (1982), Inflation, Recession and Economic Policy, Wheatsheaf Books, Brighton.

Reserve Bank of Australia (1991), “Submission to the Inquiry into the Australian Banking Industry (Martin Inquiry)”, January.

Suich, M. (1991), “Bank Ruptured”, Independent Monthly, May, pp. 14–17.

Thompson, G.J. (1991), “Directions for Prudential Supervision in the 1990s”, Reserve Bank of Australia Bulletin, May, pp. 6–13.

Westco Financial Corporation (1990), Annual Report.

Wojnilower, A.M. (1980), “The Central Role of Credit Crunches in Recent Financial History”, Brookings Papers on Economic Activity, 2, May, pp. 277–326.

Wojnilower, A.M. (1985), “Private Credit Demand, Supply, and Crunches: How Different are the 1980's?”, American Economic Review, 75(2), May, pp. 351–356.

Wojnilower, A.M. (1991), “Financial Institutions Cannot Compete”, First Boston.

Wojnilower, A.M. (1991), “Some Principles of Financial Regulation: Lessons from the United States”, this volume.

Appendix: Capital Raisings

Date Shares Price Amount Propn of Exist Cap Type Explanation
  (m) ($) ($m) (%)    
ANZ Banking Group
1980 10.7 market   8.5 AC Acquire Bank of ADL
1984 9.5 5.50 52 4.5 AC Acquire Devel Fin Corp
Jul. 84 60.9
1:4 Cash
At time of Grindlays acquisition $282m
Dec. 85 67.7 3.75 254 20.0 1:5 Cash  
1985 40.4 market   9.8 AC Acquire ANZ New Zealand
Jul. 88 120.2
1:6 Cash $1.90 Of which 40.1m contribs at
Feb. 89 25.8 4.34 112 3.2 DRP 1988 final dividend of 22c
Apr. 89 16.2 4.85 79 1.9 DRP Special dividend of 26c
Jul. 89 23.8 4.30 102 2.8 DRP 1989 interim dividend of 22c
Feb. 90 20.4 5.43 111 2.3 DRP 1989 final dividend of 22c
Jul. 90 26.8 4.35 117 2.9 DRP 1990 interim dividend of 22c
Feb. 91 27.0 2.90 78 2.8 DRP 1990 final dividend of 16c
National Australia Bank
Apr. 81 108.1 3.25 351 73.0 AC Acquisition of CBC
Sep. 83 64.5 2.00 129 25.0 1:4 Cash  
Sep. 84 60.0 3.40 204 18.4 Cash Convertible Notes
Feb. 87 17.0 5.24 89 4.8 Placmnt To overseas institutions
Mar. 87 18.0 5.60 101 4.8 Cash Convertible Notes
Aug. 87 108.4 4.00 433 22.3 1:5 Cash Acquisition of Clydesdale etc.
May. 88 131.0 4.60 603 21.7 1:5 Cash  
Jan. 89 32.8
Final 1988 div (17c cash plus 18c scrip)
Mar. 89 7.2 5.81 42 0.9 DRP 1988 special dividend of 10c
Jul. 89 19.1 5.68 108 2.5 DRP 1989 interim dividend of 25c
Aug. 89 61.8 6.08 376 7.3 Placmnt To overseas institutions
Jan. 90 33.5 6.29 211 3.7 DRP 1989 final dividend of 25c
Jul. 90 21.9 5.85 128 2.3 DRP 1990 interim dividend of 26c
Jan. 91 31.2 5.30 165 3.2 DRP 1990 final dividend of 29c
May 91 201.0 5.25 1,055 20.0 1:5 Cash Expansion
Westpac Banking Corporation
Mar. 81 163.4 3.10 507 70.0 AC Acquisition of CBA
Dec. 84 100.6 2.50 252 25.0 1:4 Cash  
Jun. 86 22.0 4.90 108 4.3 Cash Convertible Notes
Jul. 86 25.0 6.09 152 5.0 Placmnt Tokyo Listing
Feb. 87 65.1 4.25 277 11.7 AC Acquisition of AGC minorities
May 88 165.0 4.50 743 25.0 1:4 Cash  
Jan. 89 25.4
Final 1988 div of 18c plus special of 10c
Mar. 89 20.7 5.37 111 2.1 Plcmnt US ADR Issue
Jul. 89 26.3 4.50 118 2.6 DRP Interim 1989 dividend of 27.5c
Jan. 90 27.2 5.05 137 2.4 DRP Final 1989 dividend of 27.5c
Jul. 90 31.7 4.28 136 2.7 DRP Interim dividend of 25c
Jan. 91 40.0 4.00 160 3.4 DRP Final 1990 dividend of 27.5c