Conference – 1991 Prudential Supervision Graeme Thompson[1]

1. Introduction

The Campbell Committee's recommendations were largely to do with making the Australian financial system more efficient and competitive and allowing monetary policy to be implemented through market-based, rather than regulatory, means.

A decade on there is some questioning about the efficiency gains and whether a permanent increase in competition has been achieved. There is also some questioning about the stability of the deregulated financial system. And in particular whether current arrangements for prudential supervision of the banking system are adequate in the deregulated world. This is against a background of substantial loan losses for many banks and the departure of a couple from the scene. There has also been a good deal of instability in the non-bank financial sector.

This paper looks at the objectives of bank supervision in Australia and its evolution over the years (Section 2). It offers some preliminary assessment of the performance of supervision in the 1980s (Section 3) and considers what lessons have been learnt (Section 4). Judgments in this area are necessarily tentative, not least because the outworking of events in the latter part of the 1980s is not yet complete.

2. Bank Supervision: Objectives and Evolution

Bank supervision in Australia has two basic objectives:

  • a specific one to protect the interests of bank depositors; and
  • a broader one to promote stability in the banking and financial system generally.

These objectives stem from the Royal Commission on Monetary and Banking Systems which reported in 1937. Much of the philosophy of bank supervision underlying provisions of the present Banking Act derives from the analysis and recommendations in that Report. Some key passages are in Appendix 1.

The Royal Commission's strong focus on depositor “protection” – but not the guarantee of deposits – was enshrined in Division II of the Banking Act. This gave the Reserve Bank strong powers to act if it appeared that deposits were in jeopardy – it could take control of, and manage, a bank in the interests of its depositors.

But, until the late 1980s, the Act made no reference to “prudential supervision” – to requirements of banks aimed at reducing the likelihood of the central bank needing to exercise those ultimate powers. And it did not give the Bank specific powers to conduct such supervision. Until amendments were made to the Banking Act in 1989, the Bank relied on its responsibility for “depositor protection” as the basis for supervisory requirements.

Before the 1970s, bank supervision received scant attention. This was because depositor protection/banking stability objectives were achieved largely as a by-product of the regulations covering the banking system.

Banks' balance sheets were heavily prescribed through regulations of various types (the LGS convention and SRD requirement for trading banks; prescribed asset ratios for savings banks). These rules ensured that a sizeable proportion of zero, or very low, risk assets formed the base of the banks' balance sheets.

In the regulated interest rate environment where credit allocation was achieved through rationing, banks could pick and choose from a queue of potential borrowers. There was little or no need for banks to take risky assets onto their books (and, therefore, to acquire experience in pricing for risk). A common concern in those days was, in fact, the dearth of capital or funding for the more imaginative and riskier types of ventures. Some of these opportunities passed onto the books of non-bank institutions as they developed, largely free of regulation, over the 1950s and 1960s. Others were funded through the equity markets or via capital inflows from abroad. Indeed, over these years, only a relatively small proportion of business financing in Australia was obtained from banks. Banks, for all intents and purposes, accepted deposits, purchased government securities, made loans for housing and extended overdrafts to selected clients. In such an environment, the need for explicit bank supervision did not arise.

The picture began to change through the 1970s, with domestic and international factors both important.

Internationally, several incidents, including the failure of Penn Square in the United States, the secondary banking crisis in the United Kingdom and the Bank Herstatt episode in Germany, excited greater interest in supervisory arrangements. There was particular concern with adequacy of bank capital and a growing interest in harmonisation of national requirements.

Supervisors from the G10 countries formed the Basle Committee on Banking Supervision in 1974 under the aegis of the Bank for International Settlements. The aim was to close gaps in the international supervision “net”, and generally to improve the quality of supervision. In 1975, the Committee produced the first version of the “Basle Concordat” setting down principles for sharing supervisory responsibility for banks' foreign operations.

Domestically, an important factor behind pressure for more formal supervision was the Bank of Adelaide's demise at the end of the 1970s as a result of losses in its finance company subsidiary. Reserve Bank policy governing banks' associations with non-banks went back to the 1960s with a number of interests in mind. Following the Bank of Adelaide episode, the policy was re-emphasised to banks, with a strong prudential focus.

Against the background of international interest in the subject, the Bank also conducted studies of the capital position of banks. One such study in 1974 examined, as well as available data would allow, bank capital ratios over the previous 20 years. This indicated that capital ratios in Australia were low relative to a range of overseas banks. Later work showed that capital ratios also seemed to be on a long-term decline.

In the light of these analyses, discussions were held between the Bank and Chief Executives of the major banks on their capital positions and on prudential issues more generally.

Despite the concerns that were beginning to be expressed over the emerging trends, and the encouragement given to banks to improve their capital ratios, no formal requirements for minimum capital standards were established at this stage. Nevertheless, toward the end of the 1970s banks generally had agreed, on an informal basis, to maintain minimum capital ratios of about 5 per cent.

Both the Campbell Committee (and the subsequent Martin Review Group) recognised that in a deregulated environment the need for more formal supervision would increase – there would be more banks engaging in a wider range of activities, competition would be more intense and financial prices more volatile.

The Committee made several recommendations on prudential supervision of banks – these are summarised in Appendix 2. Perhaps surprisingly, the Committee's basic philosophy was not much different from the Royal Commission's in concentrating on protection of depositors, but stopping short of insurance or guarantees, and in recognising explicitly that a troubled bank should be allowed to fail causing loss to shareholders and, presumably, managers. Neither the Royal Commission nor the Campbell Report argued that banks should be protected or insulated from making losses.

At paragraph 19.10, the Campbell Committee said:

“The Committee recognises that as an important market discipline, individual institutions should be allowed to fail; the concern of the authorities should be with the promotion of general stability.”.

To support its basic philosophy, the Committee recommended that the Bank adopt various prudential supervision guidelines or standards. These were designed to minimise the likelihood that a bank would get into such difficulties that the “rescue” powers of the Banking Act would be required or that the stability of the financial system would come into question. To give force, if needed, to these requirements, the Committee recommended that the Bank be given explicit powers in the Banking Act to conduct prudential supervision.

The Government and Bank adopted, substantially, the recommendations of the Campbell Committee and implemented them over succeeding years. International moves toward more formal supervision were also influential.

The Bank did not see this evolution in supervisory practice as inconsistent with the main thrust of deregulation in financial markets, but as complementary with it.[2]

In 1985 the Bank issued a general statement on its approach to bank supervision. It stated, inter alia, that:

“The Bank's approach to supervision is predicated on the view that the prime responsibility for the prudent management of a bank's business lies with the bank itself. The Bank's system of supervision is directed towards satisfying itself that individual banks are following management practices which limit risks to prudent levels; and that banks' prudential standards are being observed and kept under review to take account of changing circumstances.”.

By and large this statement remains appropriate today. With it as background, the Bank developed a series of standards which have been set down in publicly-issued Prudential Statements. A listing of these is in Appendix 3.

The main aspects of banks' operations covered in these statements are:

  • minimum capital requirements;
  • liquidity management, including the prime assets ratio;
  • limits on large credit, and foreign exchange, exposures;
  • guidelines on associations with non-bank financial institutions;
  • restrictions on ownership of banks.

These and other aspects of banks' operations are the subject of statistical reporting and regular consultations.

As an important supplement to its direct relationship with banks, the Bank made arrangements in 1986 with banks' external auditors whereby they report to it on:

  • whether a bank is observing prudential standards;
  • whether management systems to control exposures and limit risks, as outlined to the Reserve Bank, are effective and being observed;
  • whether statistical data provided by the bank are reliable;
  • whether any statutory or regulatory banking requirements and conditions on the banking authority have been complied with.

Finally, in line with Campbell's recommendations that the Bank have more formal and explicit powers to supervise, amendments were made to the Banking Act in 1989. Notably these amendments charge the Bank with:

  1. collection and analysis of information in respect of prudential matters relating to banks;
  2. the encouragement and promotion of the carrying out by banks of sound practices in relation to prudential matters;
  3. the evaluation of the effectiveness and carrying out of those practices.

The amendments also provide for regulations to be made about prudential supervision. As long as banks generally are co-operative, this is seen very much as a reserve power.

Standing back from the detail, one can describe some broad elements in the way the Bank has gone about supervision.

  • The approach has been evolutionary, some might say cautious. Proposed policies on supervision have been discussed with banks and there has been consultation about their implementation. A good deal of importance has been placed on preserving the co-operative nature of the supervisory arrangements. As a result, the Bank has, on occasions, probably taken a less tough stance than it might otherwise have done (for instance, in counselling banks about exposures to property). The Bank has also been mindful of the importance of not placing undue restrictions on banks' capacity to innovate and to shape their businesses according to commercial dictates.
  • There has been a strong element of learning by doing, with modifications being made to existing policies as the need arose or as circumstances changed. This is a typical modus operandi for supervisors and regulators. (Progressive modifications to the “large exposures” guidelines through the 1980s are one example of this.)
  • There has been a good deal of attention to protecting against credit risk. This had been a concern since the late 1970s but took on increased importance from the mid 1980s. It has been reflected in the minimum capital requirements, which are based on credit risk; the “large exposure” standards which aim to limit risk from excessive exposure to one borrower or group of associated borrowers; and a general requirement that banks have loan portfolios which are diversified both geographically and industrially. By international standards, the Bank was quick to require banks to observe the minimum capital adequacy standard proposed by the Basle Supervisors' Committee in 1988. (This succeeded in Australia a 1986 minimum capital ratio based on balance sheets.)
  • The Bank's objective has been, for the most part, to devise prudential standards which were not greatly different from what one might have expected a prudent bank to impose on itself. It has been conscious that heavy-handed application of prudential policy could become a backdoor means of re-regulating the banking system and unduly inhibiting their capacity to compete. The aim has been to establish sensible “rules of the game”, to see that the players abide by them and to adjust them as necessary from time to time.
  • Prudential policies have been “policed” in a fairly “non-intrusive” fashion. This approach is consistent with the basic tenet that banks be clearly responsible for running their own businesses; it has been facilitated by the banks, on the whole, being scrupulous in observing the various quantitative requirements. There has been a reluctance to become too closely involved in banks' decision-making, which is appropriately the responsibility of bank management, for fear of introducing “moral hazard” risks. There has also been a wish not to add excessively to reporting burdens.

On striking an appropriate balance in supervision, the Bank said in its Submission to the Parliamentary Inquiry (1991, page 25):

“Settling on the right amount and intensity of prudential supervision involves some important trade-offs. Arrangements are required that bolster community confidence and support the reliability and viability of the banking system and the payments system. The framework needs to be simple, logical and practicable on the one hand and, on the other, it needs to minimise artificial distortions in financing.

Banks should practise prudent risk management but we also need a dynamic innovative financial system. It would be inappropriate to bear down excessively on the former at the risk of damaging the latter. Risk is an essential part of financial markets just as it is an essential part of the economic development process. It should be managed sensibly but it would be a delusion to believe it can, or indeed should, be removed altogether.”.

3. Bank Supervision – An Assessment

There is a view that supervision has been inadequate to the task – that it has somehow failed to be sufficiently tough, restraining or prescient to cope with the deregulated banking system. (This view is in intriguing contrast to the view, held widely in the 1980s, that supervision was too heavy-handed and threatened the purity of deregulation.)

Against what benchmarks are such judgments made?

One test is whether bank depositors' interests have been “protected”. Since no depositors' funds have been lost, or even come under threat, this cannot be a basis of criticism.

Clearly, the benchmark must be concerns about some general notion of banking sector stability.

Some indications of such instability would include:

  • exits/failures of banks;
  • a lack of community confidence in banks;
  • a weakened banking system beset by poor profitability and low capitalisation.

(a) Exits and Failures

One indicator of instability in a market is the incidence of exits or failures of individual institutions. It is important to define carefully what is meant by those terms. If they refer to the winding up or sale of institutions which are insolvent, or on the verge of insolvency, then the past decade has not seen the exit or failure of any Australian bank.

But some banks have indeed “exited” the scene:

  • National Mutual Royal Bank (absorbed by ANZ Bank when partnership of Royal Bank of Canada and National Mutual Life was dissolved, RBC wishing to refocus its strategy);
  • State Bank of Victoria (absorbed by Commonwealth Bank); and
  • Tasmania Bank (being absorbed by Savings Bank of Tasmania).

All of these exits occurred in an orderly fashion, with no significant liquidity strains or widespread loss of depositor confidence. None of the banks involved was in breach of the Bank's prudential guidelines at the time it was taken over, although in the case of SBV, the cost to its shareholders of preserving the bank's capital adequacy was a major factor precipitating the sale.

(b) Bank Profitability, etc.

The table below illustrates the performance of banks, measured by return on shareholders' funds, over the 1980s.

The data show that profitability was lower in the latter half of the 1980s compared with the first half, and that it declined sharply toward the end of the period.

The swings have been most pronounced for banks other than the established “major four” with their strong retail bases. In particular, the foreign-owned banks and the State banks earned profits, on average, in the mid 1980s but have incurred losses more recently. In both “other established” and “new” categories, the large losses of some banks obscure the fact that others in those groups, both foreign and domestically-owned, have continued to be profitable.

Of course, the major banks are by no means untouched by loan losses. Figure 1 shows the growth in their aggregate charge to profit for doubtful debts as a ratio to loans and acceptances.

Figure 1: Charge to Profit for Bad & Doubtful Debts
Return on Shareholders' Funds
(per cent)
  Major Banks
 
State Banks
 
Other Established Banks (a) New
Banks (b)
 
All Banks
 
All Banks
(Ex majors)
 
All companies
 
1979–80 16.5 7.9 4.4   15.0 7.5 11.9
1980–81 16.8 8.7 6.4   15.7 8.4 11.2
1981–82 15.9 10.1 3.5   15.0 9.4 8.9
1982–83 15.1 7.8 8.3   14.0 7.8 7.9
1983–84 16.3 9.3 7.4   15.2 9.0 9.8
1984–85 15.2 9.8 3.3 3.2 13.6 7.4 10.3
1985–86 13.6 10.8 5.3 1.9 11.4 5.8 11.2
1986–87 11.8 8.1 5.5 6.5 10.4 7.1 9.6
1987–88 13.9 9.6 9.4 7.0 12.2 8.3 10.4
1988–89 15.3 −2.1 −16.6 1.0 10.8 −1.6 10.6
1989–90c 10.4 −4.2 −13.1 −17.4 4.8 −12.2 8.2
Averages
1970–71 to 1979–80 13.2d
 
n.a.
 
n.a.
 
n.a.
 
n.a.
 
n.a.
 
10.9e
 
1980–81 to 1984–85 15.9
 
9.1
 
5.8
 
n.a.
 
14.7
 
8.4
 
9.6
 
1985–86 to 1989–90 13.0
 
4.5
 
−1.9
 
−0.2
 
9.9
 
1.5
 
10.0
 
All data are for consolidated groups.
  1. “Other Established Banks” are those domestic and foreign-owned banks not classified as “Major Banks” or “State Banks”, and whose banking authority was granted before 1985.
  2. “New banks” include domestic and foreign banks which received a banking authority during and after 1985.
  3. During the year ended 30 June 1990, the State Government of Victoria extended support to both the State Bank of Victoria and its subsidiary Tricontinental Holdings Ltd Group. The financial effects of this were to allow the write back of excess provisions for doubtful debts of $261.6 million and eliminate the need to charge to the profit and loss account provisions for doubtful debts ($419.8 million for the Bank, $1,990.9 million for the Group).
    Includes some estimates for 1990.
  4. Does not include the Commonwealth Bank of Australia.
  5. Figure covers only 1974–75 to 1979–80.

Source: Annual Reports
The Stock Exchange Financial and Profitability Study (various years)

Qualitatively, at least, these swings in profits are not inconsistent with a financial system where deregulation caused intensified competition and obliged the players to come to grips quite quickly with new freedoms and opportunities; where new entrants have had to struggle against established players; and where the macro-economy has moved from strong growth to recession.

Quantitatively, the recent loss experience has caused considerable stress for several banks. But does it suggest major instability for the banking sector as a whole?

One test is the capitalisation of the system. Figure 2 shows information on this.

Figure 2: Capital – Australian Banks

A good deal of capital has been lost by several of the banks. Nonetheless, the banking system as a whole has maintained a capital ratio which is both above the minimum required by the Bank and high by international standards. At latest reading in March 1991, the ratio of total capital to aggregate risk-weighted assets of banks was 9.7 per cent. In other words, notwithstanding sizeable losses for many of the banks, they have been able to maintain capital through raisings of various kinds on the market, or from parent banks in the case of the foreign-owned groups. All banks individually had a capital ratio above 8 per cent at March 1991.

(c) Community Confidence

If one accepts that on the evidence there is no indication of systemic instability in banking, it may still be that the cumulative impact of bank losses, a couple of exits, reduced dividends, etc. has damaged community confidence in the soundness of the banking system. This would be socially undesirable.

It is difficult to compile objective evidence on this. To the extent that official inquiries into banking problems are a symptom of community concern, then the current investigations into the State Bank of Victoria's subsidiary, Tricontinental, and the State Bank of South Australia would lend support to the contention. But in both cases there is the special factor of ownership by government.

Recent years also have seen runs on a couple of smaller banks. On the other hand, these episodes were minor and were handled within the resources of the banks themselves, albeit supported by central bank assurance that there was no basis for depositor nervousness.

A general indicator of community perception is that savings have generally moved to banks from other financial groups in recent years. Funds with banks increased by more than the net increase in borrowings by all financial intermediaries over the year to April 1991. The strength of this evidence is, of course, vitiated in some degree by perceived severe weaknesses in parts of the non-bank sector and the lack of suitable alternative repositories for household savings.

(d) The Lending Boom

While it can be argued that the banking system has emerged, on the whole, sound from the turbulence of the past five or six years, there remains a common view that prudential supervision could have done more to moderate the excesses and mistakes – excesses resulting in high write-offs and a growing volume of non-performing loans.[3]

If one accepts that this has occurred to an undesirable extent, it is natural to ask what more prudential supervision could reasonably have done to prevent it.

Macfarlane (1990) has described the rapid expansion in credit, including bank credit, from 1985 to 1989. With the benefit of hindsight, it is clear that much of this was done on the basis of optimistic projections of continued strength in asset prices. Too little attention was paid to the sufficiency of cash flows to support repayment. Banks were also the (gullible) victims of misrepresentation by borrowers of their true state of affairs.

Could prudential supervision have leant further against the momentum of lending?

In principle the answer is, of course, yes. And it is certainly the case that the nature of the dangers had been foreseen. The Campbell Committee had, for instance, noted the possibility of:

“competition of a kind that might be destabilising, i.e. which could lead to the adoption of higher risk portfolios and possible failures”.

In its 1985 Annual Report, the Bank said:

“The on-going momentum of financial deregulation and innovation will boost the scope for, and vigour of, competition in the Australian financial system. This underscores the need for banks in particular to maintain high prudential standards. Against this background, the Bank took a number of initiatives during the year to strengthen and to codify its role in prudential supervision of banks.”.

Various prudential standards directed at credit risk were introduced and/or tightened after 1985. This no doubt helped to reduce subsequent damage to banks.

It is at least an open question whether supervision could reasonably be expected to have done much more in the circumstances. During the period from 1985, the key issues for the supervisors were:

  1. to be confident that unacceptable risks were being taken by banks;
  2. to determine, if the former point was established, what to do about it.

As to (i), the economy was growing strongly and had been for some time. So there were good lending propositions and profits to be made. There is no firm basis for the view that supervisors are better than bankers at picking the good from the bad propositions – just as we now accept there is no case for bureaucrats to set interest rates on government securities or bank loans. It was fully expected that, as a consequence of deregulation, a higher proportion of financing would be done by banks – indeed, this was one of the objectives of deregulating banks. And it was understood – and anticipated in prudential requirements – that this process would mean some increases in the riskiness of banks' portfolios.

What was not accurately predicted by the prudential supervisors was the extent of the additional risk that banks would acquire and, more importantly, the failure of the banks themselves to factor this correctly into their pricing.

As to (ii) above, Macfarlane discusses the practicalities of a macro-economic response to the lending growth, i.e. tightening monetary policy further. For the banking supervisor within that macro-economic environment, some options would have included raising further the newly-adopted capital ratios or introducing tighter controls on direction of lending (for instance, exposures to property or equities?). But qualitative or quantitative restrictions on lending by banks would have been totally at odds with the prevailing political and intellectual climate which had been an important catalyst for deregulation such a short time before.

One consequence of such actions would have been to push financing activity back out of the banking system; but, arguably, damage control can be handled more efficiently in the banking system.

Perhaps tougher restraints of some kind could have been applied only to institutions showing the more worrying symptoms, such as the highest growth rates. This variant of picking “winners” and “losers” would have proved a very imprecise rule. While a high growth rate can be a useful indicator of impending problems for a particular financial institution, it is by no means conclusive.

Analysis of a sample of merchant banks from 1986 on shows that some rapidly growing institutions continued to prosper. On the other hand, some institutions which subsequently failed were not consistently among the fastest growing.

4. Prudential Lessons

There have been many references to the past five or six years as a “learning” experience. This can imply first that mistakes, observed with the benefit of hindsight, were to be expected. More positively, it implies that lessons have indeed been learnt by the macro-economic policymakers, by the banks and other financial institutions and by prudential supervisors.

Clearly, all players through the second half of the 1980s have learnt that in periods of transition from one regime to another it is particularly difficult to make confident readings of trends.

From the present viewpoint, the Bank believes that the Australian banking system remains fundamentally sound and its array of prudential requirements is broadly adequate.[4] But this is not to say there is no room for improvement. Events suggest that prudential supervision will need to be more “assertive” in some respects and might, in particular, need to discriminate more among banks according to their perceived risk characteristics.

At all times, however, the natural inclination of the umpire to be tougher with players in the aftermath of a rough passage of play needs to be tempered with a recognition of the importance that the game be allowed to flow, and that the players have room to innovate and take risks. Without this scope, the banking system would be increasingly less effective as the centrepiece of the financial system. The customers would wander away.

There is a danger also in the implicit view of some commentators that only supervisors are capable of learning from mistakes and misjudgments. This is an arrogance which ignores the capacity of the players themselves to learn from experience and to make changes in their ways. It will be much more efficient from the community's viewpoint if change comes about through this process rather than being driven by bureaucratic fiat.

Still there clearly are lessons for prudential supervision in recent experience, and changes are likely when this is fully assessed.

Two main themes emerging from our reflections on the post-deregulation experience are:

  • the susceptibility of banks' risk control systems to weaken under the pressures of competition, and of heavy workloads on management which can become stretched beyond its capacity;
  • the need for more effective early-warning systems about banks which might be heading into troubled water. If problems are detected early enough, action might be taken to prevent them developing into something major. If necessary, plans can be made to deal with problems before a crisis atmosphere develops.

These points are, of course, related. When management systems for assessing and controlling credit risk become stretched and ineffective, it is probably the best early indicator of significant weaknesses in a bank.

At present, the Bank's is a system mainly of off-site supervision. In some other countries, supervisors do more themselves by way of direct examination or inspection of banks.

The viability of our approach depends very much on the reliability of the information we receive from banks through statistical reporting and in consultation, and on the effectiveness of banks' systems to recognise and manage risks within prudent limits. As noted earlier, we seek additional comfort by asking a bank's external auditors to report, inter alia, on the effectiveness of the bank's management systems for monitoring and controlling risk. We would also expect auditors to have confirmed that a bank's loan provisioning was “reasonable”.

We have not been well served by these early-warning systems regarding the extent of some bank problems in recent years. In some degree this must reflect the rapidity with which asset markets turned down, but even so the recognition of difficulties for some banks seems to have been slow in coming.

As a consequence, the Bank is exploring what additional information it might usefully seek from external auditors and from banks themselves.

We are also looking at ways of developing a capacity to do some on-site review ourselves. There have been occasions when the Bank had strong reservations about a bank's risk control systems. But supervisors lacked the hard evidence, and good benchmarks against which to make judgments, to press the point over re-assurances from bank management.

There would, of course, be pluses and minuses in moving far down this track. Among the pluses, on-site review can:

  • impose a measure of additional discipline on reporting officers, including internal and external auditors;
  • give a supervisor greater assurance that a bank is observing prudential standards and that risk management systems are operating as described in its manuals;
  • equip supervisors with closer understanding of a bank's operating methods and management culture – this can help in recognising the potential for serious problems before they develop.

On the negative side:

  • on-site work can become costly, absorbing substantial additional resources;
  • if review extended to the supervisor's imposing judgments about a bank's commercial strategy, or about individual loans, it would become easier for bank management to evade responsibility for poor results;
  • the more comprehensive is supervision, the more the public – shareholders, depositors and others – can get unrealistic expectations about what protections it offers; the fact is that no system of supervision, however intrusive and costly, can prevent banks from writing bad loans or making losses. This is very clear from the track record of different supervisory regimes in other countries.

The Bank will also be monitoring moves to improve the quality of information available to banks about would-be borrowers. Deficiencies in this appear to have contributed to poor lending decisions.

Mention should be made of one particular development which has contributed to the poor performance of some bank groups in recent years. The greater freedom afforded to banks appears to have forced some of their subsidiaries doing similar business – mainly merchant banks and finance companies – to acquire balance sheets which were more risky than before in order to justify their separate existence.

These subsidiaries are not subject to the Bank's supervision although some prudential requirements (capital adequacy and large exposures reporting) now extend to consolidated groups. The main objective of the Bank's prudential statement dealing with non-bank subsidiaries of banks is to reduce the risk of contagion by emphasising the separateness of the entities. Clearly, there are practical limitations on the extent to which a bank could stand aside from a subsidiary in difficulty. We therefore advise banks that, to the extent they feel implicit responsibility for an associate, they should ensure that it is managed soundly and prudently within the bounds of its own capital resources.

Experience suggests deficiencies in some banks' capacity to observe this advice. The Bank is reviewing its policy in this area.

5. End Piece

Perhaps the main characteristic observed in deregulated financial markets has been their tendency to overshoot. This has been as evident in foreign exchange and securities markets as in lending and other areas. While the process can be disruptive, there is a self-correcting tendency in such markets – which can be seen, now, for instance in institutions' more conservative approaches to new lending.

It is likely that self-correcting mechanisms will become more efficient as experience with deregulated markets increases – although it would be too much to expect that economic and financial cycles will ever disappear, along with the need for governments and central banks to attempt to ameliorate them.

It will be necessary to weigh carefully the inevitable calls for more intrusive supervision of banks. For this could tend to amplify the natural self-correcting tendencies in markets. Even if heavier-handed supervision did not act as a destabilising force, there would be the longer-term risk of reduced efficiency and dynamism in banking.

Footnotes

Assistant Governor (Financial Institutions), Reserve Bank of Australia.
Thanks are due to Brian Gray and Bill Jones for their contributions to this paper. [1]

Not all shared that view. For instance, Hogan and Sharpe (1982) said of the Campbell recommendations, “that approach may be described as pervasive, institutional, autocratic, costly and inconsistent with a general thrust towards a deregulated and more efficient financial system”. [2]

At March 1991, the total of non-performing loans was around $25 billion, or 5 per cent of banking assets (including subsidiaries and operations overseas). [3]

Prudential requirements will, of course, continue to evolve as necessary. Currently there is a focus on issues raised by asset securitisation, funds under management and market risk. [4]

References

Australian Financial System Inquiry (1981), Final Report, AGPS, Canberra.

Hogan, W.P. and I.G. Sharpe, (1983), “On Prudential Controls”, Economic Papers, April.

Macfarlane, I.J. (1990), “Credit and Debt: Part II”, Reserve Bank of Australia Bulletin, May.

Reserve Bank of Australia (1989), “Campbell Committee Revisited – Prudential Supervision”, Reserve Bank of Australia Bulletin, July.

Reserve Bank of Australia (1990), Prudential Supervision of Banks – Prudential Statements.

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

Reserve Bank of Australia, Annual Reports, various.

Royal Commission on Monetary and Banking Systems in Australia (1937), Report.

Appendix 1:
Royal Commission on Monetary and Banking Systems in Australia (1937): Excerpts

In its discussion of the topic “Prevention of Bank Failures” (pages 235–237 of the Final Report), the Commission stated that:

“The solvency of any banking system depends ultimately upon the ability of banks to repay their deposits as they fall due. The failure of one bank to meet demands for the repayment of its deposits, even though it may have ample assets with which to meet its liabilities if allowed time, may bring about a condition which may seriously threaten the stability of the whole system. For that reason, it would appear to be the responsibility of the central bank to consider whether the actions of any bank are in conformity with the general interest.”.

In the same section of the Report it was noted that:

“If, in the opinion of the Board of the (central bank), a bank is acting in such a manner as to endanger the whole system, it may be the duty of the Board to intervene and to point out to those in control the possible consequences of their actions. It is probable that this would be sufficient, but if it were not it might be necessary for the (central bank) to exercise some of its powers to make it difficult or impossible for the offending institution to continue the course to which objection was taken.”.

If a bank found itself in a situation where it was unable to meet its immediate obligations due to an insufficiency of liquid funds, the central bank:

“should take prompt action in order to prevent serious consequences to the whole system”.

According to the Commission, it may well be that the appropriate response would be:

“a re-assurance by the (central bank) to allay public alarm and prevent the developments of a panic”.

If, on the other hand, the bank concerned were in a fundamentally unsound position:

“the (central bank) should take control of the unsound institution, either by the appointment of a person who would stand in the position of a receiver for the depositors, or by the appointment of some of its own officers to control the affairs of the bank. As soon as it is in a position to do so, it should announce its estimate of the amount which the depositors may expect to receive, and make arrangements for the release of part of their deposits to those in need.”.

The Commission went on to make a more general point:

“Each case must, however, be decided upon consideration of the circumstances, and it is impossible to lay down any general rule. We desire to emphasise the point that our system is made with the object of safeguarding the banking system as a whole. In our opinion, this can best be achieved by providing the utmost security for depositors. We are not concerned with the interests of shareholders as it is within their power to safeguard their own interests. The failure of any business other than a bank affects mainly those directly interested and does not threaten the banking system. We do not, therefore, suggest that the (central bank) should intervene except in the case of a bank.”.

Appendix 2:
Committee of Inquiry into the Australian Financial System (1981)

Recommendations on Prudential Supervision

In its final report on the Australian financial system, the Campbell Committee made a number of recommendations on prudential supervision of banks. Briefly, these were:

Framework

  • The overall principles of prudential supervision should be agreed between the Treasurer and the Reserve Bank with the latter responsible for the formulation and implementation of prudential policy. The principal characteristics of the policy should be publicly recorded.
  • The Reserve Bank should keep the Treasurer informed of, and its Annual Report should make appropriate reference to, the administration of these prudential responsibilities.
  • There should be no official prohibitions (on prudential grounds) on the nature of financial intermediation that banks may undertake or on the kinds of assets they may hold as a result.

Approach to Supervision

  • Prudential policy should be designed to promote general stability of the banking system rather than to prevent individual bank failure.
  • Supervisory efforts should continue to involve close liaison with bank management and place particular emphasis on periodic in-depth examinations as well as the resolution of specific problems as they arise.
  • The Banking Act should provide for the capacity to impose prudential requirements by regulation, but in the expectation that formal regulation would not generally be used.

Depositor Protection

  • The extent of the Reserve Bank's responsibility to bank depositors should be made clear.

Bank Entry

  • The primary criteria for entry of domestic institutions into banking should be high standing of the proposed shareholders and senior management and a capacity and willingness to observe high prudential and operational standards.
  • Foreign bank participation should be restricted only by the number of licences which the Government from time to time made available. Foreign banks should be subject to the same prudential requirements as domestic banks. Initially, the rate of foreign bank entry would need to be carefully managed.
  • The Banks (Shareholdings) Act should be repealed, but the Reserve Bank should be empowered to require subsequent divestment of shareholdings in banks in excess of 10 per cent where this would be in the best interests of depositors.

Capital Adequacy

  • Individual banks should be subject to appropriate capital adequacy requirements. Capital adequacy ratios should have regard for the interrelationship between capital and other criteria, such as the quality of a bank's assets, its management, earnings performance and the maturity structure of its liabilities.
  • The broad criteria used in determining the ratio should be publicly available, though the specific ratio for each bank should not be publicly disclosed.

Credit Exposures

  • Loans to a single customer and the aggregate value of a specified number of the largest loans should be limited to a prescribed proportion or multiple of a bank's capital.
  • Consideration should be given to imposing risk asset limits on loans to “controlling” shareholders and directors, and on investments in, or loans secured against, certain classes of property (such as low or non-income earning property of a speculative or developmental nature).

Liquidity

  • Banks should be required to meet a liquidity ratio and that ratio should be maintained at or above the required minimum.
  • Eligibility of assets for a bank's liquidity ratio should be determined having regard to their period to maturity and their quality.

Liquidity Support

  • Liquidity support to individual banks should be provided at the Reserve Bank's discretion, so long as the bank concerned is viable and well managed and cannot meet its liquidity needs without jeopardising market confidence in its viability.
  • Arrangements which might be viewed as providing individual banks with access, at their discretion, to Reserve Bank liquidity should be avoided.
  • Details of any liquidity support should be made publicly available with a discretionary lag to take account of the potential impact of disclosure on confidence in the bank.

Consolidated Supervision

  • For the purposes of prudential regulation (and monetary policy), banks should be required to consolidate the operations of intermediaries which are subsidiaries. Minimum capital and other requirements should apply to the consolidated group.

External Auditors

  • Greater use should be made of external auditors whose emphasis is on continuous detailed oversight. Arrangements with external auditors would offer support to the Bank's emphasis on periodic in-depth examinations and resolution of special problems as they arise.

Appendix 3:
Prudential Statements Issued by the Reserve Bank of Australia

Date Title Subject Number
25 January 1985 Prudential Supervision of Banks.
Note: Originally issued as note No. 1 attached to press release of 4 February 1985
Outlined the Reserve Bank's approach to prudential supervision of banks – general principles A1 (PS 1#)
25 January 1985 Supervision of Capital Adequacy of Banks.
Note: Originally issued as note No. 2 attached to press release of 4 February 1985
Outlined the framework for the supervision of the capital positions of banks, including coverageage; definition of the capital base; and imposition of a capital to total assets ratio PS 2#
1985 Banks' Associations with Non-Banks.
Note: Issued to banks on various dates
General guidance in respect of banks' associations with non-banks and financial dealings with associates G1 (PS 3#)
1 March 1985 Access to the Payments System.
Note: Issued to banks on various dates
Prudential considerations regarding access by non-bank financial institutions to the payments system through agency arrangements with banks I1 (PS 4#)
6 May 1985 Supervision of Adequacy of Liquidity of Trading Banks.
Note: Originally issued as attachment to press release of 8 May 1985 on “Introduction of a Prime Assets Ratio for Trading Banks” (item PS6 below)
Outlined the frame work for the supervision of the adequacy of liquidity of trading banks in respect of their domestic operations in Australian currency. Introduced the Prime Assets Ratio (PAR) of 12 per cent, replacing the previous LGS arrangements PS 5#
8 May 1985 Introduction of a Prime Assets Ratio for Trading Banks (Press Release) Explained PS 5 and outlined transitional arrangements PS 6#
16 August 1985 Off-Balance Sheet Business of Banks (Press Release) Introduced a reporting requirement for banks' off-balance sheet business F1 (PS 7#)
31 October 1985 Extension of the Prime Assets Ratio for Trading Banks (Press Release) Extended coverage of PAR to all liabilities (including foreign currency liabilities) invested in Australian dollar assets in Australia PS 8#
31 October 1985 Foreign Currency Operations of Australian Trading Banks.
Note: Originally issued as an attachment to press releasedated 31 October 1985 on the “Extension of the Prime Assets Ratio for Trading Banks” (Item PS8 above)
Extended the supervision of the liquidity of trading banks' operations to cover their operations in foreign currencies PS 9#
22 April 1986 Prudential Supervision of Banks (Press Release) Outlined the Reserve Bank's intention to establish links with banks' external auditors on prudential issues. Defined the relationship between banks, their external auditors and the Reserve Bank H1 (PS10#)
5 June 1986 Prudential Supervision of Banks – Large Exposures (Press Release) Outlined a formal approach to the supervision of banks' large credit exposures. Imposed a requirement that banks report all exposures to individual clients or groups of related clients above 10 per cent of shareholders' funds of the banking group PS11#
28 August 1986 Calculation of Prime Assets Ratio (Press Release) Excluded favourable overnight settlement balances from PAR calculations PS12#
5 September 1986 Supervision of Capital Adequacy of Banks (Press Release) Revised PS 2, widening the definition of capital, and imposing a higher minimum capital ratio for banks established before 1981 PS13#
23 December 1986 Ownership and Control of Banks (Note for the Press) Various requirements relating to the ownership and control of banks to ensure that due regard is paid to the interests of depositors B1 (PS14#)
29 January 1987 Prudential Supervision of Banks – Large Exposures (Press Release) Banks required to give prior notification to the Reserve Bank of their intention to enter into exceptionally large exposures to an individual client or group of related clients PS15#
23 August 1988 Capital Adequacy of Banks (Press Release).
Note: Includes Explanatory Memorandum issued on same date and press release of 7 September 1988
Introduced risk-based capital adequacy guidelines for banks consistent with those adopted by the Basle Committee on Banking Supervision (replaced PS 2 & PS 13) C1
28 September 1988 Supervision of the Adequacy of Liquidity of Banks.
Note: Issued as attachment to press release of 28 September 1988 on “Further Deregulation of the Banking System. Reserve Assets Requirement/Prime Assets Requirement”
Revised PAR arrangements taking account of the risk-based capital adequacy guidelines, removal of distinctions between trading and savings banks, and replacement of SRDs with non-callable deposits. Reduced PAR from 12 to 10 per cent (replaced PS 6, PS 8 & PS 12) D1*
16 August 1989 Supervision of Banks' Large Credit Exposures (Press Release) Revised large exposures guidelines to require large exposures reporting on a consolidated group basis (replaced PS 11 & PS 15) E1
February 1990 Supervision of the Adequacy of Liquidity of Banks Revised D1* to remove Non-Callable Deposits from PAR calculations D1
12 February 1990 Prime Assets Requirement Announced revised PAR arrangements in D1 above, and the reduction of the PAR ratio from 10 to 6 per cent Press Release No 90–08
20 June 1990 Banks' Associations with Non-Banks Imposed a requirement that banks deduct from total capital their equity and other capital investments in non-consolidated subsidiaries or associates effectively controlled by the bank Press Release No 90–14
27 September 1990 Capital Adequacy: Banks' Holdings of Other Banks' Capital Instruments (Press Release) Changed the risk-based capital adequacy guidelines to require banks to deduct their holdings of other banks' capital instruments for capital adequacy purposes Press Release No 90–24
# Refers to “Prudential Supervision of Banks – Prudential Statements” March 1987.
* Refers to “Prudential Supervision of Banks – Prudential Statements” August 1989.
All other references are to “Prudential Supervision of Banks – Prudential Statements” September 1990.