Submission to the Financial System Inquiry 2. Objectives and Types of Financial Regulation

Introduction

23. An efficient financial system will allocate savings to productive users of funds at least cost. It should offer a large range of financial instruments and institutions to assist investors balance risk, liquidity and return. It should also cater to a wide range of borrowers, from the well established to those with high-risk new ventures. The community should be able to trust the integrity and soundness of the system, without believing that everything is guaranteed by the Government. It should allow institutions to innovate – employing new technology and offering new products. It should be open to competition.
24. Although the features of financial systems vary from country to country, depending on their stage of economic development and the structure and philosophies of government, it is possible to identify three common themes or objectives underlying financial regulation:
    • a concern with the stability of the financial system and a desire to prevent financial crises – that is, situations where problems in the financial system have the potential to cause a contraction in economic activity through their effects on community wealth, credit flows or confidence in the payments system. This objective is pursued through prudential supervision of key institutions, through oversight of arrangements for settling transactions among financial institutions and through ‘crisis management’ when a problem does arise;
    • a desire to protect the interests of users of financial services in situations where information about the characteristics of products, or the riskiness of institutions offering them, is hard to assess. This form of regulation – consumer and investor protection – attempts to improve the safety of investors' funds and requires clear disclosure of financial information and appropriate standards of financial advice so that investors and borrowers are better able to make informed decisions; and
    • encouragement of appropriate levels of competition among those offering financial services, in the interests of efficiency.
25. Of these three types of regulation, only the first – prudential supervision – is unique to the financial sector, for reasons discussed below. Competition policy should involve the application of a common set of principles to all industries in the economy. Similarly, consumer protection rules can apply across a range of products, although there are particular issues involved with financial products; hence a lot of emphasis is given to investor protection. In the discussion below, prudential supervision receives the greatest attention because it is central to the RBA's concerns and expertise.

Prudential supervision

General aspects

26. Prudential supervision, in its broadest sense, is about maintaining the longer-run stability of the financial system by avoiding (or at least reducing the chances of) financial crises. History suggests that economy or system-wide financial crises do not occur often, but when they do their consequences are very severe. Most developed economies have only experienced such crises a few times per century. In Australia, such events occurred in the 1890s and the 1930s. Financial disturbances in the late 1980s and early 1990s reminded Australians that this danger was still present. A number of financial institutions incurred significant losses and there were some insolvencies, but the damage was less than in the earlier two episodes.
27. Prudential supervision, in its narrower sense, is about encouraging prudent risk management by financial institutions whose failure could precipitate a financial crisis. It works through rules which minimise the chance that supervised institutions will become insolvent and, failing that, by crisis management procedures. As a by-product, it offers the public a relatively safe haven for those savings where security is more important than return.
28. Certain sorts of institutions enter into contracts with the public whereby they promise to repay a specified nominal sum of money at some future date. The most common examples are deposits with banks and other retail deposit-taking institutions, where principal and interest must be repaid, or an insurance policy, where the claim must be paid out in full. If these institutions cannot meet their nominal commitments, they become insolvent and fail. Unlike a unit trust or an accumulation superannuation fund, their promised return is legally ‘locked in’; they cannot justify a lower (or negative) return on the grounds that market conditions proved unfavourable.
29. These products involving a fixed nominal contract have evolved over centuries to fulfil a genuine community need. Holders of deposits need to be sure that the expected funds are there when bills have to be paid, and a policyholder could be ruined if the insurance company was only able to pay a proportion of the sum insured. The public expects these institutions to still be around, and able to pay, when the time comes to get their money back.
30. For this reason, governments put in place rules designed to minimise the chances that institutions of this type will fail, although failure cannot be ruled out altogether if other unacceptable costs are to be avoided. The cornerstone of these rules is that the institutions have adequate capital to cover the risks they must take. Another characteristic of prudential supervision is that it is necessarily institution-based, because only institutions can become insolvent. Prudential supervision is, therefore, applied to banks, other deposit-taking institutions and insurance companies, but the same principle would apply to defined-benefit superannuation funds.
31. Another important argument for supervision is the ‘moral hazard’ argument. Because of the potential suffering involved if one of these institutions was to fail, there is a widespread community belief that the ‘government would do something about it’. In some countries this support is legislated, but even without legislation there is a belief that claims on these institutions are guaranteed. This means that in the event of failure, a government could be forced to make good the public's losses with taxpayers' funds. Also, if all institutions are viewed as being equally safe, there is no incentive for managements to compete on safety. The ‘moral hazard’ is that the incentives tend to make institutions compete on offering the highest return regardless of risk. This will lead to excessive risk taking in the industry, increasing the likelihood of a financial crisis and the need for a government bail-out. The most recent international example of this was the collapse of the Savings and Loan industry in the US. Prudential rules are seen as a necessary restraint on this tendency. Of course, the existence of a supervisory regime might tend to confirm in the public's mind that the institutions are immune from failure; supervision itself provides no such guarantee.
32. A theoretical alternative to prudential supervision is ‘caveat emptor’, that is, customers make their own assessments of the soundness of individual banks and insurance companies, without the support of prudential rules. With one or two minor exceptions in earlier periods, this approach has not been followed in any major country. The judgment has been made that the public do not have the required skills or time to do thorough assessments of the health of financial institutions, and the stakes are so high that an error can be ruinous. Even relatively sophisticated financial analysts have made serious misjudgments in their evaluations, so it would be reckless to expect individuals to do better. This does not mean that only governments can be responsible for the prudent behaviour of financial institutions; there is a complementary role for private ratings agencies in combination with a high level of disclosure to assist in this process, but they are not a substitute for prudential supervision.

Prudential supervision of banks

33. While both banks and insurance companies share a need for institution-based prudential supervision, banks have some special features which make them crucial for the maintenance of financial system stability.
34. First, the structure of their balance sheets makes banks vulnerable to disturbances, even short-lived ones. Most of their liabilities are at call, or very short-term, but their assets are mostly long-term.^[2] It is the nature of banking to take on this maturity mismatch. It is also generic that a large part of bank lending will be to small and medium-sized businesses where information about creditworthiness is difficult to obtain or standardise, and where loans cannot be securitised and hence made liquid. A bank is thus vulnerable to a run on deposits that it cannot meet. Even if the bank is sound, in that the finally realisable value of its assets is greater than its deposits, the ‘fire-sale’ value of its assets could easily be less than its deposits.
35. Second, banks are subject to contagion. A run on one bank, which the public suspects is unsound, can easily lead to runs on other banks which were otherwise prudently managed. However, whether a bank is sound or not, it cannot withstand a determined run, and some lender of last resort is required to restore equilibrium. That lender could be another bank or group of banks, but in practice it is almost bound to be a central bank or a consortium led by a central bank or other bank supervisor.
36. Third, banks play a crucial role in the transmission of a financial crisis. Threatened with a run, banks will, not surprisingly, adopt a survival strategy – they will be reluctant to make new loans, will call in risky loans and will give preference to holding marketable government securities over non-marketable private sector loans. The provision of credit will tend to dry up, spreading the financial disturbance quickly to the real economy through a contraction in business activity. Modern scholarship on the Great Depression now sees the drying up of credit as a result of bank failures as central to its severity, and more important than the fall in the share market (see Bernanke and James (1990) and Bernanke (1994)).
37. In principle, prudential supervision could be conducted by the private sector through, for example, self-regulatory organisations or ratings agencies. However, prudential supervisors tend to be in the public sector – either central banks or other statutory bodies. Public sector supervisors can do a number of things more effectively than private bodies, eg:
    • Where a bank's prudential standing falls significantly, the supervisor can attempt (usually successfully) to resolve the problem effectively and quietly, thereby avoiding a run by investors. If credit ratings were the prime source of prudential information for the public, a decline in ratings below a certain level could precipitate a run. Similarly, a supervisor might act more quickly to resolve the problem of an institution under threat than can disparate groups of creditors (who might not be able to organise decisive action until too late) or shareholders (who might gamble on a risky project saving the company from insolvency).
    • The public sector, through the central bank, can be the ultimate liquidity provider to a bank which is essentially sound but suffering liquidity problems. Banks are generally the providers of liquidity to the economy, but there is always a possibility they might be unwilling to lend to a competitor about whom they lack information that a public sector supervisor has.
38. Enhanced disclosure of financial information is viewed by some as a possible alternative to prudential supervision. Improving the transparency and quantity of information contained in financial statements is important and should be encouraged. Though unlikely to be consulted by most depositors, improved information is useful to the investment community where share analysts and ratings agencies are constantly evaluating banks' performance. Their assessment of, for example, a bank's bad loans can affect its share price and send a useful message to management. As a result of RBA pressure, banks now publish figures on their problem and impaired assets on a standardised basis to assist in market evaluation. While bank supervisors recognise the value of greater disclosure, no-one relies exclusively on this approach; disclosure can be a useful complement in that it increases private sector discipline but it is not a substitute for public sector regulation. Disclosure, no matter how comprehensive, cannot provide a timely picture of a bank's financial performance or risk profile, which can change quickly with the use of derivatives and other complex financial instruments. As the Chairman of the US Federal Reserve Board has noted:
    
    

    A generation ago, a month old balance sheet was fairly indicative of the current state of an institution. Today, owing to the proliferation of transactions, a day old balance sheet can be obsolete.

39. The Reserve Bank of New Zealand's (RBNZ) approach is often cited as one which relies exclusively on disclosure, but this is not the case. While the RBNZ does give a lot of emphasis to disclosure, it retains a supervision department which licenses banks, imposes the Basle capital adequacy standards, monitors compliance, holds regular consultations with senior bank management, and has in place crisis management arrangements to cover potential bank failures.

Regulation of investment products

40. Investment products offer returns based on the earnings of some specified pool of assets. These include unit trusts and the various products offered by funds managers to the public or to superannuation funds. While the products are clearly defined, the institutions which manage them range from specialised funds managers, insurance companies, bank subsidiaries to friendly societies.
41. Investment products do not involve a nominal contract as the assets are managed on a ‘best endeavours’ basis. Provided the manager is honest, the worst that can happen is that the product will yield disappointing returns, possibly involving falls in absolute value. In this event, customers might withdraw funds and move them to other providers. While substantial falls in the market value of investments, if sustained, will reduce wealth and consumption, these effects will generally be less pronounced than those which follow bank failure. Similarly, if the managing institution gets into difficulties, this has few implications for the unit holders; they will still be entitled to the market value of the underlying assets on liquidation or takeover by a new manager. Thus, these products are different in kind as well as degree of risk to deposits or insurance policies. A summary of the differences is given in Table 4.
42. As a result of the different risk profile of the two types of products, the required form of supervision is entirely different. For the first group, prudential supervision has to concentrate on the health of the institution and the adequacy of its capital. In the second group, the underlying institution is not at risk to any great extent and the capital needs are minimal. The investor bears the risk, and should be under no illusion that the value of his or her investment is being preserved by the supervisor. People holding investment products do so because they wish to access the high-return/high-risk end of the risk/return frontier. They cannot expect the same degree of protection against the fall in the value of their investment as they would had they held deposits or insurance policies.
43. For this reason, the appropriate form of regulation of investment products is one based on disclosure of the characteristics of the product, rather than on the solvency of the institution offering the product. These are entirely separate approaches, and only the latter could be termed prudential supervision. Indeed, it would be very dangerous to the long-term health of the financial system if the public were to perceive that investment products were supervised in a manner similar to that of deposits or insurance policies. This would be an extreme form of moral hazard in that it would blur differences in risk and, at worst, could lead people to think that bank deposits and investment products were equally riskless, ie that the government or one of its instrumentalities stood equally behind them.
44. For this, and other reasons, the RBA believes that the centrepiece of financial regulation should be the clear separation of regimes for prudential supervision and product disclosure regulation. The nature of regulation for investment products is set out in the next section.
45. Accumulation superannuation funds do not fit neatly into the two-part division outlined above. Although essentially investment products in that their annual return varies with the market and can be negative, they are subject to a form of quasi-prudential supervision. They are required to operate within government rules for fund trustees in respect of their approach to risk, return, diversification and liquidity. This quasi-prudential oversight reflects the compulsory aspect of superannuation, some lack of investor choice, taxation concessions and the long-term nature of investments. These aspects add up to an implicit promise by the funds to pay back contributions plus, in the long term, a positive return not very different from the market average.

Product and advice regulation

46. Product disclosure and advice regulation (often called consumer protection) permeates all areas of retail business activity in Australia. It deals with unfair and deceptive practices (eg pyramid selling, misleading conduct), product safety and information, and dispute resolution.
47. Other areas of the economy have specific consumer legislation. It can relate to physical safety (eg food, poisons, explosives, motor vehicles and occupational health) or to situations where consumers make decisions that concern large amounts of their money (eg the licensing of builders, rules applying to the borrowing or investing of money). These specialised areas of consumer regulation are often backed up by some form of enforcement to see that retailers are complying with standards (eg health and building inspectors).
48. In the financial sector, consumer protection aims to ensure that information disclosed by product producers and sellers is sufficient for investors to make well-based decisions (which may, of course, include a decision to invest in a highly risky venture), with the ultimate objective of promoting efficiency in financial markets. Much of the regulation in relation to investment products and to financial advisers has this goal. Other regulations deal with the competence and integrity of investment trustees and managers; with provision of information to consumers about the on-going conditions of contracts (including charges); with avenues for complaint and redress when disputes arise; and so on. Sometimes information must be provided in a way which facilitates comparison of competing products or services; examples include disclosure standards for life insurance policies, consumer credit laws and the Code of Banking Practice.
49. This area of regulation is best achieved by regulating particular products or functions, regardless of institution. Unless financial products are uniquely identified with particular institutional groups, the relevant product regulator will necessarily deal with several groups. For example, the same basic principles can apply to an independent sole-trader providing financial advice as to the largest financial conglomerate in Australia. Indeed, it can be argued that these principles could be embodied in regulation which relates to all financial instruments and services.

Regulation of financial markets

50. Market efficiency is usually concerned with the liquidity, fairness and orderly trading of markets. Participants should be able to buy or sell the products they want, in the volumes they require, and at true market prices. This requires an effective market infrastructure, transparent pricing mechanisms, good settlement and clearing procedures, and freedom from fraud and malpractice. Reliable settlement procedures and arrangements for handling a failure to settle also promote stability.
51. To promote market efficiency and stability, governments usually provide a legislative framework and allow the relevant industry or exchanges to establish detailed trading rules and enforcement procedures. The task is, of course, greatly simplified if supervision of the market-makers and the regulation of products and advice are effective.

Regulation to promote competition

52. Most countries have regulatory bodies which aim to prevent anti-competitive practices, including price fixing, monopolies and misleading conduct. They usually have authority to prevent or to challenge mergers or acquisitions which might reduce competition. Their responsibilities normally cover competition in all sectors of the economy since there is no justification to have a different (or very different) competition policy in financial services than elsewhere. Another aspect of competition regulation is the use of litigation, by both the regulator or aggrieved parties, to prosecute breaches of competition laws. Whereas prudential supervisors and regulators of products, advice or markets continuously monitor the financial industry, competition regulators tend to focus more on specific incidents or proposals.

Other regulation

53. Other types of regulation, with objectives other than stability or efficiency, impinge on the financial system. The financial system is a massive database of the economy's financial transactions and wealth. Financial institutions are required to inform the Australian Transactions and Analysis Centre of suspicious or large cash transactions. Lenders and credit assessment agencies are the only private sector bodies specifically subject to the provisions of the Privacy Act. And the Australian Taxation Office requires deposit-takers to deduct tax from the accounts of those who do not provide a Tax File Number. Taxation and social security regulations can also affect the choices people make about which financial product to purchase.

Trade-offs between types of regulation

54. While the various types of financial regulation are directed to objectives which the community has endorsed, they are not always consistent with each other. This is inevitable, and no amount of reorganisation of responsibilities can avoid it. An appropriate balancing of objectives is required.
55. For example, prudential supervisors usually have authorisation criteria relating to minimum capital and specified ownership structures. This creates a barrier to entry to the particular market which could reduce competition in some circumstances. Similarly, a prudential supervisor will sometimes resolve a potential financial crisis by requiring amalgamation of financial institutions, thereby increasing concentration.
56. In addition, there are constraints on the implementation of prudential regulation which are imposed by international competition and international financial regulators. Differences in regulatory regimes can have competitive impacts, including diverting activity to offshore markets (or vice versa). Further, the overseas expansion of Australian financial institutions can be blocked if they are not supervised to internationally-agreed standards. For example, banks operating internationally need to satisfy the capital adequacy guidelines of the Basle Committee on Banking Supervision.

Footnote

Insurance companies are almost the opposite: their liabilities are not liquid and the majority of their assets are readily marketable (shares, bonds, property). They are thus not as susceptible to runs or contagion as banks and hence not as crucial for the spread of financial crises. [1]