Submission to the Financial System Inquiry 3. Present Regulatory Responsibilities

Published as Occasional Paper No. 14

Introduction

  1. Reflecting the Constitution, responsibilities for regulating Australia's financial system are divided between the Commonwealth and the States. Commonwealth agencies supervise banks and insurance companies, while the States have responsibilities for building societies, credit unions, friendly societies, trusts and unincorporated enterprises. The Australian Securities Commission (ASC) and the Australian Competition and Consumer Commission (ACCC) operate under State and Commonwealth co-operative schemes. Overlaying the formal regulatory structure is the Council of Financial Supervisors (CFS).
  2. This Chapter describes how these regulatory arrangements fit together. Its main focus is prudential supervision, but it also looks at regulation to protect consumers of financial instruments and services as well as market regulation. The current regulatory arrangements in Australia are summarised in Table 5.

Prudential supervision of capital-backed institutions

Credit institutions

  1. Credit institutions in Australia fall into two main categories: supervised deposit-taking institutions (banks, building societies and credit unions) and unsupervised issuers of debt securities (eg finance companies, merchant banks).
  2. Banks are supervised by the RBA. Building societies and credit unions are supervised by State Supervisory Authorities under the Financial Institutions Code, which is administered by the Australian Financial Institutions Commission (AFIC). Supervisory policies for these institutions are similar in that they rely heavily on capital adequacy standards applied to the banking system by the RBA. However, differences in the main activities of the institutions and in their relative size and sophistication have led to some differences in approach. RBA supervision tends to be less intrusive and prescriptive than that conducted under the AFIC framework. In on-site work, the RBA has specialised teams which assess credit risk and market risk management by banks; SSAs conduct more detailed and frequent inspections.
  3. Under the Reserve Bank Act, the RBA must exercise its banking policies to contribute best to ‘the economic welfare and prosperity of the people of Australia’. The Banking Act specifies two broad objectives for bank supervision. The first is to protect the depositors of banks[3]. The second addresses the potential for problems in the banking system to create broader damage to the financial system. The RBA is charged with encouraging a bank:
    • to keep itself in a sound financial position;
    • not to cause or promote instability in the Australian financial system; and
    • to demonstrate integrity, prudence and professional skill.

The Act gives the RBA powers to monitor and evaluate how effectively banks meet these objectives.

  1. AFIC's statutory aims are to protect depositors and to promote the financial integrity and efficiency of the institutions supervised under the Financial Institutions Scheme.
  2. Unsupervised credit institutions may issue securities and be regulated by the ASC under the Securities Chapter of the Corporations Law. This requires issuers of debt securities to be licensed as securities dealers and to meet ASC tests for financial soundness, competence and integrity. If securities are issued to retail investors, a prospectus and trust deed are required. The trustee will usually have powers to obtain financial statements from the company and, if trust deed provisions are breached, to act on behalf of debenture holders. Credit institutions, such as finance companies, can issue securities to wholesale markets but usually need a rating to do so. Certain standards specified by ratings agencies must be met to achieve a high credit rating.
  3. Special purpose vehicles for securitisation schemes also issue securities. They are subject to the Corporations Law in the same manner as other issuers. However, they do not exist as companies per se but provide the vehicle by which the operations and some risks are undertaken by the arranger of the scheme or are outsourced to third parties (eg mortgage originators, mortgage insurers). Again, they need to meet ratings agency requirements to borrow on wholesale markets.

Institutions offering insurance and superannuation products

  1. These institutions comprise insurance companies, friendly societies and defined benefit superannuation funds. Life and general insurance companies and superannuation funds are supervised by the ISC[4]. Its aim is to promote public confidence and help avert instability in the insurance and superannuation sector, as well as provide a safe haven for (retail) savings. To this end, it requires such institutions to maintain adequate risk management policies and internal controls.
  2. At a very general level, insurance companies are supervised like deposit-taking institutions, with an emphasis on capital/solvency requirements. However, capital requirements for life insurance companies – which hold mainly marketable assets – focus more on market risk than credit risk. There are some additional requirements for insurers: eg scrutiny of actuarial assumptions underlying the valuation of liabilities and of risk-shedding arrangements with reinsurers. Life insurance companies split their business into statutory funds. Each statutory fund can cover a wide variety of insurance policies, but capital-backed and investment-linked businesses are kept separate. Each statutory fund is required to have sufficient reserves to be able to service the business of that fund. Unlike banks, insurers are not subject to an internationally agreed supervisory framework.
  3. Friendly societies are currently supervised by State bodies but are due to come under AFIC in early 1997. They operate in a similar manner to life companies and, within the AFIC regime, will have broadly similar capital and other prudential requirements.
  4. The very large number of superannuation funds (around 120,000) restricts the ISC's ability to maintain close and frequent contact with each fund. The supervisory regime for superannuation funds reflects this. Trustees of company and industry superannuation funds are required to have equal numbers of company and employee representatives. Trustees are also required to determine the investment strategy of superannuation funds – namely to have regard to risk, return, the benefits of diversification and liquidity needs. The ISC's approach to supervision is similar to, but more intensive than, the ASC's regulation of unit trusts and other fund raisers. It has more of an audit-type role, concentrating on larger funds and those which appear to be in difficulty.

Oversight of funds managers

  1. There are six types of funds managers, or institutions offering investment-linked products: unit trusts, investment companies, common funds, accumulation superannuation funds, some life insurance statutory funds and some friendly society benefit funds.
  2. Institutions offering these products make promises about the categories of assets on which their returns will be based and about redemption arrangements. Most importantly, however, they do not promise to pay a particular, or even a positive, return on the investment. Regulation by the ASC and ISC, therefore, concentrates on whether managers are efficient, honest and fair, and have adequate resources, systems and procedures to manage the funds.

Prudential supervision of financial conglomerates

  1. Because of the different risks that credit, insurance and funds management institutions face, governments, owners and markets insist that they be in separate corporate entities. For example, a funds manager could not merely pool assets and allow the returns to flow through to the investor if there were capital-backed products on the same balance sheet.
  2. Financial conglomerates are groupings of these different types of institution under common ownership. Supervisors of the members of financial conglomerates face important issues including contagion risk, the transparency of legal and management structures, large and intra-group exposures and the measurement of capital adequacy (particularly to avoid double-gearing).
  3. Most countries supervise financial conglomerates on a ‘solo-plus’ basis. That is, supervision of individual entities is on a stand-alone basis but is supplemented by a general assessment of the group as a whole. In Australia, members of the CFS have agreed on principles for the oversight of conglomerates. They have, in particular, agreed to share information and to liaise with each other when a problem affecting any entity is judged to have the potential to impact on other members of the group. Progress in implementing this framework has been slowed by the need for legislative changes before some agencies (including the RBA) may share information and to protect information received. A Bill to facilitate information-sharing is expected to be introduced in Parliament later this year. Internationally, standards for supervising conglomerates are being addressed by the Joint Forum on Financial Conglomerates (see Appendix E).
  4. CFS members have recommended that financial conglomerates in which a non-operating holding company owns both a bank and an insurance company be permitted, subject to appropriate regulation of the holding company. The Treasurer has announced that legislation to give effect to this proposal will not be introduced until consideration has been given to the findings of the Inquiry. In the meantime, the Colonial Mutual Group's proposal to establish a holding company structure will be facilitated under existing banking and other legislation and will be subject to undertakings which allow for the effective oversight of the holding company by the RBA.

Product and advice regulation

  1. As shown in Table 5, product and advice regulation (consumer protection) is the responsibility of a number of Commonwealth and State agencies and industry bodies. Much of the regulation has developed in the last few years, as a result of the proliferation of financial products and because of the magnitude of decisions many Australians face in providing for their retirement income. Some specific failures to provide information and advice that meets investors needs have also been a spur.
  2. The RBA plays a small and indirect role in product and advice regulation. It chairs and provides the Secretariat for the Australian Payments System Council, which comprises representatives of financial institutions, others involved in the provision of payments services, consumers and other public bodies. The Council has been monitoring compliance with the Electronic Funds Transfer (EFT) Code of Conduct (since 1989), and implementation of the Code of Banking Practice (since 1993) and the similar codes developed for building societies and credit unions (since 1994). The RBA is also represented on the Board of the Australian Banking Industry Ombudsman Scheme. This method of combining industry, consumers and Government officials has worked well in improving standards of banking industry disclosure and complaints resolution. It is an approach used in many parts of the financial sector.
  3. The ASC and ISC play similar roles for the securities, futures and insurance industries. Both use industry bodies in a self-regulatory role: eg the Australian Stock Exchange and the Sydney Futures Market have formal roles under the Corporations Law; the Life Insurance Complaints Service plays a similar role to the Banking Ombudsman. The ASC and ISC also have a role in product disclosure. The ASC has broad rules for disclosure in prospectuses enshrined in the Corporations Law (prospectuses should contain all the information necessary to enable an investor or professional adviser to make an informed assessment of the securities offered). It vets prospectuses issued. The ISC has issued a Circular on life insurance product disclosure and also vets customer information brochures issued by life offices.
  4. The ASC administers the application of the Corporations Law to firms that provide advice regarding securities, while the ISC has requirements applying to individual life insurance agents and brokers. Advisers can give advice on functionally similar life insurance investment products and securities, but be required to follow different advice rules. There are no specific requirements applying to financial advice about bank deposits.
  5. The ACCC has the responsibility of enforcing the consumer protection provisions of the Trade Practices Act; this is conducted on a case-by-case basis rather than as a continuous monitoring process. The Trade Practices Act has also been used by private parties in civil prosecutions regarding disclosure in prospectuses. The ACCC also has a role in developing consumer regulatory policies, including pricing. Its predecessors were involved in the formulation of both the banking and life insurance codes of practice, a review of the EFT Code of Conduct, an inquiry into retail transaction deposit account pricing and the monitoring of credit card pricing.
  6. The Federal Bureau of Consumer Affairs, part of the Commonwealth Department of Industry, Science and Tourism, advises the Minister for Small Business and Consumer Affairs on, among other things, consumer protection, safety and information standards. Its involvement in the financial system is relatively limited, although it has commented publicly on electronic banking issues.
  7. The States also have a role in consumer financial matters. All States have consumer affairs agencies to administer their own consumer protection legislation, which includes consumer credit. Existing credit legislation differs in a number of important ways across States and does not, in general, cover housing loans. Efforts to harmonise credit legislation across Australia and broaden its coverage have recently resulted in uniform Consumer Credit Legislation which is expected to come into force in most States later this year. The States have Tribunals which can hear consumer disputes and have, in the past, awarded hefty penalties against non-complying credit providers.

Regulation of financial markets

  1. Regulation of financial markets in Australia is mostly undertaken under the aegis of the Corporations Law by the ASC and authorised exchanges – the Australian Stock Exchange (ASX) and the Sydney Futures Exchange (SFE). The ASC, SFE and ASX are together responsible for regulation of exchange-traded markets. The Corporations Law envisages that much of the day-to-day regulation will be carried out by the exchanges. Exchanges are approved by the Treasurer and must have appropriate business and listing rules, and fidelity fund arrangements for the protection of users. They must also provide information to the ASC, which has some powers of market intervention. The Corporations Law also requires dealers to be licensed, sets out disclosure requirements to ensure that ‘investors’ can make informed decisions, and prohibits certain forms of abusive behaviour (such as insider trading, market manipulation, and making false or misleading statements).
  2. All foreign exchange trading and most bond trading is conducted by market-makers directly with the public and each other; these markets are known as over-the-counter markets. The foreign exchange market is administered by the RBA under the Banking (Foreign Exchange) Regulations. All foreign exchange transactions in Australia must be conducted with authorised foreign exchange dealers (banks and merchant banks); the RBA requires dealers to meet supervisory requirements relevant to the conduct of foreign exchange business. Over-the-counter securities markets are regulated by the Corporations Law, which requires a prospectus for the issue and sale of most securities and the licensing of most over-the-counter dealers. Exemptions from prospectus requirements are given for transactions in wholesale markets (eg if individual parcels of securities for sale exceed $500,000, or if offers are made to specified classes of sophisticated investors, eg securities dealers, life insurance companies).
  3. The regulatory structure for over-the-counter derivatives markets is more complicated and is under review by the Companies and Securities Advisory Committee. Derivatives transactions can be regulated under the futures or securities Chapters of the Corporations Law or under the Banking (Foreign Exchange) Regulations. Some contracts (eg over-the-counter commodity options) are unregulated.
  4. Because banks are at the centre of derivatives and securities markets in Australia, the RBA has been working to ensure banks' systems for managing market risks are adequate. It is also working with accounting bodies to improve public disclosure of traders' derivatives activities/exposures and is implementing the Basle Committee's capital guidelines on market risk.
  5. The exchanges have detailed rules for the conduct of derivatives and securities trading. These aid in enhancing fairness, transparency and financial integrity. They can assist in detecting the build-up of exposures and in discovering price manipulation. In the over-the-counter markets, industry bodies, principally the Australian Financial Markets Association, provide further guidelines for industry conduct. Nearly all securities and derivatives markets in Australia are computer-based and face substantial potential competition from equivalent markets overseas. Financial market regulators in Australia are aware that over-regulation of these markets is likely to lead to atrophy, just as they are aware that a reputation for well-regulated and efficient markets is likely to attract overseas business.

Regulation to promote competition

  1. The ACCC has the primary role in regulation to promote competition. This includes prohibiting mergers and acquisitions that are judged to ‘substantially lessen competition’. The factors on which the ACCC can make its judgments are outlined in Section 50 of the Trade Practices Act. They include the level of concentration in the market, the height of barriers to entry, the extent to which substitute goods or services are available and the extent of vertical integration in the industry.
  2. The ACCC also vets some agreements among financial institutions and can authorise anti-competitive practices if they have offsetting public interest benefits. Examples include the rules of the Australian Payments Clearing Association – which govern access to and procedures for the various clearing streams of payments between banks and other members of APCA – and ASX membership rules.

Council of Financial Supervisors

  1. The Council of Financial Supervisors, formed in 1992, is a co-ordinating body which brings together the heads of Australia's main financial supervisory agencies. The Council aims to enhance the quality of financial supervision and regulation in Australia by:
    • facilitating exchanges of information bearing on the efficiency and health of the financial system;
    • assisting each supervisory agency to be aware of, and to understand, developments in parts of the financial system outside its particular area of responsibility;
    • identifying important issues and trends in the development of the financial system as a whole; and
    • avoiding unintended gaps, duplication or inconsistencies in regulation.
  2. The Council encourages the harmonisation of regulatory requirements where the interests of agencies overlap. It does not, however, promote the application of identical standards to all financial institutions or products. Approaches to the protection of depositors and investors vary from one part of the financial system to another depending on a range of factors, including the nature of the products in question and the degree of risk attaching to them; the numbers and characteristics of the institutions and investors involved; and the statutory responsibilities and community expectations of supervisors.
  3. The Council is not itself a statutory body, nor is it a prudential supervisor or regulator in its own right. Its creation has not altered the statutory responsibilities and powers of its members, or replaced other channels of communication between them. The Council's work has concentrated on the supervision of financial conglomerates. In addition, Council members have been establishing bilateral arrangements for information exchange and the supervision of particular institutions or groups. The Council is also overseeing a review of unintended overlaps and inconsistencies in the regimes regulating sales and advice practices for similar retail products offered by different kinds of institutions.

Footnotes

The Banking Act does not define a ‘deposit’. Nevertheless, for the purposes of the Act, deposits can reasonably be confined to debts entered into by a bank which give rise to a banker/customer relationship – that is, cheque or term deposit accounts, rather than funds borrowed by a bank from wholesale markets. Banks' other liabilities fall outside this definition, although a broader definition may encompass some marketable instruments which are accepted in financial markets as deposits, such as certificates of deposit.

Australian law is clear about what is not to be described as a deposit: where a public borrowing by a corporation is classed as a security under the Corporations Law it has to be described as a debenture, unsecured note or similar terms. This allows borrowings of most supervised institutions (eg banks, buildings societies, credit unions, life insurance companies) or by prescribed interests or pastoral finance companies to be described as a deposits. The Corporations Law exempts banks' debts which arise in the ordinary course of banking business from the debenture provisions of the Law. [3]

Health insurers are supervised by the Private Health Insurance Administrative Council; friendly societies and some State government-owned institutions are supervised by State government bodies. [4]