Submission to the Financial System Inquiry 6. Some Other Prudential Supervision Issues

Published as Occasional Paper No. 14

Introduction

  1. This Chapter discusses authorisation criteria for banks, arrangements for dealing with a bank ‘exit’, the supervision of intermediation subsidiaries of banks and the licensing of foreign exchange dealers.

Authorisation criteria for banks

Ownership and control of banks

  1. The Banks (Shareholdings) Act 1972 seeks to promote a wide dispersion in bank ownership. To this end, it prohibits any one shareholder, or group of related shareholders, from acquiring in excess of 10 per cent of the voting shares of a bank. Exemptions can be granted by the Treasurer for shareholdings up to 15 per cent and by the Governor-General for shareholdings beyond 15 per cent. The Act requires that the Treasurer shall not refuse applications for exemptions for shareholdings up to 15 per cent unless he/she can demonstrate that this would be contrary to the national interest. For proposed shareholdings in excess of 15 per cent, the onus is on applicants to demonstrate that the exemption sought would be in the national interest.
  2. The Act's objectives are to:
    • protect depositors against the risk that a bank's resources could be used to serve the particular interests of a few dominant shareholders;
    • ensure that a bank's viability is independent of the viability of a major shareholder;
    • ensure reasonable independence and continuity of management; and
    • facilitate the raising of additional capital when necessary.
  3. It can be argued that, in promoting a wide dispersion of ownership, the Act also serves to protect existing management, restrict opportunities for takeover and impede market entry, which may, in turn, inhibit moves to promote competitive efficiency. In practice, the Act's restrictions have not proved to be a significant impediment to increased competition and reorganisation within the financial sector. This is due principally to the powers of exemption available under the Act and the discretionary manner with which these have been applied. For example, exemptions have been granted to foreign banks to enable them to establish/acquire local subsidiaries; for domestic banks to acquire other domestic banks; and for an insurance company to purchase a bank. As noted elsewhere, the number of authorised banks has almost doubled since the early 1980s.
  4. For the reasons stated above, however, it has been Government and RBA policy not to support exemptions for corporations engaged in businesses outside the financial sector. Nevertheless, it has been possible for these corporations to participate in the financial system in other forms such as finance companies or merchant banks.
  5. Most developed countries impose ownership restrictions on banks, with thresholds for regulatory intervention generally ranging between 5 and 10 per cent.
  6. The RBA believes strongly that the policy presumption in favour of a dispersion of shareholdings in banks, as embodied in the present Act, should be retained. The Act could, however, be amended to improve the efficiency of its operation by:
    • adopting a single exemption procedure for shareholdings above a minimum, which could be set at 10 or 15 per cent. The two tiers of exemption have not proved to be useful, especially given the presumption in the Act in favour of granting exemptions to shareholders wishing to acquire interests up to 15 per cent; and
    • allowing exemptions under the Act to be granted by the Treasurer alone, without Vice-Regal involvement.

It should also be made possible to attach conditions to exemptions under the Act, possibly facilitating a more liberal approach to some applications.

Minimum capital

  1. Since 1992, the minimum level of Tier 1 capital required of a locally incorporated bank has been $50 million. This is broadly consistent with total balance sheet assets of around $1 billion. A relatively high level of minimum Tier 1 capital is one of the simplest and most effective means of discouraging unsuitable shareholders from attempting to gain a banking authority. On the other hand, it might be argued that a high minimum capital requirement unduly restricts competition.
  2. In Australia, there are many avenues for those with access to only small amounts of capital to participate in the financial sector – for example, mortgage managers, small-scale finance companies, financial advisers and funds managers. To provide the relatively broad range of services expected of banks requires sufficient capital to acquire the necessary expertise and technology, and to generate the required degree of confidence. It is of considerable importance that confidence in the banking system as a whole is not undermined by the failure of small players lacking sufficient resources.
  3. The RBA does not believe that the minimum capital requirement has ruled out prospective applicants who could have made a contribution to the Australian financial system. In a world where financial institutions of doubtful pedigree are always scouting for opportunities, the minimum capital requirement for a bank is an excellent screening device.

Foreign banks

  1. Since 1992, foreign banks have been able to apply for banking status in Australia either as subsidiaries or as branches. When entry was first opened up in 1984, after a long prohibition, foreign-owned banks had to operate as subsidiaries, reflecting in part the objective of competitive neutrality with domestic banks. More fundamentally, there was a concern that with branches the RBA would not be able to carry out effectively its ultimate ‘depositor protection’ responsibilities which depend on its taking control of, and managing, a bank in difficulties.
  2. As the new foreign bank subsidiaries gained experience in Australia, they increasingly specialised in wholesale markets. In this business, they felt constrained by prudential requirements; they argued that they could be more effective competitors if they could operate as branches and take positions which were related to the global strength of their parent, rather than the size of their capital in Australia.
  3. Nevertheless, the fact remained that the Australian authorities could not accept responsibility for the solvency of a foreign bank which operated in Australia through a branch. Accordingly, when branches were allowed, they were excluded from the depositor protection provisions of the Banking Act. It was thought appropriate, however, to preserve that protection for all household depositors and foreign bank branches were consequently precluded from gathering retail deposits – specifically, initial deposits under $250,000 from persons and unincorporated entities.
  4. Foreign bank applicants must establish that they are subject to adequate standards of supervision in their home country. The approach followed in Australia is consistent with the internationally agreed Minimum Standards for the supervision of international banks described in Appendix D. Banks from countries where supervision is inadequate should not be permitted to operate in Australia.
  5. A key issue in branch applications has been the requirement that banks wishing to branch into Australia be able to make a convincing case that they will be able to make a worthwhile contribution and ‘not just add to the number of banks’. Generally, banks which are willing to commit resources to obtaining a banking authority believe they will able to deliver their range of services more effectively as a bank and thus have been able to argue that they will be more competitive (although there have been a couple of cases where the scale of the proposed branch operation in Australia has been too small for the RBA to believe the applicant should be encouraged). If foreign banks were to be compelled to have banking authorities to operate here as discussed in Chapter 5 – that is, if the ‘merchant bank’ option were retracted – the RBA may need to be more tolerant of those foreign banks which wanted to operate in Australia on a small scale.
  6. Foreign banks are also required to have an ownership structure which is generally consistent with the objectives of the Banks (Shareholdings) Act. This requirement is necessary for competitive equity with Australian-owned banks, and because the underlying principle is sound for both local and overseas entities. Nevertheless, some flexibility is required in administering this requirement to reflect differences in practices and supervision overseas. For example, in many Asian countries, large individual or family shareholdings in a bank are quite common. The RBA has also been prepared to accept banks owned ultimately by foreign holding companies where the holding company itself has a dispersed spread of shareholders, and there is provision in the home country for the supervisory oversight of the holding company. In such cases, however, the RBA prefers that a bank in Australia be owned directly by an authorised foreign bank, rather than directly by the ultimate holding company. This ensures that the Australian bank has the backing of a shareholder with the full resources of an authorised bank.
  7. One of the lessons from the BCCI case was that unnecessarily complex ownership structures should be a warning sign that it will be difficult for the supervisor to monitor activities of the group. The RBA recommends retention of requirements on prospective foreign bank applicants which are broadly consistent with Australia's models for domestic banks.
  8. The 1992 policy on foreign banks has permitted a steady flow of new entrants. Discussions with foreign banks operating non-bank subsidiaries in Australia indicate that most have not been discouraged from conversion to bank status by the prudential standards, but by the costs of interest withholding tax on a branch's borrowing from its parent (which a subsidiary can escape with properly structured borrowing in its own right) and the below-market interest rate on NCDs.

The process of authorisation

  1. Under the Banking Act, applications for authority to carry on banking business are made to the Treasurer and authorities are granted by the Governor-General. In practice, prospective applicants are encouraged to first discuss their proposals with the RBA so it can identify aspects which might not be consistent with policy. If a proposal is able to be developed to the point where it meets all entry criteria, a formal application is forwarded to the Treasurer with the RBA's recommendation that an authority be granted. Treasury will have been kept informed of the RBA's discussions with potential applicants and given the opportunity to offer any views. On no occasion has Treasury not supported the RBA's view.
  2. The concept of authorising banks to conduct banking business in Australia was first proposed by the 1937 Royal Commission into the Monetary and Banking Systems. The Royal Commission recommended that the Treasurer should grant such authorities. The Banking Act 1945 introduced the Governor-General into the process and subsequent Banking Acts retained this arrangement. It is not evident that the involvement of the Governor-General is warranted and this requirement makes the process more cumbersome.
  3. One option would be for the RBA to be assigned responsibility for granting banking authorities, with unsuccessful applicants having a right of appeal to the Treasurer. As the RBA sets the entry criteria for banks, and is responsible for their ongoing supervision, it would seem appropriate for the RBA also to be responsible for their authorisation. It is common practice overseas for supervisory authorities also to issue licences. The RBA would support such an arrangement which would be more in line with comparable provisions in the insurance industry. Under the Life Insurance Act 1995 the power to register life offices is given to the Insurance and Superannuation Commissioner, but the Treasurer is required to endorse any decision by the Commissioner to refuse an application. A similar arrangement applies under the Insurance Act 1973 for general insurance companies. Alternatively, the power to authorise could lie with the Treasurer.

Outward authorisation

  1. As noted in Appendix D, the second of the internationally accepted Minimum Standards for the supervision of international banks provides that ‘the creation of a cross border banking establishment should receive the prior consent of both the host country and the home country authority’. Australian banks are advised to consult the RBA prior to overseas acquisitions, because it is clear that such acquisitions can have a significant impact on the soundness of the local operation. This consultation presently occurs on a voluntary basis. It is usual practice for the host country authorities to ask to see evidence of home country approval for new cross-border banking operations, and this of course encourages Australian banks to consult the RBA prior to proceeding with new acquisitions or operations overseas. Nevertheless, there would be merit in including a requirement for RBA approval of such initiatives in the Banking Act. This would demonstrate that the Australian prudential regime meets international best practice in this area.

Crisis management

  1. Prudential supervision aims to reduce the probability that a bank will fail. It will never be possible (or even desirable), however, to reduce this probability to zero. As the failure of a bank would have major consequences for financial system stability, supervisors inevitably become involved in managing failure situations. The Banking Act clearly contemplates the possibility of bank failure and makes provisions for this eventuality. If a bank is unable to meet its obligations the RBA has power to assume control of its business.
  2. These provisions reflect the recommendations of the 1937 Royal Commission, which envisaged that the RBA could appoint a receiver for the depositors if it assumed control of an unsound bank. For example, the Commission recommended that one of the first acts of the central bank, after it assumed control of a bank, should be to estimate and announce the amounts likely to be available for distribution to depositors. The implication was that depositors might not, in these unlikely circumstances, recover the full value of their money.
  3. Consistent with this, the RBA has always maintained that the ‘depositor protection’ provisions of the Banking Act do not amount to a guarantee. Unfortunately, the reflection of the Royal Commission's recommendations in the current wording of the Banking Act gives rise to some ambiguity. The Act says (Section 14(5)) that where the RBA has assumed control of a bank, it shall remain in control of, and continue to carry on the business of the bank, until the deposits with the bank have been repaid (or provision is made for their repayment, or the RBA believes it is no longer necessary for it to remain in control). The wording used does not appear to allow the RBA to act as, or appoint, a liquidator to wind up the bank. As well, the reference to deposits being repaid might be taken by some to imply that they would be repaid in full.
  4. In practice, the RBA would attempt to deal with a troubled bank by arranging for its recapitalisation by shareholders or its merger with a stronger bank. The possibility that the RBA might exercise its powers to assume control of a bank could persuade management of the distressed bank to co-operate in seeking merger partners. However, its hand would be further strengthened if the legislation made it clear that, once it had assumed control of a bank, the RBA might sell the bank to other parties. This would give strong incentives for a bank's board to arrange a sale so that it could achieve the most favourable possible terms. Of course, any actions by the RBA to sell or wind up a bank, should be subject to appeal to the courts.
  5. The RBA favours amendments to the Banking Act to clarify the powers of the RBA should it assume control of a bank. The Act might also be amended to make clear that ‘depositor protection’ does not imply an official guarantee.

Supervision of non-bank subsidiaries of banks

  1. Among advanced economies, Australia appears to be unique in allowing banks to conduct financial intermediation in subsidiaries which are not authorised as banks and which operate outside the ambit of supervised financial institutions. The reasons for this are historical. Prior to Australia's decision to deregulate financial markets in the 1980s, non-bank financial intermediaries (principally building societies, finance companies and merchant banks) experienced rapid growth in market share. This was to the detriment of authorised banks, whose capacity to compete was hindered by controls and regulations.
  2. Since deregulation, the share of the finance company and merchant bank industry assets controlled by banks has been in decline. This has been due to a number of factors, including:
    • many non-bank subsidiaries had been formed to enable banking groups to circumvent direct controls, such as interest rate ceilings and limits on lending, which did not apply to non-banks. With deregulation, much of the rationale for such subsidiaries has been removed;
    • spectacular losses suffered by banks' non-bank subsidiaries earlier this decade, which in turn rebounded significantly on the performance of their parents. These included losses of $2.7 billion by the State Bank of Victoria's subsidiary Tricontinental Corporation, around $1 billion by State Bank of South Australia's Beneficial Finance Corporation, and a $726 million loss by Westpac's AGC. The losses experienced by Tricontinental and Beneficial did major damage to the viability of SBV and SBSA, and caused heavy losses for their State government owners. Another dramatic addition to this list in 1994 was the collapse of the UK's Barings Bank due to the activities of its non-bank subsidiary in Singapore.

Many of the operations of banks' non-bank subsidiaries have been wound back into the parent banks, while others have brought their subsidiaries' operations under closer control.

  1. Eleven Australian banks own finance companies and 25 own merchant banks. These finance companies currently have assets of around $23 billion (representing 50 per cent of the finance company industry) while the merchant banks have assets of around $13 billion (representing 22 per cent of the merchant bank industry). Of the 25 merchant banks, 6 are special purpose vehicles established solely to enable foreign bank branches to raise tax-effective funds under Section 128F of the Income Tax Assessment Act.
  2. The following table 6 indicates that much of the business now conducted in banks' non-bank intermediaries could be done within the authorised bank. Bank-owned finance companies have moved away from their consumer finance origins: their balance sheets are now dominated by business loans and commercial leasing. The balance sheets of bank-owned merchant banks also consist largely of business loans; they are also active in traded instruments and corporate advisory work.
  3. Despite these trends, some banks retain finance company/merchant bank subsidiaries because:
    • they perceive marketing advantages in subsidiaries which have developed valuable goodwill and customer recognition in specific market niches;
    • the subsidiaries can access longer-term retail funds through debenture issues; [9]
    • they can access tax-effective offshore funding, as noted above;
    • more suitable depreciation arrangements are available for taxation of leasing; and
    • some regulatory requirements, such as the Prime Asset Requirement and NCDs, can be avoided.
  4. The RBA has no direct legislative responsibility for, or powers to supervise, non-bank financial institutions, whether or not they are subsidiaries of banks. Nor does it believe that subsidiaries such as finance companies need to be supervised in their own right for financial system stability purposes. Nevertheless, it has been long recognised that the difficulties of a subsidiary can pose a threat to a supervised parent. Consequently – and despite the legal limitations – the RBA has sought to conduct its supervision of banks in such a way as both to take account of and contain risks which may emerge in such subsidiaries. This is achieved primarily by adopting a consolidated approach to the prudential supervision of banks: while the RBA does not have legal power to obtain separate information on each subsidiary, it applies key prudential requirements, including capital adequacy and monitoring large exposures, on a consolidated group basis.
  5. At the same time, the RBA seeks to contain the extent to which a bank can be exposed to risks undertaken by an associate by ensuring that the subsidiary's business is kept distinct from that of the bank. Among other things, this limits exposures from parent to subsidiary and requires that, in so far as a bank feels implicit responsibility for a subsidiary, it should exercise that responsibility by ensuring that its associate has sound and prudent management which is aimed at achieving undoubted viability within the capital resources of the associate itself.
  6. Experience has, however, demonstrated how difficult it is for banks to insulate themselves fully from troubles arising in a subsidiary. They inevitably face some pressure – either moral or commercial – to prop up ailing businesses with which they are associated, thereby weakening their own capital positions. There is no doubt that the task of supervising banks would be easier if they had no unsupervised subsidiaries. Nevertheless, while banks see a commercial rationale for these subsidiaries, the RBA is not inclined to pursue their prohibition. Rather it will continue to encourage banks to carry out all intermediation business within the bank. For those subsidiaries which remain, the RBA would prefer to have more formal powers to require their sound and prudent management, and to prevent a bank's support of a subsidiary where that could weaken the bank.

Authorisation of foreign exchange dealers

Current framework

  1. Arrangements in the Australian foreign exchange market are administered under the Banking (Foreign Exchange) Regulations. Financial institutions wishing to be dealers in foreign exchange must seek authorisation by the RBA and must adhere to certain guidelines. The establishment of authorised dealers is intended both to promote the liquidity and depth of the market by having a core group of institutions which stand ready to quote prices to customers, and to provide a means of ensuring the integrity of the market through the authorisation process.
  2. When the exchange rate was floated in December 1983, only the existing 14 trading banks were authorised. In April 1984, non-bank financial institutions which met certain criteria were also invited to apply for authorisation. The main criteria – that dealers be incorporated locally, and have at least $A10 million in capital, adequate systems and experienced dealing staff – were designed to ensure that dealers were of some standing and expertise. The RBA also sets net overnight position limits on their foreign exchange exposures and contingent loss limits on their options business.
  3. The extension of authorisation to non-banks greatly assisted the growth of the market through the second half of the 1980s. In recent years, however, many of the major non-bank dealers have converted to bank status. The 41 banks now authorised to deal in foreign exchange account for almost 90 per cent of total market turnover, so the liquidity added by the 33 non-bank dealers is fairly limited. Furthermore, the top ten of these account for most of the remaining turnover; the smallest 23 non-bank dealers account for less than 1 per cent of turnover. The case for having non-bank authorities is therefore no longer as strong as it was in the 1980s.
  4. The authorisation of non-bank financial institutions meant that the RBA's supervisory net widened slightly in that it began to oversee the foreign exchange activities of these organisations. Although this has never carried any assurances about the financial soundness of the institutions involved, it has put RBA in the potentially awkward situation of supervising one aspect of the operations of institutions not otherwise covered by Australian supervision.
  5. The authorisation process has some useful by-products. It gives the RBA a direct say in the foreign exchange operations of dealers, which on occasion has been helpful in developing the Australian market. The requirement that all foreign exchange transactions should be channelled through authorised dealers also makes implementation of United Nations sanctions and the tracking of money laundering easier; and it allows the RBA to collect comprehensive statistics on the Australian market. The importance of this has, however, diminished now that regular BIS surveys of foreign exchange markets are in place and, overall, these benefits are of second order importance.

International practice

  1. Australia's arrangements are somewhat unusual by world standards. Most countries follow one of two models. One is to have no specific restrictions on foreign exchange dealing, with foreign exchange treated as just another financial product. This approach is followed by the US, UK and Canada. The second model is to restrict foreign exchange dealings to banks. This is common in Europe, and no doubt reflects these countries' history of universal banking. Italy comes closest to the Australian model, having a two-tiered authorisation process – one for banks and one for other credit institutions. Japan, which used to restrict foreign exchange dealing to banks, has recently announced an extension to some other institutions as a result of pressure to deregulate its market.

Options for change

  1. Given the changing roles of banks and non-banks in the market, there is a case to review current authorisation arrangements. Two options may be considered:
    1. restrict foreign exchange licences to banks

      One option is that only banks be authorised to deal in foreign exchange. Under this approach, responsibility for supervision of their foreign exchange activities would become a part of the RBA's overall supervision of banks. The arrangement would result in a lifting of supervisory standards in the foreign exchange market. It would also lessen any perception that may exist at present that the RBA supervises non-banks. On the other hand, it could be interpreted overseas as a move to restrict participation in Australian markets. As noted, Japan, which used to follow such a policy, has recently widened authorisation to non-banks as a step towards market liberalisation.
    2. deregulation of foreign exchange market

      The other option is to remove the need for authorisation altogether, allowing any entity to buy or sell foreign exchange without limitation. This would also resolve the present awkwardness of having the RBA prudentially supervise one component of a non-bank dealer's operation, as well as being consistent with the RBA's approach to other markets (eg for bond dealers). It might also increase competition and efficiency by allowing others to participate but such effects are unlikely to be large when there are already many dealers in the market, who compete not only with each other but also with dealers in other foreign exchange centres.
  2. An important consideration is whether there would be a significant loss of integrity in the foreign exchange market if the authorisation process were abolished. Under current arrangements, there have not been problems in the wholesale side of the market, which may be because the authorisation process acts to ensure that participants are of high integrity. But, neither have there been problems in the bond market where no such authorisation process exists. If the second option were accepted, it would be necessary to remove the current exemption in the Corporations Law for foreign exchange dealing, so that non-bank dealers in foreign exchange would require a securities dealers licence and would be subject to the investor protection aspects of the law. This would be important in order to safeguard the integrity of the retail side of the market.
  3. The RBA's view is that there is a strong case for the second option – that is, for terminating the current separate licensing regime for foreign exchange dealers. If merchant banks owned by foreign banks are required to become authorised banks in Australia, as discussed in Chapter 5, most foreign exchange dealing would continue to be supervised.

Footnote

The Banking Act does not prevent debenture issues by banks but it requires that, in the event of the liquidation of a bank, depositors would have priority over secured creditors. [9]