Submission to the Financial System Inquiry Executive Summary

The Financial System Inquiry of 2014 presents an opportunity for a holistic evaluation of Australia's financial system. The evolution of financial systems tends to surprise because, as in many parts of the economy, human behaviour is unpredictable and technology evolves in unexpected ways. As a result, it is important that institutional arrangements enable the financial sector to adapt and support economic activity in the most efficient manner that is consistent with the desired level of stability in the system.

The 17 years since the Wallis Inquiry have seen many changes in the Australian financial system and systems internationally. The most striking development domestically has been the system's growth. Underpinning this expansion has been the adjustment to structural changes and technological innovation, including the deregulation of the financial sector, the opening up to foreign competition and the move to an environment of low and stable inflation. These forces have also been at work in a number of other countries since the 1980s where there have been similar, and in some cases more dramatic, expansions.

Cyclical dynamics have also shaped the growth in financial systems globally. The period since the Wallis Inquiry had distinct phases: the decade or so leading up to the onset of the global financial crisis, during which some risks were under-priced; and the period since, which has seen a reappraisal of risks generally and a renewed focus on systemic risk – that is, those risks which, if realised, would cause material damage to the economy.

The Reserve Bank's approach to financial system stability (and the public policy framework that seeks to promote it in Australia) is that the objective should not be to prevent any failure in the financial system from ever occurring, but rather to balance the cost borne by the broader economy of such a failure against the costs of reducing the probability of failure during normal times. This recognises both the benefits to society from productive risk-taking and the significant costs of an imprudent allocation of risks.

While Australia was not immune to the events surrounding the global financial crisis, the financial system and institutional framework held up well over the period compared with a number of financial systems elsewhere in the world. And while some risks in Australia were mispriced and misallocated prior to the crisis, and some public sector support was required during it, the sound prudential framework in Australia was a source of resilience. In part, the lessons learned from earlier failures were a source of strength. For instance, the substantial losses of Australian banks in the early 1990s, and the failure of HIH Insurance in 2001, promoted a greater emphasis on risk management by financial institutions and regulators as well as providing impetus to bolster supervisory and crisis management capacity. On the whole, the period since the Wallis Inquiry has been a prosperous one for Australia and the ongoing development and resilience of the financial system played a part in this.

There were, however, important lessons for Australia from the crisis. The crisis was a reminder that there are cycles in risk-taking, and that the incentives of participants are not always conducive to prudent risk management from a system-wide perspective. Globally, the events that followed the crisis demonstrated the large social and economic costs of instability in financial systems. They showed that the costs imposed by effective regulation and supervision are more than outweighed by the costs of financial instability, even if that differential only usually becomes apparent after prolonged periods.

In the period since the crisis there has been a concerted effort internationally to address the build-up of systemic risk in financial systems that the crisis exposed. These wide-ranging reforms, given political impetus by the G20, include four core areas: building more resilient financial institutions (particularly banks); addressing the ‘too big to fail’ problem; addressing risks in ‘shadow banking’; and making derivatives markets safer, including through enhancing the role of financial market infrastructures (FMIs). As G20 president in 2014, the Australian approach, supported by the Bank, is to focus the G20's efforts on reaching agreement and progressing implementation in the four core reform areas, and to be cautious, for the moment, in adding further reforms to the agenda. This approach has found broad acceptance.

The regulatory response to the crisis has already strengthened the resilience of the international financial system. Banks have generally increased their capital buffers and reduced their liquidity risk. Steps have also been taken to make financial markets more transparent and to reduce the scope for contagion in the event of financial institution distress, while preserving the global nature of finance. As with any reforms, however, regulators will need to closely monitor the effectiveness of the combination of new measures, including the potential for enhanced bank regulation to promote a shift in financing to the shadow banking sector.

A general principle that the Reserve Bank has sought to uphold in our participation in the various international forums is that the reforms should be practically implementable in a variety of national circumstances, and should not disadvantage particular activities or business models except to the extent justified by the relative risks they pose. For example, the Reserve Bank and the Australian Prudential Regulation Authority (APRA) argued for the Basel III short-term liquidity requirement to be met in Australia via a Committed Liquidity Facility at the Reserve Bank, as banks could not otherwise meet the requirement given the relative scarcity of government debt. Tailoring to national circumstances does not, however, imply that Australia can stand apart from the global regulatory reforms: Australia's financial system is highly integrated with the global financial system; and Australian banks and other institutions participate in global markets and access foreign capital, so they need to demonstrate that they meet comparable standards to their counterparts abroad. It is, in any event, in Australia's interests to adopt high standards in supervision and regulation.

Australia is well advanced in implementing many of the reforms in response to the crisis, though there are a couple of areas where work is underway in Australia which the Reserve Bank considers should be progressed.

• The first relates to the role of FMIs in the financial system. In particular, the key recommendations from the Council of Financial Regulators (CFR) in this area should be progressed as a matter of priority. With reforms in over-the-counter (OTC) derivatives markets increasingly concentrating activity in central counterparties (CCPs), it is crucial that the relevant national authorities have the power to deal with problems in FMIs if they should arise. Further, with increased cross-border provision of FMI services, there may be circumstances in which it is desirable to bring an overseas facility under the primary regulation of the Australian Securities and Investments Commission (ASIC) and the Reserve Bank, under Australian law, and within the scope of a prospective FMI resolution regime.
• Another area of work relates to distress management of authorised deposit-taking institutions (ADIs), including the arrangements for the Financial Claims Scheme (FCS). The FCS provides protection to depositors (up to a limit) in the unlikely event of a failure of an ADI, and provides compensation to eligible policyholders against a failed general insurer. The Bank supports the proposal recommended by the CFR in 2013 to introduce a small fee levied on ADIs for the FCS. Such a model, which is now common among depositor protection schemes internationally, would be consistent with the principle of users paying for the benefit provided.

Following the financial crisis, much attention internationally has been directed at policy frameworks to limit systemic risk and promote financial stability. In some jurisdictions this has involved reassignment or clarification of regulatory agency responsibilities for system-wide oversight, and/or creation of new bodies to perform this role. Some jurisdictions have also developed specific prudential measures to assist in managing systemic risk, sometimes referred to as ‘macroprudential tools’. Several advanced countries have implemented such tools since the crisis, but it is too early to judge their effectiveness. In any case, in Australia, existing prudential powers can already be directed at system-level risk.

The Reserve Bank considers that the current arrangements in Australia for financial stability policy and regulatory coordination are working well, and does not see a case for significant change. Coordination between Australia's main financial regulatory agencies is achieved through the CFR. These arrangements stood up well to the severe test posed by the financial crisis, a performance that supports their continuation. Both APRA and the Reserve Bank have responsibilities to use their different powers for system-wide oversight and promoting financial stability. The complementary perspectives of the two agencies have reinforced their focus on their common goal of financial stability. In addition, the Bank and ASIC have joint responsibility for clearing and settlement facilities under the Corporations Act 2001, and have worked effectively together since the introduction of the regime.

It is the Reserve Bank's job to look at the performance of the financial system and risks to its stability. In order to do so, the Reserve Bank closely monitors issues from a system-wide perspective, including how risk can be propagated. The Australian major banks are important sources of systemic risk because of their size and interconnections with the real economy and the rest of the financial system, even though their business models are relatively low risk. Similarly, compared with other assets, housing in most countries (including Australia) is not particularly risky, but the housing market poses systemic risk because of its size, importance to the real economy, and interconnection with the financial system. While not as large, the commercial property market also poses systemic risk through its cyclicality and strong connections to the banking system; historically it has been one of the main sources of loan losses during episodes of banking distress globally.

The Reserve Bank has more formal oversight responsibilities for certain FMIs. FMIs are critical to the smooth functioning of financial markets, but they can also be a source of systemic risk because of their centrality to the system and the lack of substitutability in the markets they serve. That said, enhancements to FMI design and operation pre-crisis ensured that they remained a source of stability when the crisis hit.

The Reserve Bank has exercised the powers granted to it in 1998 following the recommendations by the Wallis Inquiry in relation to the payments system. The Bank's payments system reforms, overseen by the Payments System Board (PSB), have focused on improving competition and efficiency in payment systems, consistent with maintaining stability and effective management of risk. The approach of the PSB has been to encourage industry to undertake reform, only using its powers when cooperative solutions have not emerged. The Bank's reforms have been followed by similar reforms in many other jurisdictions.

The past decade has seen considerable customer-facing innovation in the payments system, with electronic transactions becoming faster, more convenient, more widely accepted and available via a greater range of devices. More recently, collaborative innovation – which is often hard to achieve when competing institutions must cooperate effectively – has been spurred by the PSB's Strategic Review of Innovation in the Payments System, with the industry now working on the New Payments Platform. This will be a new centralised industry-owned infrastructure which is expected to allow consumers and businesses to make payments with rapid funds availability on a 24/7 basis, and to facilitate innovation and competition in the payments system.

While the global financial crisis interrupted some of the trends in the Australian financial system over the past 20 years or so, many will continue to shape Australia's financial system in the years ahead. The period since the Wallis Inquiry is yet another demonstration of the procyclical nature of competition in banking. In times of optimism, competition is often more pronounced on the lending side, whereas competition for funding often intensifies following a financial crisis. The competitive landscape was transformed by the earlier deregulation of the banking sector. New entrants, or the threat of new entrants, have since shaped the markets for banking services in important ways. For example, the arrival of mortgage originators led to a marked decline in spreads on mortgages. And the entry of foreign banks in the online deposit market saw deposit rates increase relative to the cash rate. But while the regulatory framework continues to affect competition, cyclical dynamics in risk-taking among market participants have played an important role.

Since the crisis, Australians – like their counterparts overseas – are adjusting to a world where the true cost of liquidity is better recognised. Associated with this has been a reassessment of funding risk by banks, investors and regulators globally. In response, Australian banks have adjusted their funding structures and competition for deposits has intensified.

These developments increased banks' funding costs and lending rates relative to the cash rate. But banks' net interest margins have remained little changed – at roughly half the levels prevailing in the 1980s. Overall, greater competition for funding is a healthy development to the extent that it enhances market discipline on financial intermediaries to manage their risks. But it is important that asset quality remains paramount in assessing financial strength, along with the allocation of capital according to risk.

A good deal of focus has been placed on competition in the mortgage market since the crisis, and a number of reforms have supported competition there. However, the market for small business loans has more structural impediments to competition than most other lending markets, because the information asymmetries tend to be more significant. Technological advances and financial innovation can help to reduce these asymmetries. In addition, measures to improve the supporting infrastructure for capital market funding can help to provide companies with alternatives to bank loans.

Another important trend over the past 20 years was that technological advances globally aided the proliferation of cross-border investment and credit, which was facilitated by the progressive removal of restrictions on foreign capital by most developed economies during the 1980s. In Australia, this enabled households and companies to access finance from abroad (either directly or via the banking system), and hedging markets developed to help manage the risks. A key reason that Australians have benefited from financial globalisation is the willingness of foreign investors to take on the risk of lending to us in Australian dollars.

The net outcome of the myriad of saving and investment decisions by Australian households, companies and governments has often been net capital inflow and a current account deficit. In the aftermath of the crisis, some commentators questioned whether enough capital would be available to meet the needs of Australians, given reduced foreign demand for bank debt globally. In the event, which was itself a severe stress test, the capital account adjusted, with the price and composition of funding shifting accordingly. This outcome provides contrary evidence to the hypothesis that the current account can only be funded by a single form of capital inflow such as offshore borrowing by banks.

In the post-Wallis period household finance became more widely available, providing greater scope to smooth consumption. Associated with this has been a rise in household indebtedness and dwelling values. The vulnerability of some households to sudden changes in financial conditions, including interest rates, has increased and Australian banks have concentrated exposures to mortgages. A corollary of this is that Australian banks have less exposure to complex securities and riskier forms of lending, such as commercial property loans.

The rise of superannuation has transformed the Australian financial system. The household sector's direct exposure to market risk increased, as was demonstrated during the financial crisis. But at the same time, the losses incurred did not threaten the stability of the system, in part because the shift in risk allocations towards households eased the build-up of concentrated risks in institutions and governments. More broadly, the growth in superannuation has been in many ways conducive to financial stability, by adding depth to financial markets, and providing a stable, more or less unleveraged, source of finance for other sectors.

While the superannuation system is often viewed as being in the asset management business, it is also increasingly in the intermediation and maturity transformation business. The sector is therefore exposed to liquidity risk, which will increase as more members draw down their superannuation savings. Superannuation funds will need to balance managing their liquidity risk with their investment profile.

Some have proposed superannuation as a potential pool of funding for infrastructure investment. In the Reserve Bank's view, it would not be appropriate to mandate superannuation funds to invest in particular assets to meet broader national objectives. Rather, investments must be managed in the best interest of the membership. It cannot be forgotten that the objective of the superannuation system is to provide income in retirement. More broadly, it is worth the Inquiry considering whether the current arrangements enable households to tailor their superannuation savings to suit their risk preferences and investment horizons at a reasonable cost.

Despite significant changes in the post-Wallis period, many key features of the financial system persist. The core functions of the system remain essentially the same, as do the sources of vulnerability. Well-functioning financial systems can help promote economic growth. However, financial activity is inherently subject to information asymmetries, risk concentration, imprudent behaviour and other sources of systemic risk. Hence effective supervision is critical, particularly during boom times.

The key lesson from the past two decades is not a new lesson at all: the financial cycle is still with us and risks need to be appropriately managed. Society's attitudes towards efficiency and risk evolve and are very much shaped by the course of history – and mainly recent history. For Australia, the resilience of the financial sector in recent decades does not imply the absence of risks. It follows that the industry, the regulators, and the supervisors must ensure that institutions are resilient to short-run shocks but are also able to adjust to longer-run trends with adequate consideration for both competition and financial system stability.

In summary, the following are eight main points the Reserve Bank considers to be worth emphasising.

• The objective of financial regulation and supervision is not to eliminate risk or prevent any failure. The goal is to strike the right balance between addressing imprudent risk allocation, and facilitating the types of productive risk-taking that are essential to economic growth.
• The financial crisis demonstrated the cyclical nature of risk-taking and the large social and economic costs of instability in financial systems. It is therefore crucial that institutions' capital be allocated according to risk, and that there is effective supervision, particularly in boom times.
• Many of the regulatory deficiencies revealed by the crisis were not observed in Australia. But the crisis did highlight some room for improvement, and it is in Australia's interests for the domestic regulatory architecture to be in line with international standards. The reforms underway domestically should be completed.
• The Bank considers that the current arrangements in Australia for financial stability policy and regulatory coordination are working well and does not see a case for significant change.
• Competition in banking has been shaped by cyclical forces and new entrants. A good deal of focus has been placed on competition in the mortgage market since the crisis. However, the market for small business loans has more structural impediments to competition than most other lending markets. The Bank considers that this market should be the focus of inquiries regarding competition in lending, rather than the mortgage market.
• The vulnerability of some Australian households to sudden changes in financial conditions, including rising interest rates, has increased in the post-Wallis period, and banks have more concentrated exposures to housing.

• Superannuation has grown strongly. This has been in many ways conducive to financial stability, by adding depth to financial markets, and providing a stable, more or less unleveraged, source of finance for other sectors.

  – The Bank would support consideration of whether the system could be improved. Areas the Inquiry could focus on include whether superannuation funds are appropriately balancing the liquidity of their liabilities and their investment profiles, and whether the fees and cost structure of managing Australians' retirement savings are reasonable.

  – The Bank does not support suggestions that investment allocations could be imposed to meet funding targets for certain sectors and/or asset classes. Superannuation assets should be managed in the best interests of their members.

• The Reserve Bank has exercised its payments system powers with a focus on improving competition and efficiency in payment systems, consistent with maintaining stability and effective management of risk. The Bank considers that these powers leave it well placed to deal with challenges arising from the likely future evolution of the payments system.