Submission to the Financial System Inquiry 3. The Regulatory Response to the Global Financial Crisis

The global financial crisis revealed a number of shortcomings in policies and practices at financial institutions and at regulatory and supervisory agencies, particularly in north Atlantic countries. These shortcomings included:^[1] insufficient financial institution holdings of high quality capital and inadequate management of liquidity risk; inadequacies in basic microprudential supervision, corporate governance and risk management practices; an under-appreciation of the scale and complexity of operations at large trading banks and other financial institutions – particularly those with activities in multiple jurisdictions – and the difficulty in resolving them when they failed; inadequate oversight of over-the-counter (OTC) derivatives markets; and insufficient visibility of the extent of interconnectedness among financial institutions, including between the regulated and shadow banking sectors, and across borders.

This Chapter outlines the progress of regulatory reforms to address these shortcomings, with separate sections on the international and domestic responses. The main observations include:

• The objective of the reform agenda 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 wide-ranging reform effort includes four core areas: building more resilient financial institutions (particularly banks); addressing the ‘too big to fail’ problem; addressing shadow banking risks; and making derivatives markets safer, including through enhancing the role of financial market infrastructures (FMIs). While considerable work remains to be done, the regulatory response to the crisis has already strengthened the resilience of the international financial system.
• 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. As is appropriate with any reforms, regulators will need to closely monitor the effectiveness of the combination of new measures.
• While many of the regulatory deficiencies revealed were not observed in Australia, the crisis did highlight room for improvement in aspects of Australian regulatory and supervisory arrangements addressed by international reforms. Furthermore, Australian financial institutions operate in the global markets and it is in Australia's interests for the domestic regulatory architecture to be in line with international standards. Australia has made good progress in implementing the international reforms, adapting them to local conditions where necessary.
• Although much attention internationally has been directed at changing policy frameworks to limit systemic risk and promote financial stability, 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.

3.1 International Response

The international policy response to the crisis included four key areas for regulatory reform, that sought to harmonise some existing standards and create new ones where gaps were identified. The first area for reform addresses the riskiness of financial institutions by strengthening prudential regulatory standards, led by banking reforms known as Basel III. The second addresses the problem of an institution being ‘too big to fail’, where the threatened failure of a systemically important financial institution (SIFI) would leave authorities with no option but to bail it out using public funds. The third limits the scope for contagion arising from interconnections between counterparties in OTC derivatives markets. The fourth addresses risks arising from shadow banking, which encompasses entities and activities outside the regular banking system that are associated with credit intermediation and maturity/liquidity transformation.

With the Group of Twenty (G20) providing political impetus, international reform efforts have mainly progressed through the Financial Stability Board (FSB) and its member standard-setting bodies, including the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions (IOSCO) and others. The credibility of these reforms has been enhanced by expansions to the memberships of these bodies and the involvement of G20 Leaders. The FSB, of which Australia was already a member, extended membership to major emerging market economies in 2008, and in 2009 the BCBS expanded its membership to 27 jurisdictions including Australia.^[2] In 2008, G20 countries also started meeting at Leader level in response to the financial crisis.

There are global benefits from the adoption of well-designed, internationally agreed reforms. A broadly consistent set of regulatory requirements gives authorities, counterparties and customers alike some comfort that international entities operating in their jurisdiction are suitably regulated and supervised at the group level as well as locally. Consistent application of international regulatory standards helps financial firms to maintain credibility with international investors, by making it easier to compare their financial positions with firms located elsewhere. A common set of minimum standards for regulation and supervision helps reduce the risk of weaker regulation in some jurisdictions leading to financial instability and spillovers to other jurisdictions. With common standards regulators can more readily rely on their international counterparts to manage risks in their own systems, or in particular financial institutions that are headquartered overseas, rather than impose additional domestic requirements (and attendant costs). Common standards facilitate competition among providers of financial services and the free flow of international capital.

Applying global reforms across diverse financial systems and regulatory approaches is not without challenges. Some of the international reforms mainly address problems specific to more market-based financial systems, which might not be as relevant for some countries. A degree of flexibility to adapt reforms to national circumstances is needed, particularly for jurisdictions where financial systems came through the crisis in relatively better shape and regulatory settings proved more appropriate, such as Australia and much of Asia. In some cases it may be appropriate to tailor regulation to be more conservative than international minimum standards require. However this can have extraterritorial effects which should also be considered.

Another challenge for regulators and financial systems has been keeping up with the rapid pace of policy development and implementation. As judged by the FSB, global policy development across the four key reform areas is broadly on track with the planned timetable, though national implementation is lagging in some areas, particularly for crisis resolution preparation (Schwartz 2013). Australia is seeking to assist further progress in these core reforms through its presidency of the G20.

3.1.1 Strengthening prudential regulatory standards: Basel III

The financial crisis revealed that banks in some countries were not holding enough loss absorbing capital for the risks they were taking. This was despite these institutions meeting minimum capital requirements in the periods immediately prior to, and even during, the crisis. Additionally, in the lead up to the crisis, North Atlantic banks' exposures to maturity mismatch increased markedly due to an increased reliance on short-term financing, and through the granting of liquidity backstops to their off-balance sheet vehicles (Brunnermeier 2009).

Australia was not as badly affected by the crisis as some other countries. Part of the reason for this is that the Australian Prudential Regulation Authority (APRA) has historically adopted a somewhat more conservative approach to its regulatory and supervisory practices than some other regulators. Specifically, APRA adopted a more conservative approach to its capital standards than the previous Basel II minimum requirements: banks were required to meet more of their capital requirements using common equity, and to deduct instruments from their regulatory capital that are not readily available to absorb losses, such as deferred tax assets and investments in other financial institutions. Additionally, Australian banks were more conservatively managed. They did not have large trading books, and were not engaged in off-balance sheet activities to anywhere near the same extent as their international counterparts.

In response to international regulatory shortcomings, the international bank standard-setting body, the BCBS, developed Basel III, a comprehensive set of reform measures that aim to strengthen the regulation, supervision and risk management practices of the banking sector.

The Basel III capital framework was finalised in June 2011 and aims to strengthen banks' ability to withstand losses (BCBS 2011). Minimum capital ratios have been raised, capital has been defined more strictly to refer to genuinely loss-absorbing instruments, countercyclical capital add-ons are now available if needed and a simple constraint on overall leverage is to be added.

To strengthen banks' liquidity management, new requirements have been developed such as the Liquidity Coverage Ratio, whereby banks must hold sufficient liquid assets to withstand a hypothetical 30-day period of funding stress (BCBS 2013).

Policy development of the Basel III reforms is now substantially complete and the BCBS aims to finalise the remaining components by the end of 2014. This includes the Net Stable Funding Ratio – which will require banks to maintain a stable funding profile in relation to the composition of their assets and off-balance sheet activities – and revised frameworks for banks' trading books and securitisation. The BCBS will continue to monitor national implementation of Basel III to ensure it is timely and effective. It will also investigate inconsistencies in the calculation of risk-weighted assets, as part of broader efforts to improve the balance of simplicity, comparability, and risk sensitivity in the Basel framework.

3.1.2 Addressing the ‘too big to fail’ problem: Crisis management and resolution

3.1.2.1 Systemically important financial institutions (SIFIs)

Following the financial crisis, there has been a push in international forums to address the potential for taxpayers to be exposed to losses from government solvency support for systemically important financial institutions (SIFIs). This emphasis on ‘too big to fail’ institutions is understandable given the experiences of both the financial crisis and more recent tension in the euro area, particularly in the light of the large injections of government capital that were needed to stabilise systemically important banks, and the ‘sovereign-bank nexus’ in which undercapitalised banks degraded the solvency of their sovereigns, and vice versa.

As defined by the FSB, SIFIs are ‘institutions of such size, market importance and interconnectedness that their distress or failure would cause significant dislocation in the financial system and adverse economic consequences’ (FSB 2013, p2). These institutions are considered ‘too big to fail’ because public authorities are assumed to be left with no option but to recapitalise SIFIs using public funds if their viability is threatened. A potential problem is that if creditors perceive that a particular institution is ‘too big to fail’ they may not fully price-in the risk assumed by the institution. This could constitute a large implicit public subsidy for private enterprise and potentially encourage SIFIs to take greater risks. Regulatory developments in this area aim to reduce the probability that a SIFI will fail, reduce the impact of failures when they do occur and eliminate any competitive advantages in funding markets that SIFIs might hold due to their ‘too big to fail’ status.

The focus of regulation to date has been on global systemically important banks (G-SIBs). Currently, 29 institutions are identified as G-SIBs, for which supervisory intensity has increased and capital surcharges have been set.^[3] A principles-based regulatory framework has also been developed for domestic systemically important banks (D-SIBs). This framework, developed by the BCBS, is more flexible than the G-SIB framework and, appropriately, allows for discretion to be applied by national regulators both to accommodate the structural characteristics of domestic financial systems and to ensure that requirements are set in a manner proportionate to the relative risks posed by various institutions. Based on principles set out by the BCBS, APRA announced a framework for Australian D-SIBs in December 2013. The Australian D-SIB framework is discussed in Section 3.2.2.1.

The SIFI framework continues to be expanded to non-bank SIFIs by the FSB and the standard setting bodies. The International Association of Insurance Supervisors (IAIS) has published a methodology for identifying global systemically important insurers (G-SIIs), and a set of policy measures that will apply to them, including the plan to develop basic capital requirements to apply to all group activities. Based on that IAIS methodology, nine global systemically important insurers were identified in July 2013. Earlier this year, the FSB and IOSCO released for consultation methodologies for identifying non-bank non-insurer G-SIFIs – in particular, finance companies, securities broker-dealers and investment funds – based largely on the G-SIB and G-SII approaches.

In 2012, the Committee on Payment and Settlement Systems (CPSS) and IOSCO published the Principles for Financial Market Infrastructures (PFMIs). These are international standards for the design and operation of systemically important FMIs that aim to strengthen their resilience, including during periods of systemic stress. FMIs are key entities in the financial system that deliver services essential to the smooth functioning of financial markets. They include payment systems, central securities depositories and securities settlement systems, central counterparties and trade repositories. The implementation of the PFMIs in Australia is discussed in Section 3.2.4.

3.1.2.2 Crisis management and resolution

A further key focus of the ‘too big to fail’ work agenda is addressing cross-border contagion risks. Cross-border crisis management groups have been established for the SIFIs, and one of their key tasks is to improve recovery and resolution plans for these firms. At the Seoul Summit in 2010, G20 Leaders endorsed FSB recommendations for improving authorities' ability to resolve SIFIs in an orderly manner, without exposing taxpayers to loss, while maintaining continuity of their vital economic functions (FSB 2010). Substantial progress has been made in implementing this framework. At the Cannes Summit in November 2011, G20 Leaders endorsed the Key Attributes of Effective Resolution Regimes for Financial Institutions (Key Attributes) as best practice for jurisdictions in establishing resolution regimes (FSB 2011). Additional guidance on resolution strategies for G-SIBs has since been issued.

Despite the progress made by international regulators towards ‘ending too big to fail’, a substantial body of work remains (FSB 2013f). Priority areas to be progressed by the Brisbane G20 Leaders' Summit include the following.

• The FSB, in consultation with standard-setting bodies and with the backing of the G20, will, by the end of 2014, prepare proposals so that G-SIBs can absorb losses in resolution (‘gone concern loss absorbing capacity’ or GLAC) – for example by holding adequate quantities of liabilities that can be ‘bailed-in’. The aim is that GLAC should be sufficient to recapitalise critical functions of a failed institution to a level that promotes market confidence and maintains market access.
• The development of a framework for the cross-border recognition of resolution actions, particularly with respect to the recognition of actions by home resolution authorities to bail-in liabilities held in host jurisdictions, and to impose short stays on early close-out of financial contracts pending their transfer upon a firm entering resolution. Progress in these areas is considered necessary for orderly cross-border resolution, particularly to prevent a run by the firm's international creditors and counterparties.

Frameworks for the recovery and resolution of financial market infrastructures (FMIs) and insurers will be finalised soon, including in relation to the protection of client assets in resolution.

Building on standards initially developed for banks, CPSS and IOSCO are finalising guidance for the requirement in the PFMIs to develop recovery plans. This follows extensive consultation (CPSS and IOSCO 2013). Within these guidelines an FMI's recovery actions would be taken within the framework of its existing rules, which form the basis for the contractual relationship between the FMI and its participants. The rulebook can be a powerful mechanism to support recovery planning, providing clarity and certainty to participants around potential future obligations. In particular, the rulebook can specify actions that would be taken in defined scenarios, including how losses would be allocated and how financial resources would be replenished to return the FMI to viability. In principle, if a comprehensive recovery plan could be executed effectively, resolution would not be necessary

However, even where the rulebook clearly specifies a course of action, an FMI may be unable to fully implement its recovery plan without public intervention. Recognising this, international policymakers are encouraging jurisdictions to establish special resolution regimes for FMIs, consistent with the FSB's Key Attributes. The FSB is also expected shortly to release guidance on how the Key Attributes may be applied in the case of FMIs. Resolution would be likely to be most effective and least disruptive if the resolution authority could complete the actions contemplated in the FMI's own recovery plan. Therefore, while recovery planning is primarily the responsibility of the FMI, the resolution authority should be content to inherit those plans. In this sense, resolution may be regarded as a ‘backstop’ to a comprehensive recovery plan, but an essential one.

Australia has also taken steps to strengthen its crisis management and resolution framework in recent years. These developments are described in Section 3.2.2.2. Progress towards developing an Australian framework for FMI recovery and resolution is discussed in Section 3.2.4 and Chapter 8.

3.1.2.3 Bail-in

The FSB has highlighted bail-in as an area where many FSB jurisdictions need to take further legislative measures to fully implement the Key Attributes (FSB 2013i). Bail-in is a resolution strategy where the unsecured and uninsured liabilities of a failing financial institution are written-down or converted into equity in order to recapitalise the firm. It contrasts with ‘bail-out’ where government funds are used for this purposes.

Views differ, but there are three broad classes of bail-in:

• contractual bail-in, for example where Basel Tier 2 capital instruments are either converted into equity or written down at a specified trigger point close to, or at the point of, non-viability in accordance with contractual terms
• bail-in via explicit statutory powers granted to resolution authorities to write-down and convert debt instruments into equity, regardless of contractual terms, subject to certain conditions being met, and in accordance with the hierarchy of claims
• bail-in by business transfer, where the viable part of the business is transferred to another financial or bridge institution, leaving tranches of lower-ranked debt in the failed institution to be wound up.^[4]

Bail-in can, in principle, be applied to any unsecured debt instrument, including (uninsured) deposits, bonds, commercial paper, derivative obligations and trade credits. However, in practice, longer-term senior unsecured debt is generally considered by policymakers to be the most bail-inable. Short-term liabilities are also considered to be less bail-inable as they are more likely to be subject to runs. Bailing-in unsecured derivatives obligations risks contagion given their widespread use as a risk management tool, and bailing-in trade credits, operational liabilities and uninsured deposits is considered to be less likely due to the social or political implications of exposing individuals or small firms to loss.

The main argument for bail-in is that it transfers the risk of loss from taxpayers to unsecured creditors. Some argue that increasing the responsibility of unsecured creditors – which should encourage more appropriate pricing of default risk – may also strengthen the market discipline of financial institutions that might not otherwise fully internalise the social costs associated with their operations (Mishkin 2006; Tarullo 2009). It is not clear, however, that this is necessarily a stronger mechanism than shareholder discipline.

The arguments against bail-in include the risk of exacerbating a financial distress situation by causing uninsured and unsecured short-term creditors to withdraw funds to avoid being bailed-in, or by making it less likely that financial institutions will be able to roll over long-term debt. Bail-in may also cause contagion if debt held by other financial institutions is bailed-in, or if it raises concerns that creditors to other banks in the same jurisdiction will also be bailed-in in the near future. Furthermore, to the extent that the existence of statutory bail-in powers encourages particular types of investors to demand more secured debt relative to unsecured debt, some types of unsecured creditors – such as suppliers – may become more exposed to losses.

The arguments against bail-in do not preclude its inclusion in the suite of available resolution tools. However, they do suggest that implementation needs to be carefully considered and should proceed cautiously in order to avoid unintended adverse consequences. The arguments for conservatism in the implementation of bail-in are further supported by the observation that there are few, if any, examples of banks which have successfully been resolved as going concerns through the use of bail-in powers alone.^[5]

3.1.3 Reforms to OTC derivatives markets

Since the global financial crisis, international policymakers have also sought to strengthen practices in OTC derivatives markets. The focus on this market reflects the rapid growth in the value of outstanding contracts over the decade preceding the crisis, and risk management vulnerabilities in some products, such as credit derivatives, revealed during the crisis.

A particular policy concern has been the lack of transparency of market activity and the scope for contagion arising from counterparty exposures between participants in OTC derivatives markets. An international policy consensus has emerged for the greater use of centralised infrastructure – trade repositories, central counterparties (CCPs) and trading platforms – in OTC derivatives markets to help address some of the concerns of regulators and market participants. Accordingly, in a statement following the Pittsburgh Summit in September 2009, G20 Leaders committed that:

All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements (G20 2009).

In November 2011, G20 Leaders added to these commitments, agreeing that international standards on margining of non-centrally cleared OTC derivatives should also be developed.

Although the end-2012 deadline was not met, progress towards meeting the G20 commitments has been made in many jurisdictions. The FSB has monitored progress closely, issuing periodic progress reports on implementation. One barrier to more rapid implementation has been difficulties in coordinating implementation across jurisdictions so as to avoid overlap, duplication, conflicts or gaps in regulatory requirements. This issue has been recognised by the G20 and FSB and work is underway to address it. In particular, a group of 12 OTC derivatives market regulators (including ASIC), known as the OTC Derivatives Regulators Group (ODRG), has been meeting regularly to examine the application of rules in a cross-border context.

In September 2013, international standard setters published a final policy framework for initial and variation margin requirements for OTC derivatives that are not centrally cleared (BCBS and IOSCO 2013). The framework sets out a time line for implementing these requirements in member jurisdictions according to the level of an entity's OTC derivatives activity.

3.1.4 Shadow banking

Shadow banks are non-bank financial intermediaries that perform some of the tranditional functions of banks including maturity and liquidity transformation and extending credit (Pozsar et al 2013). Unlike banks, however, shadow banks do not have access to central bank liquidity support, are not covered by deposit insurance schemes and are not prudentially regulated to the same extent. Examples include finance companies, structured investment vehicles and money market funds (MMFs). In Australia, these entities account for a small and declining share of financial system assets (Chapter 4).

While the presence of shadow banks has some benefits, including providing broader access to funding for borrowers, shadow banks can also amplify the credit cycle and promote financial instability, as was observed during the financial crisis.

The FSB presented a package of policy recommendations to strengthen oversight and regulation of shadow banking entities to the G20 Leaders' Summit in September 2013 (FSB 2013g).^[6] The recommendations, developed by the FSB in conjunction with IOSCO and BCBS aim to mitigate risks posed by the shadow banking system while not inhibiting sustainable non-bank financing models that do not pose such risks. They comprise:

• measures to reduce banks' interactions with shadow banking entities, including limiting banks' exposures to single counterparties and risk-based capital requirements for banks' exposures to funds
• common standards for the regulation of MMFs to reduce their susceptibility to runs
• measures to assess and align the incentives associated with securitisation, including enhanced disclosure requirements and risk retention rules^[7]
• policies to dampen risks and procyclical incentives associated with securities lending and repurchase agreements (repos) that may amplify funding strains in times of market stress, including enhanced data collection and reporting standards, regulation of securities financing including minimum standards on cash collateral reinvestment, and improvements to market structure such as central clearing
• a high-level policy framework for shadow banking entities other than MMFs.

In addition, the FSB is continuing to conduct annual data monitoring exercises to assess global trends and broader risks emanating from shadow banking; its latest global report was released in November 2013 (FSB 2013d).

While the recommendations relating to MMFs, securitisation and other shadow banking entities have largely been finalised, policy development is continuing in the areas of banks' interactions with shadow banking entities, and securities lending and repos. In December 2013, the BCBS issued its policy on capital requirements for banks' equity investments in funds, which is based on the general principle that banks should apply a ‘look-through’ approach, by risk weighting the underlying exposures of a fund as if the exposures were directly held. The BCBS is also working on proposals to ensure that all activities of banks are captured within the scope of consolidated (i.e. group-wide) supervision and regulatory reporting, and finalising its proposed supervisory framework for banks' large exposures to single counterparties (including to shadow banking entities). The FSB is proposing additional requirements relating to securities lending and repo transactions including: numerical collateral haircut floors for OTC transactions by entities that receive securities financing from regulated financial intermediaries but are not subject to prudential capital and liquidity regulation;^[8] and minimum qualitative standards for methodologies used by all market participants to calculate collateral haircuts.

With many of the shadow banking policy recommendations finalised, the focus is now switching to implementation, using a ‘road map’ of time lines released at the September G20 Summit. IOSCO is to conduct peer reviews this year on the implementation of its MMF and securitisation recommendations and, in 2015, there will be a peer review of implementation of the policy recommendations for other shadow banking entities.

3.1.5 Other areas of reform

Regulatory reform has extended beyond the four key areas already outlined. Other areas of reform which have been agreed include regulators taking greater account of macroprudential risks across the financial system (expanded upon below) and enhancing the effectivenes of supervision, as well as addressing misaligned incentives across a range of areas such as credit rating agencies and bankers' remuneration (FSB 2013b, 2013e). Some of these reforms are related to the four core areas.

3.1.5.1 Macroprudential supervision and policy

While one contributing factor to the financial crisis was microprudential shortcomings on the part of regulators, another was an under-appreciation of the importance of certain determinants of systemic risk – in particular the ways in which interconnectedness in the financial system, and a lack of diversity in financial institutions' business models, could engender financial instability.^[9] Consequently, much attention has since been directed at developing a ‘macroprudential policy framework’ to limit systemic risk.^[10]

A macroprudential framework requires prudential authorities to take a system-wide view in their supervisory activities, rather than solely focusing on the safety of individual institutions. As described by Yellen (2009) it is ‘akin to caring for an entire ecosystem rather than individual trees’. A system-wide approach to supervision recognises: that the actions of individual firms can collectively generate systemic risk via spillovers and externalities, even if those firms are individually managing liquidity, capital and exposure to risk; that risk can build over time; and that the distribution of risk matters. For example, if many small institutions, or a few large institutions, were to invest in similar classes of assets, then a downturn in that asset class may be amplified as investors simultaneously ‘rush for the exits’.

Internationally, a large number of central banks and prudential regulators, including in Australia, already have responsibilities for system-wide oversight (or ‘macroprudential’ responsibilities). Many jurisdictions embed systemic oversight in their organisational structures through measures such as establishing financial stability departments, including financial stability objectives in the mandates of regulators and establishing arrangements for regulatory coordination (Section 3.1.5.2). A number of jurisdictions also have a history of deploying macroprudential tools.

No consensus definition of macroprudential tools exists, but they can reasonably be thought of as policy measures carved out of the normal prudential framework and managed in response to evolving conditions, usually under separate governance arrangements, to achieve particular outcomes related to financial stability or system-wide concerns more generally. Emerging market economies have a history of using macroprudential tools, often because their exchange rate regime constrains the use of monetary policy (Borio and Shim 2007). Some economies have also used capital controls with explicit macroprudential objectives. In contrast, the use of explicit macroprudential tools in advanced economies has been relatively rare since financial liberalisation.

Several advanced economies have used macroprudential tools since the crisis, typically to mitigate rapid growth in residential property prices and/or household indebtedness. Policymakers have capped loan-to-valuation ratios (LVRs) and debt-servicing ratios (DSRs) to dampen activity in their housing markets, and tightened mortgage underwriting and loan amortisation standards. A few jurisdictions have sought to protect their banking system from a possible rise in loan losses by tightening provisioning requirements and increasing capital requirements for home loans.

Since their recent establishment, the macroprudential policy committees in the United Kingdom and the United States have reported at length on potential sources of systemic risk. To date, however, their policy recommendations have focused on strengthening prudential and supervisory requirements, rather than deploying specific macroprudential tools. In other economies:

• The Swiss authorities activated their Basel III countercyclical capital buffer last year and raised the buffer further in January of this year. Swiss banks are required to hold additional common equity Tier 1 capital equal to 2 per cent of their risk-weighted exposures to Swiss home loans.
• Israel has undertaken several rounds of macroprudential tightening, capping mortgage LVRs and DSRs and tightening mortgage underwriting standards, as has Canada through its government-guaranteed mortgage insurance program. New Zealand, Norway, Sweden and Finland have implemented LVR restrictions over recent years.
• In Asia, Hong Kong, Malaysia and Singapore have used measures such as LVR caps, loan amortisation caps, and various fiscal policies, such as property taxes, to mitigate risks in their residential and commercial property markets. South Korea has also used levies and caps on banks' foreign currency exposures to lessen banks' foreign currency and maturity mismatches.

It is still too early to judge the effectiveness of macroprudential tools that have been used in advanced economies since the crisis. Policymakers have offered favourable self-assessments (Wong et al 2011), and empirical studies offer some prima facie evidence that macroprudential tools can be used to constrain growth in credit and asset prices, though perhaps to a limited extent (Kuttner and Shim 2013). Other studies have suggested, however, that macroprudential tools are not always effective, particularly in the face of strong external demand and easy monetary policy (Crowe et al 2013), and several questions remain. One is the choice of an appropriate macroprudential target. Many of the tools aim to limit growth in variables or quantities in which strong growth has preceded previous financial crises. Identifying robust predictors of crises has, however, proven difficult, in part because the underlying causes of financial crises can differ, and also because predictors are often selected with the benefit of hindsight. Furthermore, without identification of the mechanisms underlying growth in particular quantities, it is difficult to determine if, in seeking to control them, the symptoms rather than the causes of future financial distress are being addressed (Ellis 2013). Overall, the use of macroprudential tools remains a work in progress.

3.1.5.2 National institutional reforms and coordination

Macroprudential oversight typically requires interagency coordination, with the degree and nature of coordination determined by the jurisdiction's regulatory structure. Most jurisdictions have a single supervisory authority for their banking system, and for many, including Australia, this is not the central bank. In addition, securities market regulation and supervision is normally undertaken by a separate agency.

In Australia, high level coordination between agencies is achieved through informal (non-statutory) arrangements, through the Council of Financial Regulators (CFR). While this approach has worked well in Australia (Section 3.2.6.2), regulators can also coordinate through formal arrangements. Some other jurisdictions, including the United States, United Kingdom, the European Union (EU), Sweden and Norway have formalised arrangements in the last few years to delineate their respective financial stability mandates, powers and tools.

In 2010 the Financial Stability Oversight Council (FSOC) and the European Systemic Risk Board (ESRB) were created in the United States and European Union, followed in 2011 by the creation of the Financial Policy Committee (FPC) in the United Kingdom.^[11] The FSOC and FPC have statutory independence despite their secretariats being housed within the US Treasury (FSOC) and the Bank of England (FPC). The FSOC and the FPC are directly accountable to the US Congress and UK Parliament, while the ESRB is indirectly accountable to the European Commission via the European System of Financial Supervision.^[12] In 2013, Sweden set up a Financial Stability Council, comprised of representatives of the Swedish Government, Finansinspektionen (the prudential agency), the Swedish National Debt Office and Sveriges Riksbank. In Norway, the Ministry of Finance has overall responsibility for financial stability (since 2006) and sets capital requirements for financial institutions, including, since October 2013, the level of the countercyclical capital buffer.

The powers of the above cross-agency authorities vary by jurisdiction. They include the authority to: break up firms considered to pose systemic risks; request additional data from institutions that they may otherwise not be required to report to regulators; and issue binding recommendations. For example, in September 2011 the ESRB issued a recommendation of minimum standards for the risk management and granting of foreign currency loans, to be implemented by the end of 2012.

It is too early to judge the performance of these more formal structures for coordination between agencies. Stated advantages include:

• enhancements to the credibility and status of financial stability policies
• potential clarification of responsibility through the creation of a body with an overarching mandate that has powers to mediate resolution of differences between regulatory agencies, enforce outcomes should the need arise, and take action if other agencies cannot or will not.

However, it is unclear how reassigning part of a regulatory agency's constituent powers to an overarching body will influence coordination and effectiveness of regulatory policies. Similarly, it remains to be seen if formality is the feature of institutional arrangements that ensures better outcomes.

3.1.5.3 Structural banking reforms

Policymakers in Europe and the United States have also taken unilateral steps towards ending ‘too big to fail’ by forcing the structural separation of banks' commercial banking and investment banking businesses. Like Basel III and financial reforms that enhance the recovery and resolution of large banks, these ‘structural banking reforms’ aim first and foremost to safeguard the financial system from bank failures and protect taxpayers and depositors from loss. Specifically, the reforms are designed to: protect retail banking activities from contagion elsewhere in the financial system; reduce the implicit public sector subsidies of risk-taking in capital markets; make systemically important banks simpler and easier to resolve; and forcibly draw a line between the so-called low- and high-risk cultures of commercial and investment banking (Gambacorta and Van Rixtel 2013).

The main differences in the various proposals, including the Liikanen reforms in the EU, the Vickers reforms in the United Kingdom, and the Volcker Rule in the United States, relate to which capital market activities should be separated from retail banking activities and how. The Volcker Rule is the narrowest in scope: it prohibits prudentially regulated institutions from engaging in most forms of proprietary trading (i.e. short-term, speculative risk-taking by the institution unrelated to client business, as opposed to market-making) and limits their investments in managed funds. In addition to a similar ban on proprietary trading, the Liikanen reforms would also require that banking groups house their trading and market-making businesses in a separately capitalised subsidiary. The Vickers reforms are broader than the other two proposals. They allow banking groups to run investment banking businesses but require their retail operations to be ring-fenced into a separate, protected entity, with limited intragroup transactions between the two. The ring-fenced entity is also prohibited from providing services outside the European Economic Area.^[13]

A concern expressed by some observers is that in attempting to protect domestic taxpayers and depositors, structural banking reforms may, unintentionally, lead to harmful fragmentation of global banking and capital markets. The FSB, together with other bodies, will report on the cross-border consistencies and global financial stability implications of structural banking reforms to the G20 Summit in November.

3.1.6 The impact of reform

The volume and breadth of financial reforms undertaken since the crisis will no doubt create challenges for regulators and market participants. Given that implementation remains in its early stages, and that many of the reforms follow extended implementation timetables, it is too early to be able to draw a full set of conclusions about the overall impact of reforms. As always, regulators will need to carefully monitor developments in the financial system to ensure that reforms are having the desired effects.

That said, as outlined above, the regulatory response to the financial crisis offers many benefits, and has already played an important role in strengthening the resilience of the global financial system. Large internationally active banks have substantially increased their capital buffers over recent years, such that nearly all of them already show a common equity Tier 1 capital ratio that exceeds the 7 per cent minimum that will ultimately be required under Basel III (BCBS 2014, p 10). Banks have also increased their holdings of liquid assets and reduced their reliance on short-term funding, which can be flighty in a crisis. Financial markets are more transparent, less interconnected, less complex, and hence less likely to become dysfunctional in the event of financial institution distress. All together, these developments have helped place the international financial system on a sounder footing that supports sustainable growth in the global economy.

The financial reform agenda aims to reduce the likelihood and severity of future financial crises, but without placing undue costs on financial institutions. Many of the ‘costs’ associated with the reforms, including an increase in the price of financial intermediation, are not unintended. The Basel III reforms have had the intended effect of forcing banks to allocate capital and liquidity more efficiently across their businesses and, by pricing risk more accurately, to internalise the costs associated with their activities. Though banks will incur expenses while transitioning to the new regulatory environment, they will be better placed to support sustainable growth in the long run, and to do so while posing less risk to taxpayers and investors. Macroeconomic assessments conducted by the BCBS and FSB in 2010 suggested that the expected long-term benefits of the Basel III capital and liquidity measures would substantially exceed the expected costs (BCBS and FSB 2010a, 2010b). Similar macroeconomic assessments of the G-SIB framework and the OTC derivatives reforms have found comparable net economic benefits (BCBS and FSB 2011; MAGD 2013).

As with any body of regulatory change, however, there is the potential for unintended consequences. Both the official sector and the private sector have identified potential costs of financial reforms that warrant close monitoring.

• Some commentators are concerned that major bank reforms will cause an increase in financial fragmentation, or a fall in cross-border capital flows. Attention has focused on how some internationally active banks have withdrawn from international markets and reduced their cross-border lending. It is likely, however, that much of the reduction in cross-border capital flows that has occurred since the crisis reflects a sensible reallocation of risk, rather than an undesirable response to steeper barriers to competition. Some pull-back in offshore activity is to be expected after a significant boom and bust in leverage, as banks need time to repair their balance sheets and realign their business models. In this context, the flexibility in the financial system has provided a valuable counterbalance to bank deleveraging. For example, many non-financial corporations have issued greater amounts of non-intermediated debt over recent years, although access to capital market funding is typically restricted to larger firms.
• Another concern is that stricter capital requirements, by encouraging market-making banks to shrink their inventories of corporate bonds and other traded assets, could cause a structural decline in market liquidity. International experience to date is that market-making banks have significantly reduced their traded security inventory. That said, a number of commentators consider that corporate bond markets have remained reasonably liquid through recent bouts of market volatility.
• Concerns have also been raised that financial reforms could constrain banks from providing long-term investment finance and operating in emerging market and developing economies. The FSB has conducted a number of studies into these areas and found that there is little evidence that points to significant adverse effects (FSB 2012, 2013c).
• The heavier regulatory burden placed on banks could push credit and liquidity intermediation into the shadow banking system, which was a major source of systemic risk for some countries during the recent crisis. International policymakers have taken significant steps towards strengthening the regulation and oversight of shadow banking systems, and will monitor developments closely with a view to prompt identification and management of emerging risks.
• Regulatory changes that require banks to hold more liquid assets and collateralise more of their derivatives exposures will increase the demand for high-quality liquid assets, potentially leading to a significant rise in the prices banks pay for these assets. Financial markets could also become more procyclical and interconnected as banks seek to manage their liquid assets more efficiently. Responses from the private sector have the potential to mitigate the adverse consequences associated with the increased demand for liquid assets but this is an area that will require close monitoring. Financial markets are already taking steps to distribute liquid assets more efficiently through the financial system – for example, by greater use of collateral management services and collateral swap transactions (Heath and Manning 2012). These actions offer some potential benefit but could also make the financial links between institutions more complex and opaque. Central banks can also alleviate collateral shortages in times of stress by expanding the range of securities that can be pledged against central bank borrowing.
• Reforms to OTC derivatives markets will make counterparty risk increasingly concentrated among a small number of CCPs. Doing so will mitigate the risk of contagion in OTC derivatives markets, but will also increase the systemic importance of large CCPs. Acknowledging this, international standard setters have implemented enhancements to standards for FMIs and made progress towards introducing effective recovery and resolution arrangements for FMIs.

Regulators will closely monitor developments in these and other areas and, where necessary, will adjust the regulatory framework to ensure that financial reforms are having the intended effects.

3.2 Domestic Response

Australian financial institutions operate in a global environment. They interact with international entities and have operations in other jurisdictions. Hence, it would be impractical and counterproductive, to adopt a ‘go it alone’ policy, by not implementing the agreed global reforms. It is, in any event, in Australia's interests to adopt high standards in supervision and regulation. In some cases, the agencies have assessed that it is in the national interest to adopt the new global standards with some adaptation to local conditions.

On strengthening prudential regulatory standards, Australia is relatively well advanced in adopting the Basel III reforms. In the area of ‘too big to fail’, APRA has released its framework for D-SIBs and FSB analysis suggests that Australia has a resolution regime for banks and insurers that is broadly consistent with best practice. Implementing G20 commitments on the regulation of derivative markets has been a difficult task internationally, but Australia is relatively well progressed. Australia was also one of the first jurisdictions to implement new international standards for the design and operation of FMIs.

3.2.1 Implementation of Basel III

Of the 27 BCBS member jurisdictions, Australia is one of 12 that have issued final Basel III capital rules, that were legally in force as at October 2013. APRA requires ADIs to meet a number of the key capital measures two or three years earlier than set out under the Basel III capital framework. An extended implementation timetable for Basel III capital measures was not thought to be necessary for Australian ADIs because they were expected to be easily able to meet the requirements. Indeed, Australia's banks now exceed the 2013 minimum capital requirements, and are on track to meet the 2016 minimum requirements. Part of the reason for Australian banks' strong capital positions is that APRA has historically adopted capital standards that are more conservative than the international minimums set by the BCBS, both in terms of the common equity requirement and the treatment of deductions. This conservative approach contributed to the resilience of Australian banks during the recent crisis, and their robust profitability over subsequent years enabled them to strengthen their capital positions further.

APRA, with input from the Bank, has also made good progress on developing the Basel III liquidity standards for Australia. While the BCBS has allowed delayed implementation internationally, APRA has kept to the original timetable and will fully implement the Liquidity Coverage Ratio (LCR) requirement – that banks will have to hold sufficient liquid assets to withstand a hypothetical 30-day period of funding stress – on 1 January 2015.

• Because government debt is relatively scarce in Australia compared to other jurisdictions, Australian banks would not be able to meet the proposed LCR requirement purely by holding existing liquid assets. In response, the Bank and APRA successfully argued for a menu of alternative approaches to these requirements, and developed and gained global acceptance for the Committed Liquidity Facility (CLF) through which the requirement can be met in Australia. In January, the BCBS' oversight body, the Group of Governors and Heads of Supervision, agreed that CLFs of a type similar to Australia's should be made available in all jurisdictions, subject to a number of constraints.
• The Australian CLF will enable ADIs to access a pre-specified amount of liquidity in times of stress by entering into repurchase agreements secured against eligible securities with the RBA. ADIs will pay an ongoing fee of 15 basis points to have access to the facility, on both drawn and undrawn amounts. Should the facility be used, ADIs will pay an interest rate on repurchase agreements of 25 basis points above the cash rate, as they would within the RBA's normal market operations. Repurchase agreements will be subject to appropriate margining which will add to the effective cost of accessing the facility. The RBA will haircut securities market values by as much as 25 per cent, depending on the type of security involved. Consequently, the CLF will only insure an ADI against the liquidity risk on its securities. The credit and market risks associated with the securities remain with the ADI (Debelle 2011). To limit the systemic risk associated with excessive cross-holdings of ADI securities, the RBA will allow ADIs to use certain related-party assets as collateral, such as self-securitised residential mortgage-backed securities, in addition to those securities which are eligible for the RBA's normal market operations.
• APRA will determine the amount each ADI can access through the CLF, subject to RBA approval, based on the ADI's overall liquidity needs and the balance of their LCR requirement that cannot reasonably be met using high-quality liquid assets. ADIs will need to demonstrate that they have taken ‘all reasonable steps’ to meet their LCR requirement by improving their liquidity risk profile, including by using stable, long-term sources of funding where appropriate. APRA has undertaken a trial exercise with ADIs on their planned use of the CLF, and will formalise their access towards the end of the year. The CLF will commence from 1 January 2015 alongside the LCR.

3.2.2 Domestic systemically important banks (D-SIBS), crisis management and resolution

3.2.2.1 D-SIBs

Australian banks are not classified as global systemically important and are therefore not subject to the stricter rules to be applied to G-SIBs to address the ‘too big to fail’ problem. However, matching recent developments in other jurisdictions, and Australia's commitment to international reforms, in December 2013 APRA announced a framework for D-SIBs, based on principles set out by the BCBS.

APRA's D-SIB framework (APRA 2013) is based on the BCBS's four objective indicators of systemic importance: size, interconnectedness, substitutability and complexity. Under this methodology, APRA determined the four major banks to be the only D-SIBs in Australia; these four banks consistently ranked highest across a range of measures of the Australian financial system. The methodology did not produce a consistent ranking of banks below the top four.

The Australian D-SIB framework involves an additional capital requirement to absorb losses (namely a common equity Tier 1 capital requirement equivalent to 1 per cent of their risk-weighted assets) and more intense supervision than is applied to other ADIs, a feature that is already embedded in APRA's supervisory approach. The additional capital requirement will be implemented through an extension of the capital conservation buffer of each D-SIB from 2.5 per cent to 3.5 per cent of risk-weighted assets. D-SIBs will be required to meet the capital conservation buffer, including the higher D-SIB component, by 1 January 2016.

APRA's D-SIB higher loss absorbency (HLA) requirement is equal to the lowest capital requirement for G-SIBs and is at the lower end of the range adopted for D-SIBs in other jurisdictions. APRA sees its HLA requirement as sufficient because of APRA's more conservative approach to the measurement of capital, as well the more intense supervision the major banks already receive under APRA's risk-based supervisory approach. The HLA capital requirement is intended to reduce the probability of a D-SIB's failure, given the significant adverse impact that a failure of a D-SIB could be expected to have on the domestic financial system and economy. It can also be thought of as consistent with potential negative externalities associated with perceptions that a bank is ‘too big to fail’.

3.2.2.2 Crisis management and resolution

A number of steps have been taken in the area of crisis management and resolution arrangements in recent years, including strengthening APRA's crisis management powers in 2008 and 2010, enhanced powers for information sharing for the Reserve Bank, ongoing engagement with the New Zealand authorities around crisis management, and improved arrangements for coordination among CFR member agencies. These changes have been motivated partly by other countries' experiences during the financial crisis, the subsequent international regulatory response, and recommendations from the International Monetary Fund's (IMF's) 2005–2006 Financial System Stability Assessment for Australia. The FSB's peer review of resolution regimes suggests that Australia's resolution arrangements in respect of ADIs and insurers were generally consistent with international best practice and compared well to many other jurisdictions (FSB 2013i).

The principles and objectives of financial distress management are prescribed by the various acts that define the powers and responsibilities of the CFR agencies and the governance of financial institutions. These include the Reserve Bank Act 1959, the Australian Securities and Investments Commission Act 2001, the Australian Prudential Regulation Authority Act 1998, the Banking Act 1959, the Insurance Act 1973, the Life Insurance Act 1995, and the Corporations Act 2001. These principles and responsibilities are summarised in the CFR Memorandum of Understanding on Financial Distress Management (CFR MOU), which member agencies signed in September 2008.

The CFR MOU identifies the responsibilities of each Council member and is intended to facilitate a coordinated response to stresses in the financial system. It states that, in exercising their respective financial distress management responsibilities, member agencies will seek to balance the following objectives:

• Protecting depositors, policyholders or superannuation fund members, with a view to avoiding or minimising losses where possible.
• Maintaining the stability of, and confidence in, the financial system.
• Resolving the distress situation effectively and as quickly as practicable.
• Ensuring that the owners, directors and management of a distressed or failed institution bear appropriate responsibility.
• Minimising the economic and fiscal impacts of any financial distress resolution arrangements, and maintaining appropriate market disciplines. (CFR 2008)

The CFR MOU recognises that private sector, or market-based, solutions are generally the preferred means of responding to the distress of financial institutions. This conclusion reflects an important principle of responsibility: that management and boards of these institutions should be accountable for their decisions, and that it is not the role of the public sector to protect them from the consequences of those decisions. In some circumstances, however, it may be appropriate for public sector balance sheets to play an important stabilising role (Lowe 2013). For example, it has long been recognised that there is a role for central banks to supply liquidity to individual institutions and the market in times of stress by purchasing assets under a repurchase agreement, against collateral of sufficient quality, with a conservative haircut. In doing so, the central banks can provide liquidity when it is most highly valued, and with relatively little risk.

Another example is the Australian Government Guarantee Scheme for Large Deposits and Wholesale Funding (the Guarantee Scheme) where the Australian Government was prepared to insure bank debt for a fee during the financial crisis. This followed similar guarantees for financial institutions' wholesale debt by governments in several other countries, in response to a virtual closure of parts of global capital markets to non-sovereign borrowers after the collapse of Lehman Brothers in September 2008. The Guarantee helped reassure investors in Australian ADIs, and ensured that Australian ADIs were not disadvantaged compared with banks in other jurisdictions.

While the Guarantee Scheme was administered by the RBA, the CFR played an advisory role in its design and operation. Consistent with the principles set out in the CFR MOU, the fee for the Guarantee Scheme was set at a level higher than the market would have demanded for providing such insurance in normal times (Schwartz 2010). There is a strong argument that Australian taxpayers were well compensated for the risk they undertook, with insurance premiums paid by financial institutions to date exceeding $4 billion, and no money paid out under the guarantee. The Guarantee Scheme closed to new liabilities from 31 March 2010, although large deposits and wholesale liabilities guaranteed under the Scheme at that date remain guaranteed, for a fee, for the relevant term.

In circumstances where a public sector response to financial distress is required, the CFR MOU requires that the following principles will be considered:

• In considering the most appropriate means for resolving financial distress, the impacts on the broader economy will be taken into account.
• Any resolution option will also take into account short- and long-term benefits, costs and risks.
• Communication will be timely, coordinated and focused on the information needs of stakeholders.
• The response to financial distress will take into account cross-border implications where relevant, with a view to achieving a satisfactory outcome for all affected jurisdictions, subject to ensuring that the outcome meets the needs of the Australian financial system and depositors, policyholders and fund members in Australia. Trans-Tasman issues are particularly important in this context, given the integration between Australia and New Zealand in the financial area and relevant legislative mandates. (CFR 2008)

In particularly adverse and unlikely scenarios, the equity of a bank might be wiped out despite the implementation of prudential policies aimed at reducing the likelihood of failure, intervention by regulators and the provision of liquidity support by the RBA. In principle, various resolution options are available in such circumstances including the closure and liquidation of the institution, the transfer of all or part of the institution to another financial institution or a bridge entity, or, in circumstances of extreme systemic stress and risk aversion, temporary acquisition of the institution by the government until risk appetite has returned to more normal levels. The choice is guided by the principles, objectives and processes outlined in the CFR MOU and the relevant legislation.

In these circumstances, any potential decision involving public support of a troubled institution must ultimately be taken by the Government at the time and all resolution options require the consent of the Treasurer. An important principle in such cases is that public support be appropriately managed from the point of view of cost recovery. For example, if, during a period of extreme stress and risk aversion, the Government was to underwrite a capital injection for a troubled bank because the private sector was temporarily unwilling to do so, the Government's shares in the institution would be sold when the risk appetite of the private sector had returned to more normal levels. This approach worked well when, during the 1990s, the Swedish Government nationalised two of Sweden's largest banks in addition to providing a blanket guarantee of all bank liabilities. Liquidating the nationalised banks' problem assets was achieved more quickly than anticipated and at very little cost to taxpayers (Ingves and Lind 1996; Ergungor 2007). In some circumstances, taxpayers have profited from government capital injections, as illustrated by the profit realised by the US Treasury in 2012 when it sold its final holdings of common stock in American International Group (AIG), which had been acquired in 2008.

3.2.2.3 Depositor protection

Australian depositors benefit from multiple layers of legal protection. Depositors of a failed ADI could be given access to their deposits by the authorities transferring the deposit book to another ADI, or by paying them out via Australia's deposit guarantee framework, the Financial Claims Scheme (FCS).

Historically, the primary mechanism for depositor protection in Australia has been depositor preference, which is enshrined in the Banking Act.^[14] Under this arrangement, depositors have preferred legal status over other unsecured creditors in the hierarchy of claims against a failed ADI, meaning that they must be paid out before other claims are honoured.

The FCS was introduced in 2008, at the height of the global financial crisis, as a complement to depositor preference after having been discussed by Australian authorities for some years. Initially, temporary deposit coverage of up to $1 million per depositor per institution was provided free by the Government (with additional coverage available for a fee). Coverage under the FCS was reduced from $1 million to $250,000 per depositor per institution from 1 February 2012. Based on available industry data around that time, the cap was estimated to cover around 80 per cent of household deposits by value and 99 per cent of all deposit accounts by number (Turner 2011).

The FCS is currently post-funded. That is, in the unlikely event the FCS is triggered for an ADI, the Government initially provides, under a standing appropriation, the funds to make payments under the FCS. Monies paid under the FCS are then recovered from the ADI in the winding-up process, with the Government (APRA) standing in place of protected account holders in the hierarchy of claims under the Banking Act. There is provision to make up any shortfall by applying a levy on the ADI sector.

In addition to reducing the cap, other steps have been taken to refine the FCS. This includes the CFR recommendation to the then Government in March 2013 that the FCS should move to a pre-funded arrangement. Such a model, which is now common among deposit insurance schemes internationally, would be consistent with the principle of users paying for the benefits provided. Ex-ante funding would also, at least partly, compensate the Government for the risks it bears from these guarantees and would build a fiscal buffer to assist in meeting any potential future costs of ADI resolution.

Key practical design issues that would need to be decided when switching to an ex-ante funding scheme include the size and calculation of the levy to be applied to ADIs – whether to use a flat levy or a risk-based levy – and the appropriate assessment base on which the levy should be applied.

• Under a flat levy calculation, all ADIs are levied at the same rate. The amount they pay only reflects differences in the size of their assessable base.
• Under a risk-based calculation, the rate of the levy would vary between ADIs depending on an assessment of their riskiness. This can be done in an attempt to discourage excessive risk-taking, to counter moral hazard and to sharpen market disciplines on ADIs. However, the disadvantage of risk-based levies is that they could send (perhaps unwarranted) adverse signals to markets about the stability of individual ADIs that could trigger a disproportionate reaction. Further, although a risk-based fee has conceptual merit from risk-pricing and incentives perspectives, it is more complex to design and administer.

On the assessment base for the levy, the most straightforward approach, and the approach suggested to the then Government by the CFR, would be to use FCS-protected deposits as the base (i.e. covered deposits up to $250,000 per account holder per ADI). A pricing model with a wider base, such as one that includes non-FCS protected liabilities, would be more complicated (and may require, for example, a different levy rate for non-FCS protected liabilities compared with the rate that applies to protected deposits). While FCS-protected deposits could be used as the assessment base for pricing purposes, this does not mean the proceeds from ex-ante funding should be used only for FCS payouts in a closed resolution ^[15]. Allowing for a wider use of the proceeds, in particular for open resolution as well, would be more useful than using the funds only to reimburse insured deposits, given the funds would be available for use in a broader range of circumstances. This approach is supported by the Bank and the other CFR agencies, and was included in the advice provided to the then Government in early 2013.

3.2.3 OTC derivatives markets

The CFR has overseen work towards meeting the G20 Leaders' commitment in Australia on OTC derivatives markets reform. Amendments to the Corporations Act were passed in Australia in December 2012 that gave the Government the power to impose mandatory central clearing, trade reporting or platform-based execution requirements.^[16] The legislative framework is designed to be flexible, given the cross-border reach of some other jurisdictions' legislation in this area and uncertainties around the broader effects of regulation of these markets on market functioning.

Under the framework, the responsible Minister may issue a determination that mandatory requirements should apply to a specified class or classes of derivatives. In making the decision to issue a determination the Minister must take into account a number of factors, including the advice of APRA, ASIC and the Reserve Bank (the Regulators). To date, the Regulators have delivered their advice to the Minister through periodic reports based on surveys of participants in the Australian OTC derivatives market. Following a determination, ASIC may make Derivative Transaction Rules, which set out the details of any requirements, such as the institutional and product scope of the requirements and any transitional arrangements.

Given the global reach of OTC derivatives markets, the Regulators have in their advice and rule-making sought to promote consistency with overseas OTC derivatives regimes. Broad equivalence between regimes supports cross-border activity in financial markets and, where overseas jurisdictions are willing to recognise broadly equivalent regimes, reduces compliance costs for Australian businesses. Cross-border coordination is also important to avoid overlapping, duplicative or conflicting regulations.

Trade reporting is the first requirement to have been implemented under this framework. Based on recommendations from the Regulators, in May 2013, the Minister made a determination requiring a wide range of OTC derivatives to be reported (Corporations (Derivatives) Determination 2013). In July 2013, ASIC published final rules setting out the details of trade reporting requirements (ASIC Derivative Transaction Rules (Reporting) 2013). The data collected under the rules will be used primarily by the Regulators to assess systemic risk arising from OTC derivatives markets, and may also be used for other purposes such as conducting market surveillance and enforcement.

No requirement to centrally clear has yet been implemented in Australia. The Regulators have taken the view that regulatory and commercial incentives may be enough to drive industry towards central clearing. These incentives arise from a combination of factors, including implemented and anticipated overseas requirements to centrally clear, the higher capital charges applied to non-centrally cleared positions, and the resulting shift in liquidity to centrally cleared markets. Nevertheless, on the grounds of international consistency, the Regulators recommended in July 2013 that the government consider imposing a requirement for internationally active financial institutions to centrally clear interest rate derivatives that have been mandated in other jurisdictions (APRA, ASIC and RBA 2013). This recommendation has been accepted by the Government, with a proposal published in February 2014 for consultation (Australian Government 2014).

A decision on mandatory clearing of Australian dollar-denominated interest rate derivatives, which the Regulators consider to be the most systemically important derivatives product class in Australia, has been deferred until the next report in early 2014. In the meantime, two CCPs, ASX Clear (Futures) and the London-based global CCP, LCH.Clearnet Limited (LCH.C Ltd) have received regulatory approval to offer OTC derivatives clearing services to Australian participants. All four of the large domestic banks have become foundation customers of ASX's service, with two having also joined LCH.C Ltd as direct participants.

A requirement for platform-based execution has not been implemented in Australia, and there is limited uptake in platform-based execution by OTC derivatives market participants. The Regulators continue to see in-principle benefits to greater use of trading platforms, but it is not clear whether mandating their use is necessary to realise those benefits. Accordingly, the Regulators will continue to monitor developments in other jurisdictions and seek more detailed information on activity in the Australian market.

3.2.4 Financial market infrastructures

Australia has adopted the new international standards for FMIs, the PFMIs, developed by the CPSS and IOSCO (CPSS and IOSCO 2012). The Bank and ASIC have shared responsibility for oversight of FMIs in Australia and have taken complementary steps to implement the PFMIs (ASIC and RBA 2013) (Chapter 8). In March 2013, new Financial Stability Standards (FSS) determined by the Bank came into force (RBA 2012).

The FSS, aligned with the stability-related requirements in the PFMIs, are substantially more detailed than the previous standards. They clarify minimum requirements on matters such as the size of pre-funded financial resources, collateral eligibility criteria and access to liquidity. They also set new requirements in a number of areas. In particular, for the first time, FMIs are called upon to develop recovery plans, which articulate the steps FMIs would take in the event of an extreme financial shock.

The recovery planning requirements in the new FSS were subject to transitional relief in Australia until end March 2014. This reflected that international work was ongoing to develop more detailed guidance in this area. Even though the PFMIs require FMIs to hold more financial resources, in very extreme cases these might still not be enough to cover a participant default. Given the increasing (and sometimes mandatory) use of CCPs, these firms and their regulators need to have robust plans for dealing with such an unlikely scenario. The Bank has since been working with domestic FMIs on the development of its recovery plans.

The official sector is in parallel developing arrangements to intervene directly in circumstances of acute FMI distress where a recovery plan cannot be fully implemented as intended. In Australia, the Government is considering its response to a CFR recommendation to the Treasurer in February 2012 that ASIC and the Bank be given the power to appoint a statutory manager to a troubled FMI (CFR 2012) (Chapter 8).

3.2.5 Shadow banking

There has been relatively less domestic focus on implementation of shadow banking reforms given that most global proposals have only recently been finalised and the small and declining size of the shadow banking sector in Australia (Chapter 4).

During the international policy development phase, Australia advocated that regulators need sufficient flexibility to respond proportionately to risks, reflecting the fact that in Australia the shadow banking sector has a relatively small share of financing activity and the possibility that heavy regulation may impose costs in excess of potential benefits (Schwartz and Carr 2013).

Even though this sector is small, the authorities do periodically take regulatory actions. An example is the regulatory response to the failure of a number of small finance companies that were issuing retail debentures in recent years. In April 2013, APRA released proposals to restrict registered financial corporations – which include finance companies and money market corporations – from issuing retail debentures with maturities of less than 31 days and from using words such as ‘deposit’ and ‘at-call’ to market their products to retail investors. APRA's proposals re-emphasise the distinction between the regulatory framework for these entities, which are not prudentially regulated, and the more intensive supervisory regime applicable to ADIs. These proposals complement those released by ASIC earlier in 2013, which included possible capital and liquidity requirements for retail debenture issuers. In addition to regulatory action, authorities also undertake periodic assessments of developments in the sector.

• ASIC has also increased the scrutiny on hedge funds. For example, in September 2013 ASIC released its review of the level of systemic risk posed by ‘single-strategy’ hedge funds. The report, which also reviewed the results of ASIC's 2012 hedge funds survey, found that Australian hedge funds do not currently appear to pose a systemic risk to the Australian economy.
• The RBA presents an annual review to the CFR on developments in Australia's shadow banking sector. This informs a discussion among CFR members on potential risks arising from this sector, and, if necessary, for member agencies to take appropriate action within their areas of responsibilities.

APRA has also outlined work it is doing to make changes to its securitisation framework. APRA will consult on its proposed new framework which is based on simple, low-risk structures that make it straightforward for ADIs to use securitisation as a funding tool and for capital relief. This, in turn, should lead to a reduction in industry complexity, and an improvement in ADI risk allocation and management.

3.2.6 Australia's response to other reforms

3.2.6.1 Macroprudential policies and tools

In keeping with its responsibility for overall financial system stability, the RBA, along with other CFR agencies, and particularly APRA, continues to monitor international developments in the area of ‘macroprudential’ policies and tools. While these regulatory measures were used prior to the crisis – especially in emerging market economies – such measures have become more prominent in light of the crisis and have begun to be developed or used more widely, including in New Zealand. The use of macroprudential tools in advanced economies is largely a recent phenomenon, making it difficult to draw definitive conclusions about their effectiveness. The Bank will continue to carefully monitor experience with these measures, with New Zealand being a particular focus as Australia's four major banks have large operations in that market.

Australia did not need to adjust its regulatory framework to give the authorities a mandate to pursue system-wide oversight and promote financial stability, because both APRA and the RBA already had mandates and powers in these domains.^[17] In Australia's case, both APRA and the RBA have responsibilities for system-wide oversight, although each agency has different, but overlapping and complementary, powers and responsibilities. APRA has powers and responsibilities that relate mainly to individual institutions, but its legislative mandate includes stability of the system, and it can adjust its prudential settings to address system-wide concerns. The RBA has a broad financial stability mandate, existing in conjunction with other macroeconomic objectives and attached to a very different set of powers. The RBA is authorised to provide financial services to the Government and to the financial system, and has significant powers to engage in financial activities in the public interest, which enable the RBA to act as lender of last resort and liquidity manager for the financial system.

One point of difference here is that the Bank's responsibility for overall financial system stability is not stated explicitly in legislation. However, the broader provisions in section 10 of the Reserve Bank Act 1959 (the Act) have long been interpreted as implying a mandate to pursue financial stability, given the serious damage to employment and economic prosperity that can occur in times of financial instability. Further, this (implicit) goal has been made explicit in a number of ways, such as in 1998 when the then Treasurer referred to financial stability being the regulatory focus for the Bank (in the second reading speech in support of the APRA Act). More recently, this role was included in the Statement on the Conduct of Monetary Policy agreed by the Governor and the Treasurer, which (in its 2013 version) states ‘financial stability, which is critical to a stable macroeconomic environment, is a longstanding responsibility of the Reserve Bank and its Board’. The absence of a financial stability mandate in legislation has not inhibited the Bank from fulfilling this role. Given recent overseas developments involving new financial stability bodies and mandates, however, there may be appetite to consider a legislative mandate for the Bank. The Bank would see any such move as a clarification of the status quo, rather than as a substantive change in its responsibilities.

In carrying out its duties as Australia's integrated supervisor of financial institutions, it should be remembered that APRA already takes an industry-wide, or systemic, perspective, as is consistent with its financial stability mandate. APRA makes its systemic mandate operational through a number of elements of its supervisory practice. This point is sometimes not recognised by those advocating a separate macroprudential mandate. For example, APRA's risk-based approach subjects institutions that pose greater systemic risks to more intensive supervision, and potentially higher capital or other prudential requirements. In this context, and as noted earlier, APRA has released its D-SIB framework, identifying the four major banks as D-SIBs and requiring them to hold additional capital from January 2016. Further, APRA has, at times, imposed prudential measures in response to the build-up of risk in particular sectors. For example, following its stress testing of the housing loan portfolios of ADIs in 2003, APRA made significant adjustments to the risk-weighting of housing loans as well as adjustments to the capital regime for lenders mortgage insurers (LMIs). Such a response to systemic or industry-wide – essentially macroprudential – concerns reflects a broader perspective than a narrow focus on a particular aspect of lending standards such as the LVR.

The Reserve Bank will work closely with APRA in assessing the need to implement such measures in the future. For example, in terms of the Basel III counter-cyclical capital buffer (CCCB), APRA would be responsible for making and disclosing any decision to require or amend this buffer, while it is anticipated that the Bank would provide analysis to inform any decision. However, before any decisions are taken on the implementation of such measures, it will be important to judge whether these measures would achieve their intended goals, or only offer temporary benefits, and whether once implemented, they can be removed or ‘exited’ from with relative ease.

3.2.6.2 Role of the Council of Financial Regulators

The CFR is the coordinating body for Australia's main financial regulatory agencies. Its membership comprises APRA, ASIC, the RBA and the Treasury. The CFR was established in 1998 following the recommendations of the previous Financial System Inquiry (the Wallis Inquiry).^[18] It is a non-statutory interagency body, and has no regulatory functions separate from those of its four members.

CFR meetings are chaired by the Reserve Bank Governor, with secretariat support provided by the RBA. They are typically held four times per year but can occur more frequently if required. As stated in the CFR Charter, the meetings provide a forum for:

• identifying important issues and trends in the financial system, including those that may impinge upon overall financial stability;
• ensuring the existence of appropriate coordination arrangements for responding to actual or potential instances of financial instability, and helping to resolve any issues where members' responsibilities overlap; and
• harmonising regulatory and reporting requirements, paying close attention to the need to keep regulatory costs to a minimum (CFR 2004).

Much of the input into CFR meetings is undertaken by interagency working groups, which has the additional benefit of promoting productive working relationships and an appreciation of cross-agency issues at the staff level.

The CFR has worked well since its establishment and, during the crisis in particular, it has proven to be an effective means of coordinating responses to potential threats to financial stability. For example, the CFR played a critical role in the latter part of 2008 at the height of the financial crisis when the Government introduced the FCS along with the Guarantee Scheme for Large Deposits and Wholesale Funding. The CFR provided advice to the Government on the specific features of these guarantee arrangements. In 2010, the CFR undertook an assessment of the suitability of the structure of the FCS to the post-crisis environment. The advice from this exercise informed the Government's revised arrangements for the FCS, including a lowering of the cap. The CFR also has a role in advising the Government on the adequacy of Australia's financial system architecture, such as OTC derivatives markets and payment and settlement systems, in light of ongoing developments.

The experience since its establishment, and especially during the crisis, has highlighted the benefits of the existing non-statutory basis of the CFR. In a joint APRA-RBA paper on domestic financial stability policy prepared for the IMF's Financial Sector Assessment Program review of Australia in 2012, the two agencies stated, in referring to the CFR, that ‘these arrangements provide a flexible, low-cost approach to coordination among the main financial regulatory agencies’ (APRA and RBA 2012, p 4).

In addition to the CFR, there is strong bilateral coordination among the four CFR member agencies. The broad terms of these coordination arrangements are set out in various bilateral Memoranda of Understanding. Those to which the RBA is a signatory include the RBA/APRA Memorandum of Understanding and the RBA/ASIC Memorandum of Understanding. There are also formal meetings of a coordination committee of senior officials from APRA and the RBA which meets roughly every six weeks.

Other jurisdictions have adopted different approaches to interagency coordination in recent years, and in a number of instances have moved in the direction of greater formalisation of coordination arrangements (Section 3.1.5.2). However, the potential benefits of such approaches should not be overstated and these arrangements are too new in many (advanced) jurisdictions to judge their effectiveness. Adopting such an approach in Australia by formalising the CFR with explicit responsibilities and policy tools would involve transferring agency constituent powers to the CFR, with the risk of blurring lines of responsibility that to date have worked well. In a number of countries the approach has been to create separate macroprudential and microprudential regulatory bodies. The Bank, along with APRA, is not convinced of the merits of such a division between macroprudential and microprudential policy. The RBA and APRA ‘view macroprudential policy as subsumed within the broader and more comprehensive financial stability policy framework’ (2012 p.1). If the financial stability framework is effective and there is strong interagency cooperation and coordination, separate governance arrangements for macroprudential policy are not necessary. More generally, most macroprudential tools being discussed are essentially normal prudential tools used for macroprudential purposes, which also means a clear distinction between macro- and microprudential policy could be difficult to maintain in practice.

Moreover, the approaches adopted overseas are often not readily applicable to Australia. For example, the FPC is a part of the Bank of England (BoE), with the BoE and its new subsidiary, the Prudential Regulation Authority accounting for 5 of the 10 voting members of the FPC. In contrast, the CFR is separate from the RBA and is comprised of heads of the four agencies on an equal basis (with the RBA chairing). As noted in a recent FSB peer review of the United Kingdom, the ‘specific governance model chosen in the UK is unique and reflects the UK's experience with their Monetary Policy Committee, on which the FPC's structure appears closely modelled’ (FSB 2013h, p 17). In the United States, financial regulatory responsibilities are divided among many agencies (for example, FSOC has 10 voting members, each representing a different agency or industry). In Australia, reaching agreement among CFR members has, to date, usually not been difficult, given only four agencies are involved, and there has been a long tradition of cooperation between them (the CFR, and its predecessor, has been in operation for over 20 years).

Measures short of legislative change can also help underpin effective cooperation. For example, maintenance of relations with senior APRA executives is one of the key position objectives listed on the position description for the RBA's Financial Stability Department senior managers. Similar position descriptions for senior executives and policy staff at APRA typically require them to develop and maintain strong external relationships with relevant stakeholders. Mutual staff secondments are also an important way to build and maintain staff contacts and a level of cooperation and trust.

Finally, it is important to note that formalised, legal frameworks for financial stability coordination are not a guarantee of success. In particular they cannot be relied on to engender a ‘culture’ of cooperation, trust and mutual support between domestic regulatory agencies. These are essential elements of an effective financial stability framework, especially during a crisis.

3.2.6.3 Consumer credit regulation

Consumer protection laws and policy measures aimed at improving financial literacy contribute to the transparency, efficiency, and therefore competitiveness, of financial markets. They do so by addressing information asymmetries between providers and users of financial services and by increasing bargaining power.^[19] Problems arising from the subprime mortgage market in the United States during the recent financial crisis refocused attention on these issues. Although lending standards in Australia were not as lax as in the United States during the pre-crisis period, the share of loans that were ‘low-doc’ – where borrowers self-certify their income in their loan application – grew strongly in the lead-up to the crisis.

The Australian Government subsequently took action to further reduce the already limited scope for lending standards in Australia to give rise to the same issues seen in the United States. Specifically, the Commonwealth assumed nationwide responsibility for consumer credit regulation by introducing the National Consumer Credit Protection (NCCP) legislation in 2009. This legislation adopted and extended the former state-by-state system's Uniform Consumer Credit Code (UCCC) and introduced a national licencing regime for providers of credit or credit-related services, and responsible lending requirements. In addition, legislation was introduced to deal with unfair contract terms, giving courts the power to alter unfair terms and conditions in contracts.

Due to Australia's already relatively prudent lending standards, the reforms were not expected to have a large effect. Standards of low-doc lending in Australia tightened considerably in the aftermath of the crisis reflecting a reassessment of the risks by lenders and residential mortgage-backed securities investors. The introduction of the NCCP legislation may also have contributed to the reduction in the low-doc share of mortgage approvals.

3.2.6.4 Promoting appropriate policies and avoiding undue regulatory burden

Though Australia avoided the worst of the crisis, as a member of the global financial system it is in Australia's interests to ‘play by the international rules’. International reforms have also addressed areas where there was room for improvements in Australia's arrangements. These points are sometimes lost in the debates about implementing financial regulatory reforms, which often focus on the increase in the regulatory burden faced by financial institutions.

It would be impractical, and counterproductive, for Australia, and its regulators and financial institutions, to adopt a ‘go it alone’ policy, by not implementing globally agreed reforms. Australian financial institutions already interact with foreign entities and have operations in other jurisdictions. While the flexibility to adapt rules to national circumstance should be, and is, taken into account, failing to implement agreed international reforms could be counterproductive to the extent that it poses obstacles to Australian banks wanting to expand their operations overseas or fund themselves in external markets, as well as potentially deter Australia's attractiveness as a financial centre. It is, in any event, in Australia's interests to adopt high standards in supervision and regulation.

Nonetheless, CFR agencies have, to the extent of their influence, sought to ensure that international reforms are sensible for Australia. Examples where the Bank and other CFR agencies have sought to modify international proposals that were not well suited to the Australian financial system include meeting the LCR through the CLF to reflect the relative scarcity of government debt available as liquid assets, and promoting appropriate weights for high quality mortgages in the Net Stable Funding Ratio requirement. In its membership of the global bodies where these policies are debated and developed (such as the G20, the FSB, and standard-setting bodies such as the BCBS), the motivation of the Bank and other domestic agencies has been to ensure good policy outcomes, and that flexibility in rules and implementation is retained where appropriate.

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.

Footnotes

These shortcomings have been extensively analysed by the jurisdictions most affected by the crisis, including in: the UK Financial Services Authority's ‘Turner Review’ (FSA 2009); the Senior Supervisors' Group Report (SSG 2009); the Joint Forum's Review (BCBS, IAIS and IOSCO 2010); the US Financial Crisis Inquiry (FCIC 2011); the Vickers' Report (ICB 2011); and the European Union's ‘Liikanen Report’ (EU 2012). [1]

The BCBS originally consisted of Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States. [2]

No Australian banks have been identified as G-SIBs (FSB 2013a). [3]

The FSB notes that bail-in through business transfer powers is not fully equivalent to the description of bail-in in the Key Attributes, which requires that all, or parts of, unsecured creditor claims are converted into equity of the firm in resolution (FSB 2013i, p 24). [4]

A summary of bank creditor losses in the recent crisis is given in Appendix 3 of Schich and Kim (2012). Further examination by RBA staff suggests that none of those banks returned from resolution as a privately owned, stand-alone entity. [5]

The FSB (2013g, p iv) broadly defines shadow banking as ‘credit intermediation involving entities and activities (fully or partially) outside the regular banking system’. [6]

Risk retention rules aim to ensure that entities which sponsor financial transactions retain a portion of financial risk, or ‘skin in the game’. [7]

The proposed minimum haircuts would not apply to government securities. [8]

This was cited as a contributing factor that allowed risks to build up in the United States (FCIC 2011, pp 55–56). [9]

After their meeting in 2010, G20 Leaders called on the FSB, IMF and Bank for International Settlements (BIS) to investigate how countries could implement macroprudential policy frameworks (FSB, IMF and BIS 2011). [10]

The FSOC was created in July 2010 by the Dodd–Frank Wall Street Reform and Consumer Protection Act 2010. The ESRB was created in December 2010 with powers set out in EU Regulations No 10/92/1010 and No 1096/2010; and the FPC first met in 2011 but only became a statutory body in April 2013 as a result of the Financial Services Act 2012. [11]

Under United States and European Union arrangements, decisions are made by majority vote. Voting mechanisms were chosen in these jurisdictions due to the expected need for rapid decision-making in a crisis and the large number of agencies participating in these committees. The FSOC has 10 voting members and the ESRB has 37 voting members. The UK FPC, which has 10 members, makes decisions by consensus, although a decision is reached by majority vote if a consensus cannot be found. [12]

Some jurisdictions have also taken steps to enhance the resolvability of foreign banks operating in their jurisdictions, including by ‘ring-fencing’ their operations. In the United Kingdom, the authorities are considering a set of reforms that may require foreign bank branches to incorporate as a subsidiary if their home country supervision and resolution arrangements are not sufficiently equivalent to those in the United Kingdom (or if their parent is headquartered in a country with depositor preference laws, such as Australia). In the United States, the Federal Reserve recently finalised a rule that will require large ‘foreign banking organisations’ to consolidate their bank and non-bank subsidiaries under a ring-fenced holding company. [13]

Australia is one of the few countries with depositor preference. Other jurisdictions with some form of depositor preference include Argentina, China, Hong Kong SAR, Malaysia, Russia, Switzerland and the United States. More recently, the EU has reached an agreement to introduce depositor preference as part of the Bank Recovery and Resolution Directive and legislation has been passed in the United Kingdom that will extend depositor preference to deposits covered by the Financial Services Compensation Scheme. [14]

Closed resolution occurs when the bank is closed to new business and liquidated. It contrasts with open resolution where the core functions of the bank are transferred to another bank or a bridge bank, or the bank is recapitalised in situ. [15]

The amendments also established a licensing regime for trade repositories. Under the regime, ASIC has responsibility for regulating and supervising trade repositories. [16]

See APRA and RBA (2012) for a detailed description of the tools and practices of APRA and the RBA that are designed to support financial stability from a system-wide perspective. [17]

The CFR succeeded the Council of Financial Supervisors, which operated from 1992 to 1998. [18]

Information asymmetries occur when different market participants have different levels of knowledge. One example would be when financial service providers understand more about their products or services than the consumers of those products. Conversely, information asymmetries could arise because consumers know more about their individual circumstances than financial service providers. [19]

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