Submission to the Inquiry into the Australian Banking Industry D. Prudential Supervision

65. Prior to the 1980s the Bank's prudential supervision of Australian banks was largely informal although, on the face of it, effective. The problems of the Bank of Adelaide in 1979 were identified promptly and the merger of that bank with the ANZ Bank was organised smoothly without loss to depositors and with minimal disruption to banking system stability.
66. During the 1980s, a number of factors persuaded the Bank that greater formality, based on publicly available guidelines, was needed in pursuing its supervisory role. A Bank Supervision Unit was established by the Bank in 1980, which has subsequently developed into the Bank Supervision Department. The reasons for this change in approach included:
    • recognition that the process of deregulation would involve banks in greater operating risks, increasing the importance of adequate capital and liquidity and effective management controls;
    • the growth in banks' overseas operations gave risk management an added dimension and meant that overseas banking supervisors would be looking for evidence of effective supervision in Australia;
    • a strong move internationally towards consistent minimum standards of banking supervision in all major banking centres; and the close contacts needed to underpin an informal supervisory system became more difficult as the number of banks increased and there was greater devolution of authority within banks.

(a) Trade-offs in bank supervision

67. Settling on the right amount and intensity of prudential supervision involves some important trade-offs. Arrangements are required that bolster community confidence and support the reliability and viability of the banking system and the payments system. The framework needs to be simple, logical and practicable on the one hand and, on the other, it needs to minimise artificial distortions in financing.
68. Banks should practice prudent risk management but we also need a dynamic innovative financial system. It would be inappropriate to bear down excessively on the former at the risk of damaging the latter. Risk is an essential part of financial markets just as it is an essential part of the economic development process. It should be managed sensibly but it would be a delusion to believe it can, or indeed should, be removed altogether.
69. The Bank has been very aware of these trade-offs in developing its approach to banking supervision. Its primary concerns are to protect the depositors of banks and to maintain stability in the banking and financial system. Underpinning its approach is a belief that the main responsibility for the prudent conduct of a bank's operations rests with the board and management of that bank. It has developed a set of general guidelines against which to assess a bank's operations and, through statistical collections, consultations and continuous assessment of banks' risk management systems, it monitors each bank's performance. Banks' external auditors report to the Bank on each bank's observance of the prudential guidelines, and on whether its management systems are effective, its statistical reports are reliable, and statutory requirements have been met.

(b) The supervisory framework

70. Specific elements of the bank supervision framework relate to:
    • minimum capital requirements;
    • liquidity management;
    • large credit exposures;
    • associations with non-bank financial institutions;
    • ownership of banks.

These are detailed in a set of publicly available Prudential Statements, a copy of which is being supplied to the Committee together with this Submission.

(c) Protection of depositors

71. An element of the Reserve Bank's role which is not always well understood relates to the protection of bank depositors. Some see this as a guarantee that a bank will never fail or that a depositor will never lose money kept in a bank account. That is not the case. The Reserve Bank does not guarantee bank deposits^[5]; the Bank uses its powers to protect the interests of depositors, i.e. to minimise the risk that they could be subject to loss.
72. In most countries, it is usually the case that bank deposits rank towards the lowest-risk end of the risk spectrum. That is also the case in Australia and banks pay certain costs for being in that position. They are required to hold at least 1 per cent of their total Australian dollar assets in Australia in low-interest deposits with the Reserve Bank; they must hold another 6 per cent in ‘prime assets’, i.e. cash and Commonwealth Government securities; and they must meet the capital requirements and other prudential guidelines mentioned earlier.
73. These various arrangements do not save banks from making bad loans or suffering losses. Rather, they are designed to minimise the possibility that such bad loans or losses will put the banks themselves or their depositors' funds at risk.
74. If a bank authorised under the Banking Act were to get into serious difficulty, the Reserve Bank has very wide powers which go beyond the provision of liquidity support and the conduct of a thorough investigation of the bank's position: if necessary, it could assume control of the bank and manage it in the interests of the depositors, perhaps pending a merger with another, stronger bank. If a bank was unable to meet its obligations, the Banking Act stipulates that its assets within Australia should be used first to ‘meet that bank's deposit liabilities in Australia in priority to all other liabilities of the bank’. This preferred position of their depositors makes banks unique among Australian financial institutions.
75. It is the total package of arrangements – the supervisory oversight of the Reserve Bank, the access to the Reserve Bank for liquidity support and the protective provisions of the Banking Act – that gives bank deposits their status as an especially low risk haven for savings.
76. Every efficient financial system requires that a spectrum of risk be available to savers and investors, with expected returns broadly consistent with the degree of risk involved. To seek to offset those risks by official intervention, e.g. through officially sponsored deposit insurance arrangements, involves a degree of moral hazard and some aspects of the S&L problems in the USA illustrate the potential dangers in this. Such schemes risk reducing the onus on managers and directors to act prudently, and on depositors and investors to weigh risk sensibly. They can also encourage governments to accept responsibilities which rightly should be shared between depositors and the managers of their funds.
77. Nonetheless, it is appropriate that there should be a safety haven for small investors, a role traditionally filled by banks. The need to maintain a stable and dependable position in domestic and international payments arrangements gives further support to the case for putting banks in a special category for prudential policy and for depositor protection.

Footnote

The Commonwealth Bank's liabilities are guaranteed by the Commonwealth Government, while State banks carry a State Government guarantee. [5]