Week 3 Bank Regulation
Introduction
Government intervention in Australian banking
Australian government intervention in financial institutions include
General legal infrastructure (Corporations Law, Taxation law,
privacy Law,
Finance sector specific
- Financial Transactions Report Act
- National Consumer Credit Protection Act
- Financial Services Reform Act
Key Financial Regulators
Reserve bank of Australia (RBA)
- Responsible for monetary policy, systemic stability and
the payments system
Australian Prudential Regulation Authority (APRA)
- Responsible for prudential regulation and supervision of
deposit taking institutions (including banks, building
societies and credit unions), insurance companies and
superannuation funds
Australian Securities and Investments Commission (ASIC)
- Responsible for consumer protection and market
integrity (including corporations Law and FSRA licensing)
Key Banking Legislation
Banking Act 1959
- Bank must be authorised
- Depositor priority (depositors have first claim on the
Australian assets of an insolvent bank)
- Bank mergers require Treasurers approval (four pillars
policy)
Financial Sector (Shareholdings) Act 1998
- Maximum shareholding (15% unless approved by
Treasurer)
Why regulate banks?
Reduce systemic risk
- Precent panic and bank runs due to contagion
- Contribute to the efficient flow of funds
- Support the payments system
- Provide a conduit for monetary policy
Protect consumers
- Safety of deposits and clients are treated fairly
Reduce moral hazard
- Moral hazard = banks take more risk because they are
protected and market discipline is weak
Regulatory Change
Once in the past
- Direct controls over bank decisions (loan prices
interest rates) were set by regulators
- Concern about lack of competition and inefficiency
- Campbell Report (1981) and deregulation
- Wallis Report (1997)
Now
- The GFC has meant concern over managing systemic
risk and bank survival under times of stress and so
resulted in refinements to capital adequacy (Basel III)
and bank risk management (such as liquidity risk) as
well as the Murray Report (2014)
Australian Prudential Regulation Authority (APRA)
Established in 1 July 1998 to consolidate regulation of the
main financial institutions: Banks, Building societies, credit
unions, Friendly societies, insurance companies and
superannuation funds
Funded from levys placed on its regulated institutions based
on a percentage of total assets subject to an overall dollar
ceiling
APRAs powers
APRA is the only body which can authorise the operation of an
ADI in Australia
It also
- Sets prudential standards and supervises the operations
of ADIs
- Issues and revokes their authorisation to operate in
Australia
- Sets and enforces prudential standards
- Requires to supply information
- Assumes control of an ADI in financial difficulty or
appoints an administrator or liquidator arranges for an
ADI winding up
- Arranges for an ADI winding up
APRA and Bank Authorisation
Locally incorporated banks
- May be Australian or foreign owned
- Are supervised by APRA
- Must increase competition and create economic benefits
- Depositors have first claim on assets if a bank becomes
insolvent
- Covered under the financial claims scheme (FCS)
APRA and Foreign Bank Branches
Foreign bank branches
- May NOT accept retail deposits less than $250k
- Are NOT subject to Australian capital adequacy
requirements (must comply with those of home country)
- Depositors do NOT have first claim on assets
- Are not covered by the Financial Claims Scheme
Current Australian Prudential Standards
Prudential Standards
Prudential regulation refers to requirements or standards
designed to limit the risk taking in order to help ensure the
safety of depositors funds and the stability o the financial
system.
APRAs core mission is to establish and enforce prudential
standards and practises designed to ensure that, under all
reasonable circumstances, financial promised made by
entities it supervises are met within a stable efficient and
competitive financial system
Safety of depositors funds and stability of the financial system
are threatened if a bank becomes insolvent
Risk of bank insolvency depends on two things
- Risk impacting on a bank
- Amount of bank capital
Regulators aim to keep risk of bank insolvency down to an
acceptable level by
- Limiting bank risks
- Requiring banks to hold more capital
Current Australian Prudential Standards
APS 220 Credit Quality
Credit risk the risk to earnings and capital that an obligor will
fail to meet the terms of any contract with the bank, or other
wise fail to perform as agreed
Level of credit risk for a bank depends on
Credit risk of individual transactions/loans
Credit quality
- Level of diversification
Increased diversification reduces risk
Banks must have a credit risk management system which
includes
- Well-structured credit risk grading system
- Security valuation policy using net market value where
possible
- Approved system for setting provisions
- An approach to measuring and reporting on impaired
assets
Impaired assets
- Items where ultimately collectability of principal and
interest is compromised
- These include
Non-accrual items
- Payments more than 90 days past due and
security is sufficient to cover the amount due
- Provisions must be made and interest ad other
income earned but not received may not be
recognised
Restructured items
- Facilities in which the original contractual terms
have been modified to provide for concessions
of interest, or principal or other payments due
or for an extension in maturity for a noncommercial period for reasons related to the
clients financial difficulties
- To be classified to non-accrual if recovery of
principal or interest is in doubt, or provisions
have subsequently been struck.
Other assets acquired through security
enforcement (the homes of businesses of
borrowers who have defaulted on their loans
APS 221 Large exposures
ADI must have an effective policy for managing large
exposures and risk concentrations
Limits should apply to
- Individuals, corporations, governments
- Groups of related counterparties
- Industry sectors
- Countries
- Asset classes (commercial property)
A large exposure is an exposure of 10% (or more) of the
banks capital base
- E.g. if a bank has capital = $100, any loan of $10 would
be classified as a large exposure
All large exposures must be reported to APRA
Consultation with APRA is required prior to exceeding an
exposure of 25% of capital base to a non-ADI counterparty
APS 210 Liquidity
Committed liquidity support facility (CLSD) is also available for
a fee from the RBA to help ADIs meet these APS 210
requirements
Small banks which do not use sophisticated liquidity
management strategies and do not wish to conduct scenario
analyses must hold a minimum holding of 9% of their liability
in specified high quality liquid assets at all times
Compliance
Compliance = bank comply with APRAs requirements
Compliant costs are costs banks must pay as a result of the
regulations
Examples of compliance costs
- Staff and administration services needed to develop and
monitor systems and to compile data as required
- Costs of implementing risk management systems that
the bank would not use if not required to do so by the
regulator
To ensure compliance
Banks provide APRA reports and statistics
- APRA analyses returns and risk management systems
External auditors report to APRA on
- Reliability of banks statistical data
- Observance of prudential standards
- Risk management systems
On-site inspection reports by APRA staff
- Credit risk (since 1994)
- Market risk (since 1995)
APRA with non-compliance
Issue a formal direction
- If the bank does not follow the direction
Its authorisation may be revoked, and
Individuals involved may be subject to criminal
proceedings
Transfer the powers of the bank board to a statutory manager
this may be APRA or an administrator appointed by APRA
APRAs data analysis
APRA assesses each bank using a system called Probability
and Impact Rating System (PAIRS)
It then decides what supervisory Oversight and Response
System (SOARS)
PAIRS
APRA analyses the data and constructs internal ratings using a
system called Probability and Impact Rating system (PAIRS)
PAIRS estimates
- Probability of insolvency/failure of the institution
- Impact of that insolvency on the Australian financial
system
Probability of insolvency =
Inherent risk
- Default risk, balance sheet risk, market risk, insurance
risk, opertional risk, liquidity risk, legal and regulatory
risk, strategic risk, contagion and related party risk
MINUS management and control
- High quality management and control mitigates risk
MINUS capital support
- Current levels of capital and earnings and access to
additional capital
Impact of insolvency
Depends on primarily on the institutions Australian residential
total assets
- Insolvency of larger banks is expected to have a greater
impact on the Australian financial system
PAIRS construction
1. An index for probability of failure (insolvency)
1 (lowest risk) to 256 (highest risk)
2. An index for impact
3. A Supervisory Attention Index (SIA)
PAIRS example
ABC Bank has
A probability index of 10
Total assets of $320m
There for its impact index = 320/200 = 1.6
ABC Banks PAIRS Supervisory Attention Index
SOARS
SOARS is the Supervisory Oversight and Response System
APRA uses PAIRS to analyse the level of risk for each ADI
- PAIR probability rating based on the banks probability
index
Ratings = low, low-medium, high-medium, high,
extreme
- PAIRS impact rating based on the banks impact index
Ratings = Low, Medium, High, extreme
It then uses SOARS to decide what type of regulatory
supervision to apply
Supervisory response will depend on each banks overall
position according to a table
Regulatory response may include
- Normal supervision, Oversight, Mandated
improvement, Restructure
Normal
Entity is not expected to fail
Typical supervision activities
- Prudential reviews according to a regular cycle
- Analysis of data normally submitted
Oversight
Entity is not expected to fail but there is some concern
Typical supervision activities
- More frequent prudential review and collection of data
- Communication with auditors
- Request for revised business plans
- Expressing concern to bank management and where
applicable to overseas regulators
Mandated improvement
Entity is not expected to fail immediately but serious long
term concerns requiring urgent action
Typical supervision activities
- Rectification plans and monitoring milestones
- Revised business plans increased capital requirements
- Issuing directions
- Enforceable undertakings (exit a risky business)
- External resources to report to APRA
Restructure
APRA has lost confidence in the entity
- Needs new capital, management or owners
- Aim to minimise losses to depositors
Typical supervision activities
- Withdraw licence
- Replace persons and/or service providers
- Merge entities
- Run-off existing business
- Quarantine assets
- Appoint a provisional liquidator
- Issue directions or sanctions
- Place the company into receivership/liquidation
Deposit insurance
Banks play a crucial role in
- Funding the company
- Providing a payments system
- Safeguarding savings
This relies on confidence in the banking system
- If depositors lose confidence, there is a bank run as
depositors all try to withdraw their funds
- Banks cannot repay all deposits at once
A bank run can bring finance to a halt
Provides small depositors protection against their loss of
deposits in the case of bank failure and so
- Protects the savings of unsophisticated depositors
- Protects the stability of the financial system by
preventing bank runs
Explicit deposit insurance is a publicly announced system
which guarantees deposits up to a certain limit should a bank
become insolvent
Implicit deposit insurance is where no explicit scheme exists
but depositors believe the government will rescue them
should a bank, particularly a too big to fail bank have
trouble
Depositor protection in Australia
The banking act (section 12) requires APRA to protect
depositors but does not say how. Section 13A(3) allows it to
take over a bank to protect their interests
While no depositors had los money, they could. It was not a
guarantee
Due to the GFC, the Australian government, like other
countries, temporality guaranteed ADI deposits on 12 October
2008
It was later replaced by the financial claims scheme
Financial claims scheme
The FCS differs from deposit insurance schemes overseas as it
currently entails no premiums or other inspections APRA
administers it
The government will fund APRA to pay the first $250,000 of
ones deposits within a short time of an ADI failing. The failed
ADI would then be liquidated and the government gets repaid
from the proceeds. If insufficient, the remaining ADIs are
levied to cover the shortfall
Depositors could still lose any amounts in excess of $250,00
with that institution
The FCS covers 99% of Australian bank accounts and 82% of
household deposits
Advantages of deposit insurance
Clearly separates safe deposits (for small depositors) from
other risky investments
Large uninsured depositors are encouraged to monitor the risk
of banks rather than assuming implicit insurance
Costs are fair instead of the tax payer providing for implicit
insurance
Encourages competition since small banks are seen as equally
safe as large banks
Stops bank runs and supports the stability of the financial
system
More certainty about what will happen if a bank does fail
- Less time spent tying to work out what to do
Disadvantages of deposit insurance
Moral hazard problem where there is deposit insurance there
is less incentive for depositors to monitor the risk of taking of
banks, there is less market discipline and banks may take
more risk .
With very large banks the government may still come under
political pressure to help the whole bank (including uninsured
depositors)
May limit financial innovation since deposits are protected
there is benefit from developing alternative forms of savings
and investments
