Regulation and Australian Financial System Essay Example

century, there was a significant influx of capital and the creation of channels for British investment. Additionally, foreign exchange markets were established, competition in interest rates was encouraged, and a network of branch banks began to emerge. The growth of the banking industry during this time was fueled by the rapid expansion of the pastoral sector.

In the latter half of the century, the discovery of gold in Victoria in the 1850s played a crucial role in driving growth. This led to the establishment of over 30 new colonial banks as well as several British banks. By the 1890s, more than 1000 branches had been set up, making retail branch banking widely accessible.

The history of Australian banking experienced a significant turning point during the 1890s depression. In the 1880s, Australia witnessed a surge in investment, mainly driven by extensive building projects and speculation in the property market. Meanwhile, banks faced fierce competition from non-bank financial institutions like building, pastoral, and mortgage companies and took on more risk to maintain their market share in the 0-3 market. As a result, when the real estate market collapsed during the depression years, several banks experienced financial crashes. This event highlighted to the banking industry the necessity for improved prudential practices (Peat Marwick 1985: 1). From 1891 to 1893, only 10 out of 64 banks were able to avoid closure or payment suspensions for various durations (Gollan 1968: 28).

The outcome was the consolidation of the industry into fewer functioning banks. Additionally, it sparked a demand for a national bank similar to the Bank of England and for a paper currency to stabilize and safeguard the financial system (Gollan 1968:18). However,

the establishment of a central bank had to be postponed until Federation occurred (Lewis and Wallis 1997:49). The development of the central bank commenced with the Federation of the Australian states into the Commonwealth in 1901, granting the Commonwealth parliament authority to legislate banking and currency matters.

In the months following the Commonwealth's inauguration, banks were asked to provide their views on a banking act, specifically regarding note issue control. The discussion on establishing a national bank and its responsibilities continued for ten years as different models were examined. The Commonwealth Bank was established in 1911 through the Commonwealth Bank Act. It was authorized to offer both savings and general banking services with backing from the Federal government.

The Commonwealth Bank, originally founded to compete with commercial banks and manage government accounts, was not initially responsible for central banking or issuing notes. However, in 1910 the government took over note issuance from private banks and eventually transferred this duty to the Commonwealth Bank in 1924 (with interim oversight by the Australian Treasury). Throughout its history, the Commonwealth Bank grew to become a prominent government banker.

The original plan for the Commonwealth Bank was to become a central bank like the Bank of England. In 1924, an amendment to the Commonwealth Bank Act created a Commonwealth Bank Board and gave the Bank the power to discount bills and set a discount rate. This was intended to establish central banking principles, but it took fifty years before the discount rate was used as a tool for monetary policy (Lewis and Wallis 1997: 49). During the depression in the 1930s, Australian banks had fewer closures and mergers compared to those in

the 1890s.

During the Great Depression of the 1930s, it became clear that economic growth and employment were closely linked to the stability of the financial system. As a result, there was an extensive examination of banking activities, leading to the creation of the Royal Commission into Money and Banking in 1936-37.

The findings of this Commission resulted in a series of recommended measures aimed at ensuring stability within Australia's financial system. These recommendations were primarily implemented through the Bank Act and Commonwealth Bank Act of 1945.

These acts officially granted central bank status to the Commonwealth Bank. This new designation gave the bank authority over setting interest rates, regulating lending by private trading banks, and requiring these banks to keep a portion of their funds with it.

The enactment of the Banking Act (1959) aimed to regulate bank expansion and required them to obtain licenses. This caused a conflict between the Commonwealth Bank, which had both central banking and commercial roles, and private trading banks who claimed that the Commonwealth Bank had an unfair advantage in the industry. As a result, the functions of trading and central banking within the Commonwealth Bank were separated. In 1960, both the Banking Act (1959) and the Reserve Bank Act (1959) led to the establishment of the Reserve Bank of Australia (RBA).

Origins of Financial Deregulation

The regulatory system following World War II was designed to directly restrict bank activities with monetary and supervisory objectives.

The regulatory regime had a negative impact on the banking industry, limiting its operational flexibility and competitiveness. One limitation was the inability of banks to attract funds because of interest rate ceilings imposed on deposit accounts. Moreover, trading bank approvals

were subjected to guidelines that restricted lending opportunities. Savings banks also faced restrictions in offering housing loans as they were mandated to hold a majority of their assets in cash, government securities, or central bank deposits.

The growth of non-bank financial intermediaries has played a crucial role in addressing the gaps caused by constraints on banks. This includes merchant banks, which cater to corporations, and building societies, which serve the home lending market. From 1955 to 1980, not only did commercial banks' market share decrease, but their assets also declined relative to GDP. This had significant implications for monetary policy that relied on direct controls on banks and raised prudential concerns. Australian authorities recognized this trend early and implemented deregulatory measures during the 1960s and 1970s. These efforts aimed to strengthen banks' position and establish influence over the broader financial system. For instance, in 1972, maximum rates on large overdrafts were eliminated and in 1973 interest rates on certificates of deposit were liberalized, granting some flexibility to banks in managing their liabilities.

However, regulation primarily concentrated on the domestic market and competition between domestic institutions. When regulations were relaxed in certain areas, it led to increased pressures on the remaining regulations. By the 1970s, these pressures were exacerbated by the growing sensitivity of capital flows to interest rates. This was largely due to the establishment of merchant bank subsidiaries of foreign banks, which had access to funds from their parent organizations abroad. The volatile nature of these capital flows, coupled with a fixed exchange rate, made it challenging to control domestic liquidity and worsened the impact of differing regulations within the financial system.

The purpose of the 1979

Campbell Committee inquiry was to address various issues within the Australian financial system. One such problem involved the central bank's responsibility to provide funding for any government debt shortfall caused by ineffective debt-raising methods, which posed challenges in managing liquidity. The inquiry also acknowledged the increasing significance of non-bank financial institutions (NBFIs) and the need to evaluate regulatory changes implemented sporadically throughout the 1960s and 1970s. Ultimately, the primary aim of the Campbell Committee was to examine and assess financial system regulation, control, and structure with a view to promoting efficiency and stability.

The Inquiry suggested that regulations hindering efficiency, such as interest rate controls and lending restrictions, should be removed. They also recommended strengthening prudential oversight to enhance stability. The Campbell Committee's report argued that deregulation would improve the financial system's efficiency in three ways: by eliminating barriers to savings being invested in high-yielding opportunities, reducing interest rate margins maintained by Australian banks, and encouraging financial innovation to meet consumer needs. The Committee proposed various reforms, including removing interest rate ceilings and maturity restrictions on bank deposits, introducing a tender system for selling government securities, relaxing portfolio controls on savings banks, and lifting capital controls and restrictions on foreign bank entry. These recommendations were implemented in the early 1980s. Additionally, the Campbell Committee recommended floating the Australian dollar as it became recognized both domestically and globally that maintaining a fixed exchange rate with mobile capital was incompatible with pursuing an independent monetary policy.

The floating of the Australian dollar in 1983 was driven by concerns about speculation against the currency and prompted broader considerations. The government acknowledged the need to allow time for various stakeholders to

adapt to the recommendations outlined in the Campbell Report, as they were accustomed to a heavily regulated environment. As a response, the new Labor government conducted an investigation into the financial system in 1983, taking into account both their own economic and social objectives as well as the recommendations from the Campbell Report. The resulting Martin Report strongly endorsed these recommendations and solidified the government's commitment to deregulation. Consequently, significant recommendations from both reports were quickly put into effect (Lewis and Wallace 1985).

Developments after Deregulation

During the early 1980s when deregulation took place, Australia witnessed rapid transformations within its financial sector. Between 1983 and 1988, capital within this sector surged from $4.5 billion to $20 billion. Additionally, there was a notable increase in banking groups operating in Australia from 15 to 34, while merchant banks grew from 48 to 111.

From 1983 to 1988, 2 Credit experienced a significant increase of 147%. However, this growth resulted in unforeseen issues. The decrease in barriers to entering financial markets led to heightened competition, which in turn fueled technological advancements and provided consumers with greater options. Deregulation played a key role in enhancing the sector's efficiency by redirecting efforts towards innovation and away from obsolete regulations. Additionally, deregulation expedited the impact of globalization on the Australian market.

Technological advancements reduced the costs of international transactions, while deregulation eliminated barriers, allowing markets to become more global. This contributed to the rapid changes occurring in financial markets. However, these changes also presented new challenges for regulators. Product innovation led to a blurring of boundaries between financial instruments and institutions. Since regulations still followed traditional institutional lines, providers were able to exploit regulatory gaps.

For example, non-bank financial institutions offering savings products multiplied because they were not subjected to the same strict regulations as banks. Additionally, non-financial service competitors (such as retailers, airlines, and telecommunications companies) entered the industry by offering financial services to consumers.

The financial system underwent changes that resulted in the expansion of products and distribution channels beyond traditional banking, insurance, and stock broking categories. This expansion necessitated regulatory measures to ensure fair competition between institutions offering similar products. The rise in consumer knowledge and the increased accessibility of product information further fueled this transformation. Additionally, demographic factors like an aging population and government efforts to encourage retirement savings contributed to shifts in consumer preferences.

The importance of deposits as a form of savings has declined, and there have been specific developments in the post-deregulation environment that have prompted a review of the financial system. Corporate gearing increased significantly in the 1980s, driven by a rise in highly leveraged corporate takeovers from 1984-87. Credit growth after 1987 was largely fueled by a property boom. Lower credit quality can be attributed to various factors, and banks took time to adjust their risk assessment procedures.

In the deregulated environment, banks were able to take on riskier borrowers and had to consider exchange rate and interest rate risks more than before (Valentine 1991). This led to excessive borrowing as investors took advantage of rising asset prices due to high inflation and a tax system that incentivized borrowing for capital investments. As interest rates increased, credit standards weakened, resulting in higher levels of non-performing loans and write-downs. This caused significant losses at two of the largest banks, the re-capitalization or

takeover of state-owned banks, and the closure of some financial institutions. Foreign banks also had a significant amount of non-performing loans during the early 1990s recession. Non-performing loans in the foreign bank sector reached a peak of 12% of total assets, twice the peak in the overall system.

The higher proportion of non-performing loans in the foreign bank sector, despite the experience of their parent institutions, suggests that domestic banks may have taken actions to protect their market share, possibly leading foreign banks to engage in riskier business. Domestic banks responded to the potential competition from foreign banks in the early 1980s through mergers, acquisitions, and increased lending, long before deregulation and before any foreign banks had actually entered the market. In managing country currency risk, the shift to a floating exchange rate in 1983 was a response to pressure from capital inflows rather than outflows, which is more commonly seen in other countries. However, there was a learning phase for agents to understand and handle currency mismatches. In the immediate post-float period, some agents took advantage of lower interest rates abroad by borrowing in foreign currencies without hedging.

Many farmers and small businesses borrowed significant amounts in Swiss francs. When the exchange rate dropped dramatically in 1985 and 1986 (approximately 40%), these borrowers faced substantial losses, resulting in many business closures. The primary issue regarding the Swiss franc loans was the failure to recognize the associated risks. The problems faced by farmers received significant publicity, which ultimately helped educate the corporate sector about the importance of managing risks. Although Australia managed to avoid a complete banking crisis during this period, the consequences were long-lasting. The economy's

recovery from the recession of 1990-1991 was hindered by the necessity for banks and corporations to rectify their financial situations.

The Australian Banking Industry Inquiry in 1991 was established to investigate concerns about the performance of the banking sector in a deregulated environment. The report aimed to enhance bank supervision and address weaknesses identified during the late 80s/early 90s. Regulatory adjustments were made to overcome issues raised in the 1980s and 1990s, including coordinated supervision of banks and non-bank financial intermediaries, as well as the implementation of regulations in the insurance and superannuation industries. The financial system underwent substantial transformation during this period and continued to experience significant change. In 1996, in response to these developments and the anticipated impact of globalization, the Government initiated a new inquiry known as the Financial System Inquiry or the Wallis Inquiry to review these changes and propose further enhancements to regulatory arrangements.

The Inquiry was established to provide recommendations on regulatory arrangements that would address the developments of the previous decade and ensure an effective, flexible, competitive, and responsive financial system. The main objectives of the Wallis Inquiry were to enhance competition for greater efficiency and to maintain confidence and stability in the financial system while allowing for responsiveness to market developments and innovation.

According to the findings of the Inquiry, the level of prudential regulation should be proportionate to the extent of market failure it addresses. However, this regulation should not include a government guarantee for any part of the financial system. The primary responsibility for keeping the promises made to consumers lies with the board and management of financial institutions. Prudential regulation and supervision should only serve as

an additional measure by promoting sound risk-management practices within firms and facilitating the early detection and resolution of any financial issues.

The Inquiry suggested that while some degree of prudential regulation is necessary, stricter forms of regulation should be gradually reduced over time. Instead, the focus should be on monitoring the behavior of market participants and ensuring transparent disclosure of information. The Wallis Committee's financial regulation framework, as outlined in its Final Report of March 1997, aimed to be adaptable to ongoing changes in the financial sector. In general, the evolving market requires a shift in regulatory philosophy towards increased reliance on disclosure and market-based signals, rather than highly specialized prudential or industry-specific regulation. The majority of the Wallis Inquiry's recommendations were accepted by the Australian Government and implemented accordingly (Costello 1997).

The key recommendation of the Wallis Inquiry was to introduce a new organizational framework for regulating the financial system. The recommended model proposed three regulatory entities based on functional objectives. These entities include a single prudential regulator, a regulator responsible for conduct and disclosure, and an institution accountable for systemic stability and payments. Prior to the Wallis Inquiry, the regulatory framework employed a sectoral approach, where different regulatory institutions oversaw specific industries within the financial sector. However, following the Wallis reforms, the Reserve Bank of Australia (RBA) assumed responsibilites for monetary policy, overall financial system stability, and regulation of the payments system.

The RBA's main focus is on maintaining stability in the financial system, which includes the payments system that plays a crucial role in maintaining stability. The RBA is responsible for systemic stability and works closely with other financial sector regulators to monitor

it. One significant change to the RBA's functions was the removal of its responsibility for prudential supervision of banks and depositor protection. This change aimed to make it clear that although the RBA can intervene to support systemic stability, its balance sheet cannot guarantee deposits and it clarified the accountabilities for regulatory tasks.

The Australian Prudential Regulation Authority (APRA) gained control of prudential regulation for deposit-taking institutions, general insurance, life insurance, and superannuation. As a result, all prudentially regulated entities in the financial system fell under Commonwealth jurisdiction and were regulated by a single agency. This eliminated artificial and anti-competitive differences between similar product providers and aided in regulating financial service conglomerates. Before the Wallis reforms, prudential regulation was divided among multiple agencies at both the Commonwealth and State government levels.

The Australian Securities and Investments Commission (ASIC) was tasked with the responsibility of maintaining market integrity, protecting consumers, and supervising companies in the financial system. These responsibilities were transferred from multiple regulators to minimize inefficiencies, inconsistencies, and regulatory gaps that hindered effective competition in financial markets. To effectively carry out their role, the regulators were granted significant operational independence from the Government in administering legislation and handling specific cases in prudential supervision or conduct and disclosure. The enabling legislation outlines the clear goals and responsibilities of the financial sector regulators. The Federal Government bears the responsibility for establishing the overarching regulatory framework for the financial sector, while the regulators are accountable for the day-to-day supervision of financial institutions and markets.

The Government, represented by its ministers in the Treasury portfolio, is responsible for setting the overall policy direction and priorities for regulating the financial sector. They are

also responsible for introducing new legislation or making amendments to existing legislation through proposals presented to Parliament. To assist in this role, the Government established the Financial Sector Advisory Council (FSAC) in March 1998. FSAC is a non-statutory body that brings together various participants in the financial market to provide advice on policies that promote the growth of a strong and competitive financial sector. The regulatory structure in Australia, which aligns regulatory bodies with their specific objectives and consolidates oversight of financial institutions, follows similar trends observed internationally. Countries such as Canada, Denmark, Norway, Sweden, and the United Kingdom restructured their regulatory systems in the late 1980s and early 1990s by establishing a single prudential regulator independent of the central bank. The regulatory framework implemented after the Wallis Review has also served as a model for regulatory changes in other countries.

A number of countries have created a single financial sector regulator, while others have adopted arrangements similar to those in Australia. In Australia, private sector general insurers are regulated by APRA under the Insurance Act 1973. However, it was recognized that the prudential arrangements outlined in the Act were becoming less effective and adaptable in a rapidly changing market and regulatory landscape. Factors such as globalization, convergence, and advancements in both domestic and international regulatory practices had necessitated more flexible and advanced approaches for regulators to effectively oversee the general insurance sector.

In 2000, the Government announced the reform of the regulatory framework for the general insurance industry. This new framework started on July 1, 2002, with a phased implementation of capital requirements by July 1, 2004. The main objective of developing this new framework was

to create a safer environment for policyholders. The revised Insurance Act strengthens the requirements for general insurers and grants APRA increased enforcement powers. These amendments aim to make the Insurance Act more flexible and less restrictive compared to previous legislation, allowing the prudential regime to adapt to market developments more easily over time. APRA's authority to establish standards ensures that the framework can effectively respond to changes in commercial and international best practices.

Australia has aimed to create a regulatory framework that can adapt to future changes in the global landscape. However, the financial sector has been thriving in the Australian economy, and this trend is expected to continue. As globalization, financial convergence, and new technologies shape the business environment, the structure and operation of the financial sector will evolve. Consequently, regulating the financial sector will remain an ongoing and dynamic challenge.