THE NBFl REFORMS

by JEFF CARMICHAEL*

On 1 July of this year building societies and credit unions came under new legislation. The reform process that culminated in this legislation brought the Statebased financial institutions under a nationally coordinated system of prudential supervision similar to that which has faced banks for over a decade. My paper focuses on these standards. In particular, it focuses on the differences between these standards and those facing banks. But first, I should give a brief background to the reforms themselves.

The reform process By the end of the 1980s banks had re-established their pre-eminence in

Australia's financial system. These banks had been enjoying the benefits (and I should add, some of the dangers) of a decade of financial deregulation. During that decade they had clawed back market share from merchant banks, finance companies, building societies and credit unions-all of which had previously exploited the inability of banks to compete because of heavy regulation. .

The irony was that the State-based financial institutions-building societies and credit unions-had gone from being one of the growth industries of the 1970s to a steadily shrinking industry in the 1980s. In a financial system in which financial institutions were barely distinguishable in terms of their services, the State-based institutions laboured under a heavily prescriptive and fragmented system of regulation that was totally inappropriate to the modern financial environment.

At about that time, Queensland, which had probably the most restrictive legislation of any of the States, commissioned an inquiry into the industry. During the term of the inquiry, Pyramid Building Society collapsed. 'Ib some, Pyramid was a disaster, to others it was a opportunity to press for long overdue reforms. While Pyramid may have been an extreme case, it was not the only problem with the industry. Pyramid was symptomatic of an approach that ran through the industry in a number of States. In a sense, Pyramid was convenient in that it focused minds on the more general problems of the industry. It acted like a catalyst. In particular, it highlighted the enormous interstate differences that existed in legislation and the way in which that legislation was being enforced.

The problem was more than just a matter of dissolving the various pieces of legislation into one. The interstate barriers of non-uniformity had

Australian Financial Institutions Commission.

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unbalanced the playing field. In Queensland, building societies, for example, were restricted to lending only against fully-insured mortgages. In Victoria, some building societies were little more than property development companies.

The need for national uniformity was overwhelming both for the national image of the industries involved and for any semblance of sensible interstate trading. Pyramid provided the catalyst for uniformity to become a reality. It created an air of Cooperation probably never before seen among the States. They simply didn't want to see anything like Pyramid happen again. This unique level of cooperation culminated in the Heads of Agreement at the 1990 Special Premiers' Conference and the subsequent 1991 Financial Institutions Agreement.

If, even then, you had asked me whether it would be possible that, within 12 months, a system of nationally coordinated legislation and supervision was a possibility, I would have said you were mad.

That such a system had become a reality is a tribute to the dedication of the people involved in the Implementation 'Igsk Force. In putting together the legislation they had to legislate:

for the future of over 400 institutions; in two separate industries; across eight jurisdictions: and for institutions regulated directly by some 25 different Acts.

They had to consult widely with the industry, and reach agreement among 20 or so officials from:

State lleasuries; Departments of Attorneys General; Registrars; Corporate Affairs; Cooperatives; Commonwealth Government; and Reserve Bank. It was a non-trivial exercise. And, to make matters more difficult, they

had to keep the process moving quickly enough to prevent the wheels from falling off the new cart of State cooperation.

The prudential standards Following the approach set down in the banking industry, the Financial

Institutions Scheme separates the roles of legal existence and prudential supervision. The Finance Institutions Code handles issues associated with existence. Supervision is delegated to the Australian Financial Institutions Commission. AFIC's role is to set the prudential standards and to oversee their coordination among the States. Implementation of these standards is through a system of State Supervisory Authorities. At present, there are five of these SSAs, with a number of the smaller jurisdictions electing to subcontract their supervisory duties to the larger States.

In designing the standards, we were guided by principles set out in the

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Financial Institutions Scheme that are very similar to those adopted by the Reserve Bank, namely, “the protection of the interests of depositors and protection of the financial integrity and efficiency of the State Based Financial Institutions”.

Further guidance was provided by the legislation. Section 10 of Part 2 of the Code spells out a number of principles, including that: the standards should preserve for these institutions an on-going role in the Australian financial system; supervision should be aimed at the prevention of problems; supervision should include a role for on-site inspections; supervision should not shift responsibility from the boards and management of financial institutions; and the supervisory arrangements should be uniform across States.

Beyond these principles, our main reference point was the banking prudential standards followed by the Reserve Bank. These we found very helpful as a starting point. Indeed, one should probably acknowledge the parentage of the Basle Agreement for all superhsory standards, including our own. But they were just a stating point and only that.

There are several important reasons why the standards established for State-based financial institutions diverge from those for banks:

first, the legislation required them to diverge in several areas (for example, in the role played by special services providers); second, there are some important areas in which State-based financial institutions are quite different to banks (in particular, they are not backed by the RBA-AFIC cannot issue liabilities that are generally accepted as part of the liquidity base of the financial system). Thus liquidity manage- ment, for example, had to be approached differently; third, there were some areas where we wanted to diverge from the RBA for practical reasons (I will mention these in a minute): and finally, and most importantly, the system of having a single standard- setting body, with a series of decentralised State supervisors implementing the standards requires a different level of detail in the standards (some have criticised the detail as being too prescriptive but, in most cases, the written word has an RBA parallel in practice)-the need for national uniformity demands it. The three main elements of the standards are: risk management, capital

adequacy, and disclosure. It is in the second and third of these that the non- bank standards diverge most from banking standards. The working level approach also diverges to the extent that the AFIC approach includes a major role for on-site inspections.

With risk management we have identified five main areas of risk run by any financial institution: liquidity risk, market risk, credit risk, data risk, and operations risk.

In all cases, we have required societies to provide to their State Super- visory AQthorities written details of their systems to measure, monitor and manage all these risks.

In addition, there are minimum standards, particularly in the liquidity

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area. There is a prime liquid asset requirement of 10% for building societies and 7% for credit unions; this is comparable with PAR for banks. There is also an operational liquidity level of around 10% for building societies and 8 % for credit unions on average.

There is also a large exposure limit on liquidity. We have taken into account that large exposures in the source of funds can be just as dangerous as large credit exposures. Of particular concern here is that societies do not become too heavily concentrated in the wholesale markets. There is also, of course, a large exposure limit on credit risks. Apart from the detail, AFIC’s approach to risk management is similar to the Reserve Bank’s.

The second step in protecting the interests of depositors is capital adequacy. If a society finds itself in financial distress, depositors must look to capital as their main source of protection. There are two elements in AFIC’s approach to capital adequacy.

As adopted by banking supervisors throughout the world, assets are risk weighted. We have diverged from the detail of the banking model in a few respects. In particular, we have emphasised counter-party risk and collateral value in determining risk weights. By itself, however, the process of risk weighting is not sufficient for depositor protection. The risk categories inevitably lump a lot of different risks together. We decided that it would be unwise to try to define a detailed range of weights from 0 to 100, in fine gradations. The cut-off points would be arbitrary and difficult for super- visors to monitor.

In any case, such an approach would ignore the fact that risks interact. ’Ib account €or these problems, the non-bank standards emphasise a variable capital ratio, starting from a base of 8 % based on an assessment of overall risk. It will be up to the State Supervisors to lift that capital ratio if the overall risks being taken are judged to be excessive. We will assess overall risk through a combination of objective and subjective measures. The objective measure is based on a ratio analysis for Predicting financial distress. The subjective element will come from on-site inspections and from assessment by SSAs. Over time, we hope to develop a more portfolio-based approach to risk evaluation.

Accounting and disclosure is the third leg of our approach to supervision. We saw this as a fundamental element of depositor protection. We have taken the Australian Accounting Standards as our base. Within those standards we have set certain minimum standards with respect to key areas, such as provisioning for bad and doubtful debts, depreciation, accounting for fee income and so on. We have been fairly tough, but we saw it as essential that there be consistency in accounting treatment. If State Supervisory Authorities are to be able to assess risk across institutions, they must know that they are comparing apples with apples.

Closing comments In a number of small ways we have tried to push the parameters of

supervision forward. If we can make them work in practice, I believe that

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the emphasis on overall risk ratings and high uniform standards of disclosure will prove to be positive steps. I also believe that on-site inspections will prove to be an important element of our approach to supervision.

Let me close by saying that this has been an historic process. The legislation may not be perfect, and I can assure you that the supervisory standards will need to evolve. But the process has been remarkable for doing what I and many others thought would be politically impossible.

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