The Inquiry’s recommendations are designed to enhance the resilience of the Australian financial system, which underpins the strength and efficiency of the economy. The recommendations seek to make institutions less susceptible to shocks and the system less prone to crises, reducing the costs of crises when they do happen, and supporting trust and confidence in the system. They aim to minimise the use of taxpayer funds, protect the broader economy from risks in the financial sector and minimise perceptions of an implicit guarantee and the associated market distortions.
The recommendations seek to strike a balance between system stability and competitiveness, and, where possible, aspire for competitively neutral regulatory settings. In many cases there is little trade-off, as greater stability promotes trust and confidence in the financial system and enhances resilience and long-term allocative and dynamic efficiency.
This chapter describes eight recommendations to strengthen stability settings, applying across a number of sectors.
Banking: these recommendations broadly have two objectives:
- Reducing the probability of failure. Evidence from ADIs, regulators and others suggests that Australian banks’ capital ratios are not in the top quartile of internationally active banks when it comes to capital strength. The Inquiry believes it is in Australia’s interest that they are. To this end, ADI capital levels should be raised. In achieving this, the transparency of existing capital settings and the competitive neutrality of the system for determining risk weights should also be improved. The risk-weighted approach to capital requirements should be supplemented with a leverage ratio that protects against potential weaknesses in the risk-weighting system.
- Minimising the costs of failure. The toolkits available to regulators to prevent distress and resolve failing financial institutions are critical and should be enhanced. ADIs should also maintain sufficient loss absorbing and recapitalisation capacity to allow effective resolution with minimal risk to taxpayer funds, in line with emerging international practice. As this area is complex and evolving, Australia should take a cautious approach in developing requirements for such capacity.
These recommendations, which reduce the probability of failure and minimise the cost of failure when it does occur, are complementary and should not be seen as substitutes for each other. Several of the recommendations focus on an ADI’s liability structure: the mix of different types of debt and equity instruments used to fund the institution. Box 6: ADI liability structures and prudential requirements explains the main categories of instruments and the role these play.
Insurance: Significant reforms took place following the collapse of HIH Insurance Limited (HIH) in 2001, with ongoing subsequent improvements, including a comprehensive review of capital standards in recent years. The regulatory framework continues to change, with health insurers shortly moving to prudential supervision under APRA. Some of the proposals in Recommendation 5: Crisis management toolkit relate to insurance. Beyond these, the Inquiry has not seen a compelling case for further changing stability settings in insurance at this stage. However, as noted in Chapter 4: Consumer outcomes, Government is facilitating greater competition in the North Queensland market by clarifying restrictions on the use of Unauthorised Financial Insurers (UFIs). Should the use of UFIs became widespread, the stability implications should be revisited.
Superannuation: The GFC highlighted the benefits of Australia’s largely unleveraged superannuation sector. The absence of borrowing enabled the superannuation sector to have a stabilising influence on the financial system and the economy during the GFC. Continuing to restrict leverage in the sector will be important for mitigating future risks. The Inquiry recommends limiting borrowing in superannuation funds.
Financial market infrastructure (FMI): Substantial reforms have taken place since the GFC, such as making greater use of FMI for over-the-counter trading derivatives transactions. The Inquiry supports reforms to FMI regulation to strengthen the resolution framework and preserve critical functions in a crisis.
Shadow banking: Australia currently has a small shadow banking sector, which is reviewed annually by the Council of Financial Regulators (CFR). Although the Inquiry is making no direct recommendations to address shadow banking, it is aware that measures to enhance resilience in the banking sector could encourage some activities to move outside the prudential regulation perimeter. This risk is being actively monitored globally.5 In Australia, the CFR should continue to monitor risks in the shadow banking sector to enable prompt responses to notable changes.
More generally, the Inquiry notes that considerable work is continuing in the international arena to enhance financial system stability and that, where possible, Australia should align itself with international developments. Domestically, the CFR agencies continue to work on planning and pre-positioning to ensure they are ready to respond to any emerging threats to stability. The Inquiry is supportive of this work.
Finally, the Financial Claims Scheme (FCS) is a fundamental component in protecting depositors in the system, providing a guarantee on deposits of up to $250,000 per account holder per institution. This is supported by Australia’s system of depositor preference, which further protects depositors from loss. The Inquiry recommends maintaining the current ex post funding model for the FCS, while noting that the cap of $250,000 is relatively high compared to other countries.
5 Financial Stability Board (FSB) 2014, Global shadow banking monitoring report 2014, FSB, Basel.