Australia has had a relatively stable financial system for most of the past two decades, following considerable disruption at the end of the 1980s and in the early 1990s. Other than the failure of several non-systemic financial service providers, the only major failure since the early 1990s was HIH insurance in 2001.1, 2 This period of stability is the result of a number of factors, including: a stable macroeconomic environment; a strong regulatory and supervisory framework; prudent risk management by financial institutions themselves; and a traditional, comparatively low-risk commercial banking model that remained profitable.
Financial instability limits the financial system’s ability to allocate funds, facilitate payments, transfer risk and create liquidity. Instability can result in losses for users of the financial system and damage to the financial sector’s ability to serve the economy. As shown by the GFC, it can also have severe negative effects on the economy, including low growth and high unemployment, and result in responses that lead to higher government debt. Financial instability can manifest in a number of ways. Most damaging is when several financial institutions fail at once or when a systemically important institution fails. Instability can also lead to large swings in asset prices, markets seizing up, and rapid changes in investor and depositor confidence.
Instability can come from many sources. Regulation is most focused on the parts of the financial system where the consequences of an institution failing are generally highest — such as banking and insurance — although risks can also arise from outside this regulatory perimeter.
Balancing stability and efficiency
A systemic crisis can impose significant costs on the financial system and the broader economy. Globally, a Basel Committee on Banking Supervision (BCBS) literature survey puts estimates of the median cumulative global output cost of a financial crisis over a number of years at around 19 per cent of pre-crisis GDP, if growth returns to trend, or up to 158 per cent of pre-crisis GDP if the crisis has a permanent effect.3 Haldane suggests the cumulative cost could be at least 90 per cent of 2009 world GDP.4
Within a country, the costs of instability are felt in their effect on the financial system, broader economy and in any taxpayer support required to minimise further damage. Academic studies suggest that the average cost of a banking crisis results in real GDP per person falling by 9 per cent and unemployment increasing by 7 percentage points.5 During the crisis, United Kingdom taxpayer exposure to the financial sector peaked at £1.2 trillion (75 per cent of United Kingdom GDP),6 while in Ireland financial sector support increased gross public debt by 40 per cent of GDP.7 The Australian Government did not make a financial loss from its support to the financial system, but seasonally adjusted real GDP growth slowed from 4.8 per cent in the year to September 2007 to less than 1 per cent in the year to September 2009. The seasonally adjusted unemployment rate also increased from 4.0 per cent in August 2008 to 5.9 per cent by June 2009.
Stability can also come at a cost. Many measures to promote stability introduce barriers to entry to the financial system. These may reduce competition, place regulatory costs on financial institutions and reduce the availability of credit during economic upswings.8 Policy makers need to be cognisant of this and balance any loss of efficiency or competition against the benefits of a stable system.
Different financial institutions pose different risks to stability.
The business of banking creates particular risks of failure. Banks are exposed to a wide range of risks through their core activities of credit intermediation and maturity transformation, including credit, liquidity, market and operational risks.
Insurers are less likely to generate or amplify systemic risk within the financial system or in the economy. This is because traditional insurance underwriting risks are less correlated with the economic business cycle and financial market risks. Although, in broad terms, financial market losses do not affect the magnitude of insurance liabilities, insurers do write business and conduct activities that are connected to the financial markets. Thus, the disorderly failure of a large insurer and the consequent cessation of coverage can damage the economy, as seen in the case of HIH.9
Since the Wallis Inquiry, superannuation funds have grown substantially in size and importance to the financial system. They are subject to market risk and so are susceptible to the failure of other financial institutions. However, their current limited direct leverage restricts superannuation funds’ tendency to transmit or amplify financial shocks.
Financial market infrastructure (FMI), including trading platforms, high-value payment systems, clearing and settlement systems, and trade repositories, is the ‘plumbing’ of the financial system. Failure of these institutions could in some instances severely compromise the entire financial system’s operation and be particularly costly.
The shadow banking sector includes many of the non-prudentially regulated financial institutions, such as mortgage finance companies, securities lenders, structured investment vehicles and hedge funds. The sector is a source of financial innovation but can also develop systemic risks. In part, this is because ‘regulatory arbitrage’ can see risky activity move from the regulated sector into the shadow banking sector. It can be difficult to identify risks in the shadow banking sector, as there is often a lack of transparency and relevant data.
Australia’s financial stability relies on its prudential framework. This framework seeks to avoid financial crises and minimise the incidence and cost of financial institution failures, while not unduly limiting competition or impeding innovation. A number of agencies have mandates to promote financial stability in conjunction with the Government, with the Australian Prudential Regulatory Authority (APRA), the Reserve Bank of Australia (RBA) and the Australian Securities and Investment Commission (ASIC) most prominent. For an overview of the regulatory structure, see the Regulatory architecture chapter.
The RBA has an implied mandate for the stability of the entire financial system. In this capacity, it provides ongoing monitoring and analysis of the system, using its public communications to highlight emerging risks. It is the provider of system liquidity and, in a crisis, can act as a lender of last resort.
APRA has responsibility for prudential supervision and financial stability. APRA regulates and supervises banks, building societies and credit unions, insurance companies and most segments of the superannuation industry. In terms of financial stability, its mandate is to set requirements for and supervise these institutions to reduce the likelihood they will fail. If an institution becomes financially distressed, APRA has primary responsibility for ensuring its return to health or managing its orderly failure.
ASIC does not have a formal mandate for ensuring financial stability. However, it provides oversight of a broad range of financial entities that fall outside the prudential perimeter. It can assist with identifying emerging systemic risks, for example in the shadow banking sector.
The GFC was followed by a considerable international policy response. Financial supervisors around the world sought to coordinate their actions and achieve broad consistency across jurisdictions. This process is ongoing, with further change likely over the next few years.
Since 1988, the BCBS — of which Australia is a member — has set global standards to promote banking sector stability. All major economies follow the Basel framework, leading to a relatively consistent global approach to bank regulation, despite some differences in implementation.
Basel III, which was developed in the wake of the GFC, seeks to significantly increase the robustness of banks globally. Australia is adopting some aspects of Basel III earlier than a number of other jurisdictions and, although adhering to the minimum ‘headline’ capital ratios, has been more conservative in some details of its implementation.
The post-GFC era has also seen greater international coordination on policies regarding insurers and FMI. This work has generally been overseen by the Financial Stability Board (FSB) at the request of the G20, with the International Association of Insurance Supervisors (IAIS) developing insurance capital standards and the Committee on Payment and Settlement Systems (CPSS) and International Organization of Securities Commissions (IOSCO) FMI standards.
2 A number of non-prudentially regulated financial service providers have failed, including during the GFC. In some cases these involved significant losses for individual investors but did not destabilise the financial system or discernably damage the economy.
3 Basel Committee on Banking Supervision (BCBS) 2010, An assessment of the long-term economic impact of stronger capital and liquidity requirements, BCBS, Basel.
4 Haldane, A 2010, The $100 billion dollar question, speech at the Institution of Regulation & Risk North Asia (IRRNA), 30 March 2010, Hong Kong.
5 Reinhart, C and Rogoff, K 2009, This Time it is Different: Eight Centuries of Financial Folly, Princeton Press, Princeton, NJ.
7 IMF 2013, IMF Fiscal Monitor, April 2013.
8 See for example Bank for International Settlements (BIS) 2011, Basel III: Long-term impact on economic performance and fluctuations, BIS Working Papers No. 338, BIS, Basel and Lowe, P 2012, Bank Regulation and the Future of Banking, remarks to the 41st Australian Conference of Economists, 11 July, Melbourne.
9 AIG in the United States is an example of a large insurance group failure that had systemic implications. The failure was primarily caused by losses in the group’s non-insurance business.