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BUSINESS
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Lecture 3
BANK REGULATION

BFF2401 Commercial banking and finance

LEARNING OBJECTIVES

Students should be able to:

 Discuss the regulatory environment in which Australia’s
banks and other deposit taking institutions operate
 Outline the licensing/authorisations required for deposit
taking institutions to operate in Australia
 Describe current Australian Prudential Standards
 Discuss the methods used to ensure banks comply with
the regulator’s requirements
 Discuss the benefits and costs of deposit insurance
 Outline examples of regulatory response to COVID-19

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REFERENCES

 Text: Lange et al. (2015), chapter 2, pp.61-70. Also

chapter 18 (please only read a little this week as we cover
this in detail in weeks 9 & 10).
 https://www.apra.gov.au/adi-standards-and-guidance
Note the above link is where you can find various
Australian Prudential Standards.
 www.rba.gov.au
 www.business.gov.au

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LECTURE OUTLINE

 Introduction
– government intervention in Australian banking
– why regulate banks?
 Australian Prudential Regulation Authority
 Current Australian Prudential Standards
 Compliance
 Deposit insurance
 Regulatory response to COVID-19

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INTRODUCTION

Australian government intervention in financial institutions

include:
– General legal infrastructure, e.g. Corporations Law, Taxation law,
Privacy law
– Finance sector specific, e.g.
• Financial Transactions Reports Act 1988
http://www.austrac.gov.au/about_austrac.html
• National Consumer Credit Protection Act 2009
https://asic.gov.au/regulatory-resources/credit/credit-regulation-
background/
• Financial Services Reform Act (FSRA) 2001

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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

* These 3 coordinate their actions through the Council of Financial Regulators

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KEY BANKING LEGISLATIONS

 Banking Act 1959

– Bank must be authorised.
– Depositor priority – depositors have first claim on the Australian
assets of an insolvent bank.
– Bank mergers require Treasurer’s approval (four pillars policy).

 Financial Sector (Shareholdings) Act 1998

– Maximum shareholding (15% unless approved by Treasurer)

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WHY REGULATE BANKS?

• Reduce systemic risk

– Prevent 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

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LECTURE OUTLINE

 Introduction
 Australian Prudential Regulation Authority
 Current Australian Prudential Standards
 Compliance
 Deposit insurance
 Regulatory response to COVID-19

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AUSTRALIAN PRUDENTIAL REGULATION AUTHORITY (APRA)

 Established in July 1998 to consolidate regulations of the

main financial institutions: Banks, Building societies,
Credit unions, Friendly societies, Insurance companies
and Superannuation funds.

 Funded from levy’s placed on its regulated institutions

based on a percentage of total assets subject to an overall
dollar ceiling.

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APRA’s 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

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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)

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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

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LECTURE OUTLINE

 Introduction
 Australian Prudential Regulation Authority
 Current Australian Prudential Standards
 Compliance
 Deposit insurance
 Regulatory response to COVID-19

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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 of the financial
system.

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PRUDENTIAL STANDARDS

 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:
– Risks 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

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CURRENT AUSTRALIAN PRUDENTIAL STANDARDS (APS)

Net Risk
Examples
= inherent risk minus Credit risk
good management & Liquidity risk Capital
control

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CREDIT RISK: APS 220 and APS 221

 Credit risk - the risk to earnings and capital that an

obligor will fail to meet the terms of any contract with the
bank, or otherwise fail to perform as agreed.
 Level of credit risk for a bank depends on
– Credit risk of individual transactions/loans
• i.e. credit quality
– Level of diversification
• Increased diversification reduces risk

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 APS 220 CREDIT QUALITY

The key requirements are that a bank must:

– Have an effective credit risk management system appropriate
to its needs;
– Regularly review its credit risk management system, taking into
account changes in operating circumstances, activities and
risks;
– Have a robust system for the prompt identification, monitoring
and accurate and complete measurement of its credit risk. This
includes recognition of impaired facilities and estimated
future losses on the credit portfolio;
– Maintain provisions and reserves adequate to absorb existing
and estimated future credit losses in its business given the facts
and circumstances applicable at the time.

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APS 220 CREDIT QUALITY (cont.)

Impaired assets:
– Items where ultimate collectability of principal and interest is
compromised
– These include:
• Non-accrual items
• Restructured items
• Other assets acquired through security enforcement (e.g. the
homes or businesses of borrowers who have defaulted on their
loans)

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APS 220 CREDIT QUALITY (cont.)

 Non-accrual items:
– Payments are ≥ 90 days past due and security is insufficient to
cover the amount due.
– Provisions must be made and interest and 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 non-
commercial period for reasons related to the clients’ financial
difficulties.
– To be reclassified to non-accrual if recovery of principal or interest
is in doubt, or provisions have subsequently been struck.

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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 e.g. commercial property

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APS 221 LARGE EXPOSURES (cont.)

 A large exposure is an exposure of 10% (or more) of

the bank’s capital base.
– E.g. if a bank has capital = $100m, any loan of $10m 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.

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 APS 221 LARGE EXPOSURES (cont.)

 Changes to take effect from 1 Jan 2019:

– a reference to Tier 1 Capital as a basis for determining large
exposures;
– a recalibration of existing large exposure limits, and the
introduction of a lower limit on D-SIB to D-SIB exposures; and
– a stronger set of requirements for measuring exposure values,
and for assessing groups of connected counterparties.

*D-SIB: domestic systemically important banks

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 LIQUIDITY RISK: APS 210

 Liquidity risk: Risk to earnings and capital due to the

bank’s inability to access sufficient cash and other sources
of funds to meet day-to-day expenses and commitments
 Each bank must have a comprehensive liquidity policy
approved by APRA.
 It must also conduct a scenario analysis of domestic and
foreign currency liquidity to ensure its continuance.
 Banks must also comply with Basel 3’s Liquidity Coverage
Ratio (LCR).
Stock of HQLA
≥ 100%
Total net cash outflows over the next 30 calendar days

HQLA: high quality liquid assets

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APS 210 LIQUIDITY (cont.)

 Committed liquidity support facility (CLSF) 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 liabilities in specified high quality liquid assets at all
times.

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APS 210 LIQUIDITY (cont.)

 Banks must also comply with the Net Stable Funding

Ratio (NSFR) (from 1 Jan 2018)

Available amount of stable funding

≥ 100%
Required amount of stable funding

 To reduce the funding risk over a one-year time horizon, a

bank is required to fund its activities with sufficiently
stable sources of funding.

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CURRENT AUSTRALIAN PRUDENTIAL STANDARDS

To be covered in week 9 &

week 10

Net Risk
= inherent risk minus
good management &
control Capital

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LECTURE OUTLINE

 Introduction
 Australian Prudential Regulation Authority
 Current Australian Prudential Standards
 Compliance
 PAIRS
 SOARS
 Deposit insurance
 Regulatory response to COVID-19

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COMPLIANCE

 Compliance = banks comply with APRAs’ requirements

 Compliance costs are costs bank 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

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COMPLIANCE

To ensure compliance
 Banks provide APRA reports and statistics
– APRA analyses returns and risk management systems
 External auditor’s report to APRA on
– Reliability of bank’s statistical data
– Observance of prudential standards
– Risk management systems
 On-site inspection reports by APRA staff
– Credit risk (since 1994)
– Market risk (since 1995)

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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
– The administrator may continue to operate the bank, restructure
the bank or wind up the bank.

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APRA’s DATA ANALYSIS

 APRA assesses each bank using a system called

Probability and Impact Rating System (PAIRS).
 It then decides what supervisory action to take using a
system called Supervisory Oversight and Response
System (SOARS).

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PAIRS

 APRA analyses the data and constructs internal ratings

using a system called Probability and Impact Rating
System (PAIRS).
 PAIRS estimates
(a) Probability of insolvency/failure of the institution
(b) Impact of that insolvency on the Australian financial system

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PAIRS

(a) Probability of insolvency

equals

Inherent minus Management minus Capital

risk and control support

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PROBABILITY OF INSOLVENCY

 Inherent risk
– Default risk, balance sheet risk, market risk, insurance risk,
operational 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

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PAIRS

(b) Impact of insolvency

 The potential adverse consequences of an institution’s
failure encompass not only the direct financial impact on the
depositors, policyholders or fund members of a regulated
entity but also the potential for indirect damage to:
• the industry concerned; and
• the broader economic system.

 The impact index is derived with reference to each entity’s

liabilities, and then adjusted further to better reflect the
potential impact of entity failure on beneficiaries and the
wider financial system.

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PAIRS CONSTRUCTION

1. An index for probability of failure (insolvency)

2. An index for impact of failure

3. A Supervisory Attention Index (SAI)

Overall index = probability index × impact index

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PAIRS EXERCISE

 Visit https://www.apra.gov.au/sites/default/files/2018-02-
pairs-guide-ud-external.pdf
 Look at Figure 3 of Chapter 10 on Supervisory Attention
Index (SAI), page 30:
 What is the range of probability index?
 What is the range of impact index?
 What is the SAI of an entity that has a probability index of 16
and an impact index of 225?
 How should this SAI be interpreted?
 What level of SAI would pose potential threats?

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PAIRS EXERCISE (cont’d)

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SOARS

 SOARS is the Supervisory Oversight and Response

System.
 APRA uses PAIRS to analyse the level of risk for each
ADI.
 It then uses SOARS to decide what type of regulatory
supervision to apply.

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SOARS AND PAIRS

SOARS begins by considering two ratings:

 PAIRS probability rating based on the bank’s
probability index
– Ratings = Low, Lower Medium, Upper Medium, High, Extreme
 PAIRS impact rating based on the bank’s impact index
– Ratings = Low, Medium, High, Extreme

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SOARS

 Supervisory response will depend on each bank’s

overall position according to a table (see next slide).
 SOARS comprises four supervision stances:
– Normal supervision
– Oversight
– Mandated improvement
– Restructure

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SOARS STANCES

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SOARS STANCES

(1) Normal
 Entity is expected to remain able to meet their
obligations to beneficiaries under reasonably
foreseeable circumstances.
 Typical supervision activities
– Prudential reviews according to a regular cycle
– Analysis of data normally submitted
– Contact with home regulators for foreign owned entities
– Other risk based supervision activities as determined by
responsible supervision team.

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SOARS STANCES

(2) Oversight
 Entity is expected to remain able to meet their
obligations to beneficiaries over the short to medium
term, but there is some concern about vulnerabilities in
extremely adverse circumstances.
 Typical supervision activities
– More frequent prudential reviews and collection of data
– Communication with auditors
– Request for revised business plans
– Expressing concerns to bank management and where
applicable to overseas regulators

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SOARS STANCES

(3) Mandated improvement

 Entity’s operations or circumstances potentially put
beneficiaries and/or the financial system at risk.
 Typical supervision activities
– Rectification plans and monitoring milestones
– Revised business plans
– Increased capital requirements
– Issuing directions
– Enforceable undertakings e.g. exit a risky business
– External resources to report to APRA

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SOARS STANCES

(4) Restructure
 Non-viability is assessed as imminent, and/or the entity
poses an unacceptable risk to the financial system or to
beneficiary interests.
 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

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LECTURE OUTLINE

 Introduction
 Australian Prudential Regulation Authority
 Current Australian Prudential Standards
 Compliance
 Deposit insurance
 Regulatory response to COVID-19

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DEPOSIT INSURANCE

 Banks play a crucial role in

– Funding the economy
– 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.

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DEPOSIT INSURANCE

 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.

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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 lost money, they could. It was
not a guarantee.
 Due to the GFC, the Australian government, like many
other countries, temporarily guaranteed ADI deposits on
12 October 2008.
 It was later replaced by the Financial Claims Scheme
(FCS).
https://www.apra.gov.au/financial-claims-scheme-0

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THE AUSTRALIAN FINANCIAL CLAIMS SCHEME (FCS)

 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
one’s 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
$250,000 with that institution.
 The FCS covers 99% of Australian bank accounts and 82%
of household deposits.

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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 taxpayer 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 trying to work out what to do…

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DISADVANTAGES OF DEPOSIT INSURANCE

 Moral hazard problem - where there is deposit

insurance, there is less incentive for depositors to
monitor the risk 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 innovations since deposits are
protected, there is less benefit from developing
alternative forms of savings and investment.

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LECTURE OUTLINE

 Introduction
 Australian Prudential Regulation Authority
 Current Australian Prudential Standards
 Compliance
 Deposit insurance
 Regulatory response to COVID-19

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Regulatory Response to COVID-19

 Providing a Small-to-Medium Enterprise (SME) guarantee scheme

 Providing an exemption from responsible lending obligations for
lenders providing credit to existing small business customers.
 Supporting the flow and reducing the cost of credit - Reserve Bank of
Australia
• Supporting Non-ADI and smaller ADI lenders in the securitisation
market
• The Australian Prudential Regulation Authority (APRA)
has announced temporary changes to its expectations regarding bank
capital ratios.

• https://www.business.gov.au/risk-management/emergency-
management/coronavirus-information-and-support-for-
business/coronavirus-sme-guarantee-scheme

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Conclusion

 Introduction - Why banks must be regulated

 Australian Prudential Regulation Authority (APRA)
 Current Australian Prudential Standards
 Focus on APS 210, 220, and 221
 Compliance
 PAIRS
 SOARS
 Deposit insurance
 Explicit versus implicit
 Features of the Australian scheme
 Advantages and disadvantages of an explicit scheme
 Regulatory response to COVID-19

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