Australia
Financial Sector Assessment Program: Detailed Assessment of Observance of Standards and Codes

This assessment of the current state of Australia’s implementation of the Basel Core Principles for Effective Banking Supervision has been completed as part of a Financial Sector Assessment Program (FSAP) undertaken in December 2005 by the International Monetary Fund. The assessment team reviewed the legal framework for banking supervision. The team had the benefit of working with a comprehensive self-assessment completed by the Australian authorities, enjoyed excellent cooperation with its counterparts, and received all the information it required. The financial system is relatively large and diversified.

Abstract

This assessment of the current state of Australia’s implementation of the Basel Core Principles for Effective Banking Supervision has been completed as part of a Financial Sector Assessment Program (FSAP) undertaken in December 2005 by the International Monetary Fund. The assessment team reviewed the legal framework for banking supervision. The team had the benefit of working with a comprehensive self-assessment completed by the Australian authorities, enjoyed excellent cooperation with its counterparts, and received all the information it required. The financial system is relatively large and diversified.

I. Basel Core Principles

A. General

1. This assessment of the current state of Australia’s implementation of the Basel Core Principles for Effective Banking Supervision has been completed as part of a Financial Sector Assessment Program undertaken in December 2005 by the International Monetary Fund. An assessment of the effectiveness of banking supervision requires a review of the legal framework, both generally and as specifically related to the financial sector, and a detailed examination of the policies and practices of the institutions responsible for banking supervision.

2. Australia has adopted a functional approach to oversight of the financial system, with the roles and responsibilities of the various agencies broadly divided by regulatory objective. The Australian Prudential Regulation Authority (APRA) is the agency responsible for the prudential supervision of banks, insurers and superannuation funds. The Australian Securities and Investments Commission (ASIC) is the market conduct regulator and also administers the provisions of company law for both listed and unlisted companies. The Reserve Bank of Australia (RBA) has responsibility for payment system oversight and overall financial stability. The federal financial intelligence unit (FIU), the Australian Transaction Reports and Analysis Centre (AUSTRAC), has a dual role as both an FIU and anti-money laundering and countering the financing of terrorism (AML/CFT) regulator. As the AML/CFT regulator, AUSTRAC is responsible for ensuring compliance with current AML/CFT legislation. With respect to banking and other financial services issues, the Treasury is responsible for the preparation of laws and regulation and provides the Treasurer with policy advice. Legislation confers on the Treasurer certain responsibilities and the Treasurer might also play a role in financial sector supervision through issuing directions to APRA and ASIC. With respect to AML/CFT, the Attorney-General’s Department is responsible for the preparation of laws and regulation and provides the Minister for Justice and Customs with policy advice.

B. Information and Methodology Used for Assessment

3. The assessment team1 reviewed the legal framework for banking supervision, held extensive discussions with the staff of the APRA, ASIC, the RBA, ASIC, the Treasury and participants in the banking and financial markets, and examined the current practice of APRA’s on-site and off-site supervision. The assessment team had the benefit of working with a comprehensive self-assessment completed by the Australian authorities, enjoyed excellent cooperation with its counterparts, and received all the information it required. The team extends its thanks to the staff of the various agencies and the Treasury and in particular to the staff of APRA for their participation in the process and comprehensive self-assessment.

4. Reaching conclusions required judgments by the assessment team. Banking systems differ from one country to another, as do their domestic circumstances. Furthermore, banking activities are changing rapidly around the world, and theories, policies, and best practices for supervision are swiftly evolving. Nevertheless, by adhering to a common, agreed methodology, the assessment should provide the Australian authorities with a reliable measure of the quality of its banking supervision in relation to the Core Principles, which are internationally acknowledged as minimum standards.

5. The assessment of compliance with each principle is made on a qualitative basis. A four-part assessment system is used: compliant; largely compliant; materially non-compliant; and non-compliant. To achieve a “compliant” assessment with a principle, all essential criteria generally must be met without any significant deficiencies. A “largely compliant” assessment is given if only minor shortcomings are observed, and these are not seen as sufficient to raise serious doubts about the authority’s ability to achieve the objective of that principle. A “materially non-compliant” assessment is given when the shortcomings are sufficient to raise doubts about the authority’s ability to achieve compliance, but substantive progress had been made. A “non-compliant” assessment is given when no substantive progress toward compliance has been achieved.

C. Preconditions

6. The preconditions for effective banking supervision are well established in Australia. Over the past two decades, Australia has implemented wide-ranging structural reforms and strengthened the frameworks for monetary and fiscal policies, which have yielded rapidly rising incomes through strong job creation and high productivity growth. The economic expansion that began in 1992 is now in its fourteenth year. The unemployment rate has fallen by 6 percentage points since 1992, supported by more flexible labor markets and welfare reforms. Inflation has remained low and net public debt has been all but eliminated, all in the context of a stable and resilient economy.

7. The financial system is relatively large and diversified. Financial system assets amount to over 300 percent of GDP. Authorized deposit-taking institutions (ADIs, consisting of banks, credit unions, and building societies) account for about half of total financial system assets.2 A further 23 percent of assets are held by life insurers and superannuation funds. Stock market capitalization is also relatively large, at over 100 percent of GDP.

8. The banking system was made up of 238 ADIs, including 14 Australian-owned banks, 11 foreign subsidiary banks, 28 branches of foreign banks, 14 building societies, 158 credit unions, 3 specialist credit card institutions, and 3 ADIs that provide services to member building societies and credit unions. Of the banks, the largest five held some 74 percent of assets, with the bulk of the remainder being held by other domestic banks, locally incorporated foreign banks, and foreign bank branches. The credit unions and building societies play a modest role, with their total assets comprising less than 2 percent of total ADI assets.

Monetary policy framework

9. The power to determine monetary policy is conferred on the Board of the RBA by the Reserve Bank Act 1959, which requires the Board to conduct monetary policy in a way that, in the RBA Board’s opinion, will best contribute to the objectives of the stability of the currency of Australia, the maintenance of full employment, and the economic prosperity and welfare of the people.

10. The RBA Board conducts monetary policy independently of the Government. This is made explicit in the Statement on the Conduct of Monetary Policy agreed between the Treasurer and the Reserve Bank Governor in 1996 and reaffirmed and updated in 2003. The Statement includes a commitment by the RBA to hold consumer price inflation to between 2 and 3 percent, on average, over the course of the cycle. Under the Statement, the Government notes the role that disciplined fiscal policy must play in achieving the inflation objective. Monetary policy is conducted through the cash rate. Open market operations by the RBA in the money market keep the cash rate at or near an operating target decided by the RBA Board.

Currency regime

11. The Australian dollar was floated in 1983 and has become a key economic shock absorber. By moving broadly in accordance with the fluctuations in external demand and commodity prices, the exchange rate has tempered the impact of these fluctuations on Australian economic activity.

Disclosure arrangements

12. Listed companies are subject to a modern continuous disclosure regime, and ADIs (the majority by number are not listed) are subject to specific disclosure requirements which include publication of their annual reports. APRA prescribes key elements to be disclosed, including the entities’ governance and risk-management arrangements, as well as audited financial statements. APRA also publishes financial statement information on the industry.

The legal system

13. The Commonwealth of Australia has a federal system of government which consists of the Commonwealth Government, six State Governments and two Territory Governments. The Australian Constitution (1901) establishes the Federal government and sets out the basis for relations between the Commonwealth and the States. It also provides the system of separation of powers, by providing for the Parliament, the Executive government, and the Judiciary. APRA operates in accordance with Commonwealth law, and the winding up of banks is carried out under Commonwealth law.

14. The Constitution gives the legislative power to Parliament. Proposed legislation must be passed by both Houses of Parliament to become law. The Houses are elected by the Australian people and have equal powers, with minor exceptions. The nominal head of state is the Queen’s representative in Australia, the Governor-General, who acts on the advice of the Executive government.

15. The Executive government administers the law and carries out the business of government through such bodies as government departments, statutory authorities and the defense forces. Only Parliament can pass Acts to create statute law, but these Acts often confer on the Executive the power to make regulations, rules and by-laws in relation to matters relevant to the particular Acts.

16. Australia is subject to the rule of law. The essence of the rule is that all authority is subject to, and constrained by, the law. The rule of law also means that each citizen is equal before the law; that laws must be predictable and known to all; and that laws must be fair and apply equally to the government as well as to those it governs. This includes the openness of courts, judicial independence from government and the presumption of innocence. English common law and equitable principles are the foundation of Australian laws.

17. The Australian court system has two arms: Federal and State/Territory. The constitution provides that the judicial powers of the Commonwealth are vested in the High Court of Australia. High Court judges are appointed by the Governor-General in Council, after extensive consultation and upon the basis of merit. Australian State and Territory courts have original jurisdiction under all matters brought under State or Territory laws and in other matters where the jurisdiction has been conferred on the courts by the Commonwealth parliament. Only a court may exercise the judicial power and examine the question of whether a person has contravened a law of Parliament.

18. The provisions of the Corporations Act that deal with corporate insolvency are primarily concerned with efficient procedures for the winding up of companies, the orderly realization of available assets of those companies and the equitable distribution of the proceeds to creditors, employees and shareholders. There are also provisions governing the appointment of receivers or other persons who are entitled to assume control over particular assets of the company; the reconstruction of companies; arrangements and compromises with creditors; and the voluntary winding up of solvent companies.

19. There are three types of external administration of insolvent companies: liquidation, receivership and voluntary administration. A company comes under external administration when its directors must relinquish direction of its affairs to a receiver, administrator, provisional liquidator or liquidator. Directors have to consider the options for external administration because they are under a legal obligation to cause an insolvent company to cease trading. If they fail to do so they may be held personally liable for the company’s debts.

Accounting and auditing

20. From January 2005, Australia adopted International Financial Reporting Standards (IFRSs) issued by the International Accounting Standards Board (IASB). Some Australian-specific accounting standards have been retained to deal with particular issues, such as disclosure of director and executive remuneration, and concise financial reports.

21. A listed company is required to lodge with ASIC annual and half-yearly financial reports. The financial statements must be prepared in accordance with IFRS and must provide a true and fair picture of the entity’s financial position and performance. The annual accounts must be audited, with the half-yearly reports subject to either review or audit. Large non-listed companies are required to lodge annual statements with ASIC. ASIC has granted some relief to compliance with accounting standards to non-listed companies which are defined as “non-reporting companies.” Exemptions from reporting requirements are also provided for small non-listed companies.

22. The accounting profession in Australia is well established and recognized as being of a high international caliber. In order to audit a listed company’s financial report, the auditor must be registered under the Corporations Act. In order to be registered, ASIC must form an opinion that the applicant has the necessary qualifications, satisfies the auditing competency standard and is capable of performing the duties of an auditor. Oversight of auditors is provided by ASIC and the professional accounting bodies. Disputes over the behavior of auditors are decided by the Companies Auditors and Liquidators Disciplinary board. There are currently 6110 registered auditors. Auditing standards in Australia are established by the Auditing and Assurance Standards board (AUASB), and are based on International Standards on Auditing (ISAs). The Financial Reporting Council oversees the AUASB and the AASB.

Prudential regulation framework

23. Prudential regulation of the Australian financial system (authorized deposit-taking institutions, insurance companies, and superannuation funds) is undertaken by APRA, which aims to ensure that, under all reasonable circumstances, financial promises made by regulated entities are met within stable, efficient and competitive financial markets. Australia’s prudential framework is risk-based, and based on a consultative dialogue between supervisors and regulated entities. The risk-based approach recognizes that management and boards of supervised institutions are primarily responsible for financial soundness of their respective institution. Where difficulties arise, intervention by the regulator will be proportionate to the seriousness of the problem and the level of risk to policyholders and industry.

Mechanisms for dealing with problem banks

24. APRA has a broad range of supervisory powers which escalate from preventative, through to corrective, to failure management:

  • Preventative powers include the authorization framework, the tests of fitness and propriety, and the implementation of prudential standards.

  • Correction powers include court-enforceable undertakings, e.g. agreements between APRA and market participants, and issuing of directions to supervised entities. In serious and/or immediate cases APRA has the power to seek court injunctions.

  • Failure management powers include the ability to apply for the transfer of business of an entity that is in financial distress to a healthy institution; to initiate external administration; and to initiate wind-up.

APRA’s powers and their use in practice are addressed in more detail in the principle-by-principle assessment.

25. The Reserve Bank of Australia (RBA) is able to provide emergency liquidity (as a “lender-of-last-resort”) to distressed ADIs. The stated policy of the RBA is that it would consider lending to an ADI only if it was of the view that the failure of the institution represented a systemic threat. Furthermore, the RBA would not be willing to extend liquidity support to an insolvent institution.

26. The Government has not yet decided whether to introduce some form of explicit depositor guarantees in Australia. At present, there is depositor preference in authorized deposit taking institutions (ADIs). Hence, in liquidation, depositor claims are given priority over other claims on the estate. In the HIH Insurance failure, the Government responded on a discretionary basis to compensate policy holders. In two cases of near-failures of banks owned by State governments, their respective owners ensured that all creditors’ claims were met. The long history of depositors not suffering losses in bank failures, in part due to government intervention, creates the impression that there is an implicit government guarantee of deposits.

D. Detailed Assessment

27. This assessment has been completed against the Core Principles essential criteria, which is the FSAP standard. In the description and comments below references are made to the additional criteria. Australia has a high level of compliance with both the essential and additional criteria, reflecting a supervisory framework and practice which captures almost all elements of current international best practices. In many areas, such as capital adequacy and the overall approach to risk-based supervision, Australia is at the leading edge of current international practice.

Table 1.

Principle by Principle Assessment of Basel Core Principles

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Table 2.

Summary of Compliance with the Basel Core Principles

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C: Compliant.

LC: Largely compliant.

MNC: Materially non-compliant.

NC: Non-compliant.

E. Recommended Action Plan and Authorities’ Response to the Assessment

Recommended action plan

28. Australia has already initiated plans to address the most serious shortcomings in the implementation of the Basel Core Principles for Effective Banking Supervision, which relate to Core Principle 15. It is intended that AUSTRAC will develop the necessary skills and expertise to undertake the needed on-site verification of bank’s implementation of measures to prevent abuse by criminal elements. Coordination and information sharing between AUSTRAC and APRA will be vital in this regard because many of the specific requirements of CP 15 extend beyond the narrow confines of AML/CFT issues. If AUSTRAC is unable to share information with the prudential supervisor, it will not be possible to effectively implement measures to ensure APRA is apprised on a comprehensive and timely basis of any issues that might affect soundness, for instance though reputational risk. It will also be important the APRA receives the full benefits of insights into the broader issues of internal control and compliance than can come from the detailed on-site review of the specific aspects of internal controls that will be undertaken by AUSTRAC.

29. While the provisions to ensure operational independence of APRA fall short of those of the RBA, they currently provide a generally adequate framework to meet the requirements of the Core Principles. The power of the Treasurer to give directions to APRA has not been used; however, it would provide greater certainty regarding the independence of the prudential supervisor if this provision were removed. It would appear possible that making APRA subject to the Financial Management and Accountability Act could lead to a diminution of operational independence, and it would be preferable to maintain the greater independence arising from the current status under the Commonwealth Authorities and Companies Act.

30. Consideration should be given to revising the criteria for Section 11 exemptions to ensure that only institutions which fund themselves on a truly wholesale basis may be exempted from APRA regulation and supervision. An amended and clearer demarcation line between authorized and exempted institutions, better reflecting today’s financial market structures and instruments, would address the current concern that there is little difference in practice between unlicensed and unsupervised finance companies and foreign bank subsidiaries that fund themselves using instruments issued by prospectus which may be easily mistaken, especially by retail investors, as deposits. The revised criteria could be used to ensure that all subsidiaries of foreign banks undertaking bank-like activity in Australia are subject to APRA oversight.

31. APRA’s approach to supervision is commendable, with the PAIRS/SOARS approach reflecting current best practices in risk-focused supervision. The overall approach is still quite new, and subject to ongoing refinement. One area for improvement would be the introduction of greater standardization in off-site analysis. While it is important to avoid a check-list mentality, some of the variation in quality currently observed could be addressed by providing staff with greater guidance to shape their exercise of supervisory judgment.

32. Specific recommendations for individual principles assessed as less than fully compliant are provided below. Additional observations and suggestions are provided in the comments of a number of principles where it is possible, in the view of the assessors, to enhance the already high standard of supervision.

Table 3.

Recommended Action Plan to Improve Compliance of the Basel Core Principles

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Authorities’ response

The Australian Government considers that this has been a high quality assessment and is valuable in assisting it to consider its framework for regulating banks. It shows Australia’s high level of compliance with the core principles.

The authorities are aware of the issues raised in relation to the framework for protection of depositors in the ‘preconditions’ section of the assessment and they have been noted in the Reserve Bank of Australia’s March 2006 Financial Stability Review. The work that is currently being undertaken by the Council of Financial Regulators on the potential introduction of a Financial Claims Compensation Scheme recognizes such community attitudes to support in the event of a failure.

In relation to Principle 1(2) the Australia Government recognizes that, to achieve high quality outcomes in prudential regulation, it is important to have a regulator with operational independence from government. However, it is also an important element of Australia’s system of ministerial accountability that governance and accountability arrangements operate in such a way that regulators follow the policy intention of the parliament when implementing legislation.

The Government considers that the power of the Treasurer to issue directions to APRA on policies and priorities (but not particular cases) strikes an appropriate balance in this regard. The conditions attached to this power, such as discussing the proposed direction with the APRA Chair and tabling the direction in parliament, provide transparency and accountability in its use, such that a direction would only be considered as a final option. To date the Treasurer has not given APRA any directions under this power.

As part of a government wide review of statutory authorities, the Treasurer has agreed to move APRA’s financial framework to the Financial Management and Accountability Act 1997 (FMA Act) from the current Commonwealth Authorities and Companies Act 1997 (CAC Act). Prudential regulation is a core function of government, and the FMA Act is the financial framework that most appropriately applies to agencies delivering core functions. The CAC Act is most applicable to government entities that undertake commercial operations.

The Government does not consider that this change will materially affect APRA’s operational independence or funding. It is APRA’s enabling legislation (the Australian Prudential Regulation Authority Act 1998) that establishes the required level of operational independence necessary to exercise statutory powers objectively. Further, the Government has exempted APRA from a small number of conditions under the FMA Act that may affect its ability to fulfill its duties efficiently and effectively. As a result, the change to the FMA Act will not affect how APRA is funded or reduce its autonomy in deciding how it spends its funding and organizes itself (including its ability to set the employment terms and conditions of its staff) to meets its statutory obligations.

More generally, the Australian Government notes that its overall approach to fiscal policy over the last decade, in which all public sector spending is subject to robust discipline, has served Australia well, ensuring adequate funding for government services and agencies while producing a degree of sustained fiscal responsibility unmatched by many other OECD economies.

On Principle 15, as the IMF has noted, the Government is committed to updating Australia’s anti-money laundering and counter-terrorist financing (AML/CTF) regime to reflect developments in financial crime and revised international standards from the Financial Action Task Force on Money Laundering (FATF).

In keeping with its commitment the Government is closely consulting with industry on a range of reforms. Legislation is expected to be introduced during 2006. The reforms when implemented will bring Australia into compliance with the FATF recommendations and will ensure that Australia’s financial sector, in meeting its obligations, remains robust and internationally competitive.

Processes are currently in place to amend the existing Financial Transaction Reports Act 1988 to allow AUSTRAC to share FTR information with APRA. This will also involve the establishment of a memorandum of understanding between the two authorities. Under the proposed AML/CFT legislation APRA will be included as a partner agency with which AUSTRAC can share FTR information. These arrangements will ensure that APRA is provided with information essential to assessing reputational and liquidity risks within APRA regulated institutions. In addition, APRA and AUSTRAC will continue to improve broader cooperation and coordination arrangements.

In relation to the comments on Principle 22, the Government is currently reviewing the application of merits review to APRA decisions following a recommendation of the HIH Royal Commission and, more recently, a recommendation of the Taskforce on Reducing the Regulatory Burden on Business. The review will take into consideration the need for APRA to be able to take timely decisions where they are necessary to protect the interests of depositors and/or other policyholders. The review will also seek to balance the objective of timeliness with the need to ensure that persons affected by decisions are treated fairly.

Merits review is a key element of Australia’s system of administrative review and, where appropriate, offers the potential for a cost effective and relatively timely review of an administrative decision. In the absence of the availability of merits review, persons affected by decisions would have recourse to judicial review by the courts.

II. Insurance Core Principles and methodology

33. This assessment examines Australia’s observance with the ICP issued by the International Association of Insurance Supervisors (IAIS) in October 2003. The assessment was conducted by Su Hoong Chang from November 30 to December 14, 2005 as part of the IMF Financial Sector Assessment Program (FSAP). The assessment is based on the assessment methodology established by the IAIS.

34. The level of observance for each ICP reflects the assessments of the essential criteria only. Assessment of advanced criteria is not included in assessing observance with ICP. An ICP will be considered observed whenever all the essential criteria are considered to be observed or when all the essential criteria are observed except for a number that are considered not applicable. For an ICP to be considered largely observed, it is necessary that only minor shortcomings exist which do not raise any concerns about the authority’s ability to achieve full observance. An ICP will be considered partly observed whenever, despite progress, the shortcomings are sufficient to raise doubts about the authority’s ability to achieve observance. A Principle will be considered not observed whenever no substantive progress toward observance has been achieved.

35. Separate assessments are made for the life and general industries based on their respective legislation and regulatory regimes. Given the distinct legal and regulatory regimes for the two industries, different observance levels are recorded, where applicable. The assessments are based on a) a comprehensive self-assessment prepared by the authorities; b) a review of applicable laws, regulator/supervisory guidance and procedures; c) analysis regulatory and market data; d) interviews with staff of the authorities, industry participants, industry and professional associations; and e) documentation provided by various interviewees.

36. The assessments are based solely on the laws, regulations and other supervisory requirements and practices that are in place at the time of assessment. The authorities are in the process of reforming certain aspects of the supervisory framework during the FSAP mission. The progress of there initiatives, which have yet to be fully implemented, are noted in the report by way of additional comments.

37. The mission is grateful to the Treasury, APRA, ASIC and ATO for their full cooperation and assistance with the logistical arrangements and co-coordination of various meetings with industry bodies and companies. They have provided comprehensive responses to an extensive questionnaire as well as a thorough self assessment against the ICPs. Discussions with and briefings by the authorities during a series of technical meetings also facilitated a meaningful assessment of Australia’s adoption of international best practices.

Table 4.

Principle by Principle Assessment of IAIS Core Principles

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