Australia Banking Industry Should Australia

Australia Banking Industry SHOULD AUSTRALIA INTRODUCE DEPOSIT INSURANCE in BANKING? INTRODUCTION large number of countries have systems of financial regulation which include deposit insurance. This is not the case in Australia. However recently the Council of Financial Regulators (CFR) has recommended that Australia should introduce a deposit insurance scheme. The Australian Prudential Regulation Authority (APRA) has the power to both authorize and impose prudential standards on the banks in Australia.

According to Thomson and Abbot in the work entitled: "Banking Regulation and market Forces in Australia" published in the International Review of Financial Analysis "Throughout Australia's economic history, economic regulation of the Australian banking system has not been static but has responded to changes in technology, market forces, and the behavior of regulated institutions." (2001) Cull, Senbet and Sorge (2001) state that: "National governments operate formal deposit insurance systems in order to stabilize their financial and payment systems.

However, some economists have argued that deposit Insurance can be socially counterproductive if the system is not appropriately structured and supported by adequate regulatory environments." I.

CURRENT REGULATIONS of the APRA/POWERS of the APRA The Australia Prudential Regulation Authority "oversees banks, credit unions, building societies, general insurance and reinsurance companies, life insurance, friendly societies and most members of the superannuation industry." The APRA is the "prudential regulator of the Australian financial services industry" and is "largely funded by the industries that it supervises." (APRA Online, 2006) the institutions that the APRA supervises hold "approximately $2.2 trillion in assets for 20 million Australian depositors, policyholders and superannuation fund members." (Ibid) Cull, Senbet and Sorge (2001) state that: "National governments operate formal deposit insurance systems in order to stabilize their financial and payment systems.

However, some economists have argued that deposit insurance can be socially counterproductive if the system is not appropriately structured and supported by adequate regulatory environments." It is stated in the work of Jingqing and Johnson entitled: "An Incentive Approach to Identifying Financial System Vulnerabilities" that: "Researchers have shown that three key structural and policy elements shape the incentives faced by the main agents in any financial system: the market structure within which the system operates, the existence of government safety nets, and the legal and regulatory frameworks.

These factors influence agents' propensities to take risks and determine the inclinations of regulators, supervisors, and markets to monitor risk-taking." (2000) the work of Demirguc-Kunt and Detragiache (2001) entitled: "Does Deposit Insurance Increase Banking System Stability? An Empirical Investigation" is an analysis of panel data for 61 countries between the years of 1980 and 1997 which concludes that: "explicit deposit insurance tends to be detrimental to bank stability, the more so where bank interest rates are deregulated and the institutional environment is weak.

Also, the adverse impact of deposit insurance on bank stability tends to be stronger when the coverage offered to depositors is extensive, when the scheme is funded, and when it is run by the government rather than by the private sector." (2001) the Australian general insurance industry is stated to be "now subject to more effective regulatory standards than was the case in the past.

The new framework comprises a three-layered system of regulation: (1) the Insurance Act 1973 (substantially amended by the General Insurance Reform Act 2001); (2) prudential standards; and (3) Guidance Notes." (Somogyi, 2005) In the work entitled: "The Role of Deposit Insurance in Contributing to Financial Stability: A Global Perspective" it is related that John Raymond LaBrosse, Secretary General of the International Association of Deposit Insurers states that: implicit protection is for the purpose of protecting the public "including depositors and other creditors.".."when a bank fails." Implicit protection, according to LaBrosse "is...by definition, never formally specified.

There are no statutory rules regarding the eligibility of bank liabilities, the level of protection promised or the form in which reimbursement will take. By its nature, 'implicit protection' creates uncertainty about how depositors, creditors and others will be treated when a bank failure occurs." (nd) Further related is that "funding is discretionary and often depends on the government's ability to access public funds." (LaBrosse, 2005) II. EXPLICIT DEPOSIT INSURANCE - ADVANTAGES LaBrosse holds that the explicit deposit insurance system "is preferable to any other type of deposit protection.

It is preferable because it clarifies the authorities obligations to depositors and limits the scope of discretionary decisions that may results in arbitrary actions." In order that moral hazard is avoided the system should be: (1) properly designed; (2) well-implemented; and (3) understood by the public." Additionally stated is that."..an explicit systems needs to be part of a well designed financial safety-net supported by strong prudential regulation and supervision, effective laws that are enforced, sound corporate governance and risk management in banks and sound accounting standards and disclosure regimes." (LaBrosee, 2005) LaBrosse states the advantages of 'explicit' deposit insurance to include the factors of the protection of small depositors, support of the stability of the financial system, eliminates runs on the banks by public panic, encouragement of the uninsured depositors in monitoring their bank, provision of more certainty as to what will happen if bank failure occurs.

III. EXPLICIT DEPOSIT INSURANCE - DISADVANTAGES According to LaBrosse the explicit deposit insurance is more complex than are others. The explicit system "can deal with a bank failure or a wave of failures but cannot by themselves deal with a financial system crisis" and as well "the complexities of explicit systems require appropriate skills and resources to be effective. Such skills are in short supply, more so expert practitioners." (LaBrosse, 2005) IV. DISADVANTAGES of EXPLICIT DEPOSIT INSURANCE The 'explicit' deposit insurance system inherently has moral hazards that are presented.

This moral hazard is inclusive of failure on the part of depositors in monitoring the risk-taking of banks which results in reduced discipline in the market and more risk-taking behavior on the part of the banks. Presently the government of Australia operates under an 'implicit' deposit insurance system and mistakenly believes that in the event of bank failure that the government would protect depositors however, without a formal statement this view is not realistic and furthermore, the government regulator's official statement is that there are no guarantees on deposits.

The moral hazard in the implicit deposit insurance system is in that these agreements while "easily announced" are quite difficult at best to "eliminate or reduce" with Japan being offered as an example of exactly this. Stated is that there is a moral hazard "in all parts of the safety net: central banks, deposit insurance and supervisor. Many academics advance that there are alternatives to depositor insurance." (LaBrosse, 2005) Some of those alternatives are stated to be: (1) Market Discipline and Disclosure; (2) Depositor Preference; and (3) Governance Incentives. V.

DOES AUSTRALIA NEED the SYSTEM PROPOSED by the CFR? According to the government in Australia who has identified an issue that it states "would arise on closure of a distressed financial institution, it has also identified an issue which would arise on closure of a distressed financial institution. In these circumstances, there is currently no mechanism for providing depositors/policy holders with access to their funds on a timely basis.

While the relevant legislation give depositors/policyholders first claim on the assets of a failed institution, it makes no provision for timely payments.

Given the lengthy nature of the wind-up process, it could take many months, or even years, before funds are available for distribution." (Council of Financial Regulators - Failure and Crisis Management in the Australian Financial System 2006) This would be expected to results in financial hardship for many homes and businesses and place a great deal of pressure on the Government to "do something." (Council of Financial Regulators - Failure and Crisis Management in the Australian Financial System, 2006) the Council states that this "is an inappropriate outcome both for the more vulnerable members of society" (Ibid) as well as for the Government.

The Council states that it is: "not attracted to the cumbersome pre-funded deposit insurance and financial system guarantee schemes found in other countries. The Council in Australia has proposed a design for a financial claims compensation scheme which states as its mandate that the intention of the council is that the scheme "provide prompt payments to eligible depositors and policyholders, with payments only occurring after a decision to close the institution had been made.

The scheme would not transfer resources to creditors (other than depositors) who would not be eligible for compensation, nor to shareholders of an insolvent institution." (Council of Financial Regulators - Failure and Crisis Management in the Australian Financial System, 2006) the scheme would apply to all banks, building societies and credits unions, life insurers to include friendly societies and general insurers as well as limited superannuation products.

Within the framework of this scheme "only capital certain promises would be covered which are deposits, claims on insurance policies, and guaranteed life insurance savings and annuity products. Not covered are managed investments and ordinary superannuation products. The targeted coverage within the framework of this scheme is that the "more vulnerable consumers such as individuals, small businesses and community organizations" are covered however liabilities existing to "associates....other corporations and liabilities between financial institutions" are not covered in this scheme.

There are restrictions within the framework of this scheme in that each individual, small business or community organization will be able to make "only a single claim against the scheme for each failure of a financial institution..." with all claims that are "relevant" being aggregated. Third parties will excluded from assessing the scheme to avoid a conflict of their rights under the law for making claims against the insured with life insurance policies that recognize the beneficiary ownership rights just as they are recognized under the laws that presently exist.

There is a proposed 28 days grace period so that policyholders are able to find replacement policies. In the area of deposits "monetary limits would cap the cost of the scheme." (Council of Financial Regulators - Failure and Crisis Management in the Australian Financial System, 2006) Claimants will receive 90% of the "full entitlement under the scheme" in initial payouts while the remaining 10% will be paid at a later date. In the area of criteria of eligibility for small businesses and community organization targeting of the beneficiary groups will be required.

In terms of geographic and demographics, it is proposed to apply the scheme only to the financial institution's liabilities in Australia, reflecting the objective of the scheme as a limited customer-protection device." (Ibid) In terms of currency under the scheme the proposal is for application of the scheme to "relevant Australian dollar denominated liabilities" with no coverage in place for paying liabilities in foreign currency.

There will be no netting/set-off in order that the value of assets of the financial institution be preserved as well as there being simplification in the process of value of assets in liquidation being established. (Council of Financial Regulators - Failure and Crisis Management in the Australian Financial System, 2006) Funding and levy arrangements are of the nature that the scheme would be funded post-event.