Financial Stability Review – September 2005 3. Developments in the Financial System Infrastructure

As foreshadowed in the previous Review, later this year Australia will participate in the Financial Sector Assessment Program (FSAP) conducted by the International Monetary Fund (IMF) and World Bank.

A core element in this process will be an assessment of Australia's compliance with a number of internationally accepted standards and codes relating to financial infrastructure. Standards and codes in 12 broad areas are considered by the IMF to be relevant for its work. In Australia's case, the IMF has selected four of these for detailed assessment. These are:

• the Basel Committee's Core Principles for Effective Banking Supervision;
• the International Association of Insurance Supervisors' (IAIS) Insurance Core Principles;
• the International Organization of Securities Commissions' (IOSCO) Objectives and Principles of Securities Regulation; and
• the Committee on Payment and Settlement Systems' (CPSS) Core Principles for Systemically Important Payment Systems.

In addition, a less formal assessment will be undertaken of the CPSS-IOSCO Joint Task Force's Recommendations for Securities Settlement Systemsand Recommendations for Central Counterparties. A separate assessment is being undertaken of Australia's compliance with the recommendations of the Financial Action Task Force, a specialist inter-governmental body, on Anti-Money Laundering and Combating the Financing of Terrorism.

A second element of the FSAP process will be stress testing the capacity of Australian banks to withstand significant unexpected events. This exercise will be co-ordinated by the Reserve Bank and involve the IMF, APRA, the Australian Treasury and a number of financial institutions.

The IMF has already made a brief background visit to Australia to discuss the nature of the assessment. The full ‘mission’ visits, comprising IMF staff and experts drawn from peer-group countries, will take place in December 2005 and in March/April 2006, with the aim of producing a final report to coincide with the conclusion of the regular IMF Article IV Consultation in mid 2006. The Australian Treasury is co-ordinating the work associated with the overall process, with participation by APRA, ASIC, the Reserve Bank and private financial institutions.

Consistent with its policy responsibilities for the stability and efficiency of Australia's payments system and the stability aspects of clearing and settlement systems, the Reserve Bank will play an important role in the assessment process for systemically important payment systems, securities settlement systems and central counterparties. These areas are discussed in further detail below.

3.1 Core Principles for Systemically Important Payment Systems

There is only one payment system in Australia that is likely to be assessed against the Core Principles for Systemically Important Payment Systems – that is, the Reserve Bank Information and Transfer System (RITS). This system is owned and operated by the Reserve Bank and stands at the centre of the Australian payments system. It is a real-time gross settlement (RTGS) system, with individual interbank payment obligations being settled across Exchange Settlement accounts held by each bank at the Reserve Bank. The system is also used for the settlement of deferred net clearing obligations. The reliability of RITS is essential to the smooth functioning of the Australian payments system and the stability of the financial system more generally.

Payments through RITS on an RTGS basis arise from three sources: the High Value Clearing System (HVCS), Austraclear, and cash transfers between RITS participants. The HVCS allows participants to send large-value payment instructions to the RTGS system using the global SWIFT network. HVCS payments make up around 70 per cent of RTGS payments by value, and close to 90 per cent by volume. Austraclear is a depository and settlement system for Australian debt securities. Interbank payment obligations arising from Austraclear are settled in real time in RITS, with securities being transferred in Austraclear at the time the payments are made. These payments account for around a quarter of all RTGS payments by value, and roughly 10 per cent by volume. Cash transfers between RITS participants are generally associated with money market transactions and account for only a small share of total RTGS payments.^[4]

Payments in the cheque, direct entry, debit and credit card, and ATM systems are also settled in RITS, but as a batch on a deferred net basis at 9.00 am on the day after payment instructions are exchanged. Interbank payment obligations arising from ASX equity settlements (in the CHESS settlement system) also settle daily on a deferred net basis, but in a separate batch.

Around 90 per cent of interbank settlements by value occur on an RTGS basis in RITS, with the remainder being settled on a deferred net basis. On an average day, there are around 23,000 RTGS transactions, with a total value of around $135 billion.

In preparation for the FSAP assessment, the Reserve Bank recently conducted a self-assessment of RITS against the CPSS Core Principles. These principles cover a variety of elements relevant to the safety and efficiency of a payment system (see Box D). In addition, the CPSS has outlined four responsibilities of the central bank in applying the Core Principles. While assessments of whether a system complies fully with some of the Core Principles are inevitably subjective, the Bank's view is that RITS performs well against the Core Principles, complying with all nine principles that are considered applicable, along with the four responsibilities of the central bank.^[5]

This positive self-assessment of RITS largely reflects two factors. The first is that Australia has established a sound legal framework for payment systems, based on the 1998 amendments to the Reserve Bank Act 1959, the Payment Systems (Regulation) Act 1998 and the Payment Systems and Netting Act 1998. The Payment Systems and Netting Act has been particularly important in ensuring the legal robustness of settlement in RITS. The Act allows the Reserve Bank to approve RTGS payment systems, giving legal certainty for payments made on the day of appointment of an external administrator. In the absence of an approval, the so-called ‘zero hour’ rule (whereby an insolvency is deemed to have occurred immediately after the preceding midnight) could result in RTGS payments made on the day of insolvency being overturned. The legislation also gives legal certainty to multilateral netting arrangements that are approved by the Reserve Bank, including arrangements that settle in the 9.00 am batch in RITS.

The second factor is Australia's adoption of best practice for high-value payment systems with the implementation of the RTGS system in 1998. In doing so, Australia was able to learn from RTGS systems that had been introduced previously in other countries when considering the design features of its own system. As a consequence, Australia's system is reliable, sound and liquidity efficient.

While in the Bank's view RITS complies with the Core Principles, the outside perspective involved in the FSAP process may provide some useful insights on current arrangements.

3.2 Recommendations for Securities Settlement Systems and Central Counterparties

As mentioned, the IMF will also be undertaking an informal assessment of securities settlement systems and central counterparties as part of the FSAP. This will include the securities settlement systems and central counterparties operated by the Australian Stock Exchange (ASX) and Sydney Futures Exchange (SFE). The role of a securities settlement system is to maintain a record of title to securities and ensure the final transfer of securities from the seller to the buyer and funds from the buyer to the seller. Such systems are not counterparties to the trades they record. In contrast, central counterparties interpose themselves between the two parties to a trade and become the buyer to every seller and the seller to every buyer, and as a result take on the same risks as any other market participant. This allows some netting of obligations and centralisation of credit-risk management, but it also results in concentration of credit risk with the central counterparty.

The smooth operation of securities settlement and central counterparty functions is essential to the stability of Australia's financial system. Turnover in wholesale securities and derivatives markets is large and the failure of transactions to settle on schedule – or worse, the failure of a central counterparty – could have serious flow-on effects on participants.

While the template for the IMF's assessment of these systems will be the CPSS-IOSCO recommendations, the Reserve Bank has had in place its own standards (the Financial Stability Standards for Central Counterparties and Securities Settlement Facilities) since May 2003. These derive from the Reserve Bank's power to set standards under section 827D(1) of the Corporations Act 2001 to ensure that licensed clearing and settlement facilities conduct their affairs in a manner that contributes to the stability of the financial system. The objective of the standards is to ensure that licensees identify and properly control the risks associated with the operation of the system in question. There is considerable overlap between the CPSS-IOSCO recommendations and the Financial Stability Standards, although the latter focus on stability matters given the Bank's mandate under the Corporations Act.

The Bank monitors compliance with the Financial Stability Standards on an ongoing basis and prepares a formal report to the Parliamentary Secretary to the Treasurer once a year. Its current assessment is that both the securities settlement facilities and central counterparties operated by the ASX and SFE meet these standards. Nonetheless, as with the FSAP assessment of RITS, it is likely that the process of external assessment as part of the FSAP may provide another useful perspective on the Australian systems.

3.3 Update on the New Basel Capital Framework

Preparations for the implementation of the new Basel Capital Framework are proceeding, both at the global level and domestically. The new Framework is scheduled for implementation in Australia from 1 January 2008 and will have significant implications for the way that some authorised deposit-taking institutions (ADIs) calculate their minimum capital requirements. While the majority of Australian banks, building societies and credit unions will use the more straightforward standardised approaches, the larger banks are likely to use the more advanced approaches, subject to satisfying APRA's accreditation process.

Internationally, one concern is the possibility that the overall level of capital in the global banking system might decline significantly as a result of the new Framework, which would be counter to its original intention. Moreover, at the national level, regulators are unlikely to be comfortable with outcomes in their own jurisdictions which significantly lower aggregate capital requirements from current levels. To address these concerns, the Basel Committee has proposed adjusting capital requirements with a scaling factor calibrated on the basis of quantitative impact studies conducted by a number of countries. One complication of such an adjustment, however, is that capital requirements may be influenced by the position in the business cycle. This concern was highlighted by a recent quantitative impact study by US authorities, which found that, under the new arrangements, there was both the potential for an unexpectedly sharp drop in aggregate capital requirements and a very wide dispersion of capital levels for individual banks. One possible explanation for the fall in aggregate requirements is that the US economy has improved since earlier studies were undertaken, causing measures of credit risk, and thus capital requirements, to decline relative to current levels. It is also possible that the results have been influenced by shortcomings in data quality, the design of the quantitative study, and the design of the new Basel Framework itself. US authorities are continuing to analyse the results of the study, with further details expected later this year.

Partly in response, the Basel Committee has decided on further field testing of the new Framework via a fifth quantitative impact study (QIS 5). Most countries participating in QIS 5, including Australia, will gather data from financial institutions in late 2005. These data will then be used to assess prospective capital charges and, if need be, help recalibrate the new Framework to ensure that aggregate capital requirements do not change substantially on implementation.

Implementation in Australia

Over the past six months, APRA has released draft prudential standards covering the standardised approaches to credit risk and operational risk. The draft standard for the more complicated internal ratings-based (IRB) approach to credit risk has also been released, and APRA is aiming to make the draft standard for the advanced approach to operational risk available later this year. Further details on these draft standards are available on APRA's website.

APRA has gone to considerable effort to ensure that the revised prudential standards are appropriately tailored to the risks of lending for residential property, which accounts for over half of banks' total lending in Australia. The approach APRA is adopting for banks using the standardised approach is more risk-sensitive than the approach developed by the Basel Committee. In particular, APRA is proposing to make capital requirements on residential mortgages a function of three factors: loan-to-valuation ratios (LVR), whether it is mortgage insured, and whether it is a ‘standard’ or ‘non-standard’ loan (Table 12). Non-standard loans are mainly ‘low doc’ mortgages which involve an element of self-verification in the loan application process. While these new arrangements will see the capital requirements for credit risk on many housing loans decline, the minimum requirements will increase on more risky loans.

APRA will also be using its national discretion to maintain the risk weight for non-housing lending to the household sector at 100 per cent under the standardised approach rather than the 75 per cent weight proposed by the Basel Committee. In APRA's view, the lower risk weight is inappropriate for Australian ADIs using the standardised approach, given that it was designed for institutions with portfolios that are more diversified in both product and geographic terms than those of many Australian ADIs.

3.4 Insurance Industry Reform

APRA has continued to implement reforms relating to the insurance industry in Australia, building on the recommendations of the HIH Royal Commission. Of particular note are the initiatives relating to so-called financial reinsurance – arrangements under which payouts made by the reinsurer to the insurer are eventually refunded (partly or in full) so that the transfer of risk is incomplete. Such arrangements often amount to little more than a loan by the reinsurer to the insurer, but they have not always been reported as such, helping the insurer to conceal losses and misrepresent capital levels. Financial reinsurance transactions featured prominently in events leading up to the failure of HIH, and more recently have been investigated by regulators in Australia and overseas.

In May, APRA issued new draft prudential standards to ensure greater transparency and accountability in financial reinsurance. Under the standards, reinsurance arrangements must be adequately documented and side letters – agreements governing aspects of a reinsurance deal that do not feature in the official documentation – must be clearly disclosed. In addition, reinsurance arrangements will be subject to greater auditor and peer scrutiny, and senior executives and approved auditors will need to provide personal attestations that disclosures to APRA reflect the true state of a company's finances. APRA may then use this additional information to determine whether financial reinsurance deals are to be classified as either reinsurance or financing for the purposes of calculating an insurer's minimum capital requirement and for reporting financial data. The final standards are due to be released early in 2006.

Internationally, US authorities are considering tighter and more nationally uniform regulation of financial reinsurance; several investigations into specific violations of the existing disclosure rules are also underway. In the United Kingdom, the Financial Services Authority recently issued strict directives regarding the use and reporting of financial reinsurance arrangements by regulated institutions. Also, the German Federal Financial Supervisory Authority is informally investigating a number of insurers and reinsurers believed to have misused financial reinsurance.

In other initiatives relating to insurance, APRA recently proposed rules that would help protect insurance subsidiaries from financial difficulties arising elsewhere in the conglomerate to which they belong. A key feature of these proposals is that the insurance entity is ‘ring fenced’ – that is, that the conglomerate be prevented from siphoning capital from its insurance subsidiary to other companies in the group. This ring-fencing will apply to both supervised and unsupervised entities within domestic conglomerates, and to insurers owned by foreign groups. The new standards are expected to be in place by 2007.

Finally, the Insurance Council of Australia (ICA) released a new code of conduct in July for general insurers. This code, developed by the insurance industry over recent years, targets general insurers' performance standards and their relationships with policyholders. Prepared in consultation with industry bodies and consumer groups, the code will promote accountability and transparency on products and fees, and will also encourage faster claims processing. The new standards will be adopted by all ICA member organisations – which service around 90 per cent of the total domestic general insurance market – and are expected to become effective by mid 2006.

3.5 Framework for Governance

In May, APRA released draft prudential standards concerning arrangements for the boards of most of the institutions that it regulates.

The proposed standards are based on the Australian Stock Exchange's Principles of Good Corporate Governance for listed companies and set out requirements for board size, director independence and shareholder representation. A notable aim of the proposed standards is that boards of APRA-regulated institutions have access to independent expertise. With the exception of certain types of subsidiaries, boards are expected to have a majority of independent non-executive directors and have an independent non-executive director as chairperson. It is also proposed that boards have a policy on their renewal, establish a Board Audit Committee and a Board Risk Committee, and ensure that their institutions have an internal audit function.

An essential component of the corporate governance framework more broadly is a requirement that people in positions of responsibility are competent and trustworthy. To this end, APRA has recently issued revised draft ‘fit and proper’ standards which will apply to most APRA-regulated institutions. APRA will require that institutions ensure that individuals in positions of responsibility – directors, senior managers, auditors and actuaries – meet minimum standards of fitness and propriety. For instance, institutions will be required to formulate a written ‘fit and proper’ policy, encourage and reasonably protect whistleblowers, and inform APRA of changes to the persons in positions of responsibility. Although the onus for ensuring that persons are fit and proper falls on the institutions, APRA will reserve the power to disqualify or remove individuals if an institution does not take remedial action when needed. Final prudential standards on corporate governance and ‘fit and proper’ requirements are expected to be released in late 2005 or early 2006.

3.6 Business Continuity Management

An ongoing risk to financial institutions is the prospect of critical infrastructure failures, or disruptions to external operating environments. Computer system failures, blackouts, or systemic disruptions to public transport are among the most obvious examples of this type of operational risk. Interest in managing this risk has increased significantly over recent years in the wake of terrorist attacks in the United States in 2001 and more recently in the United Kingdom. Although financial systems in those countries proved to be resilient, many individual institutions throughout the world now perceive themselves to be at greater risk than was previously the case and have devoted more resources to identifying and mitigating the risks.

Regulators have encouraged this response. In Australia, an inter-agency taskforce is developing procedures to better protect critical national infrastructure against the threat of terrorism, with the initiative embracing a number of major financial institutions. As part of the Government's Trusted Information Sharing Network for Critical Infrastructure Protection, the Reserve Bank is Deputy Chair of the Banking and Finance Infrastructure Assurance Advisory Group. The purpose of this group is to facilitate information sharing among representatives from the owners and operators of critical financial system infrastructure and to develop strategies to mitigate risks to that infrastructure.

APRA has also recently released a new standard for business continuity management for authorised deposit-taking institutions (ADIs) and general insurers. This standard takes a whole-of-business approach to ensuring that critical business functions can be maintained or restored in the event of disruption. Under the standard, institutions will need to undertake both risk assessments and business impact analyses, and have crisis management procedures in place. The standard requires that these matters be addressed in an actively maintained business continuity plan, which should be fully integrated into the overall risk management plan of each institution. Boards will have responsibility for testing these plans and for ensuring that they are current, comprehensive, and appropriately disseminated.

ADIs have until April 2006 to meet the new standard. In the interim, they will need to report on their compliance and to outline in detail any remedial measures that they need to undertake. APRA anticipates releasing similar standards on business continuity management for life insurers in the first half of 2006.

Footnotes

More details on this can be found in Bullock, M, N McMillan and S Weston (2004), ‘The Australian High-Value Payments System’, Financial Stability Review, March. [4]

Core Principle V – Settlement in Multilateral Netting Systems – is not applicable since RITS is not a multilateral netting system. [5]