RDP 2001-07: A History of Last-Resort Lending and Other Support for Troubled Financial Institutions in Australia 10. The 1970s

Following the comparative calm of the 1950s and 1960s, the growth of non-bank financial institutions fuelled a property boom in the early 1970s. The 1974 liquidity squeeze brought the boom to an abrupt end. The failure of a number of property financiers precipitated runs on building societies in several states, particularly South Australia and Queensland. Building societies in Queensland also experienced difficulties in 1976 and 1977. Weakness in the property market brought down the Bank of Adelaide later in the decade. The Reserve Bank provided some liquidity support in each of these cases, although it did not lend directly to non-banks.

10.1 The 1974 Liquidity Squeeze

Following a boom in lending by banks and non-bank financial institutions, the Reserve Bank tightened monetary policy in 1973. This was accompanied by a drain in liquidity resulting from a deterioration of the balance of payments and a government budget surplus. As interest rates soared, property prices began to collapse triggering the failure of several property development companies.

On 30 September 1974, the property financier Cambridge Credit went into liquidation. The failure of two other substantial property developers (Home Units Australia in July and Mainline Corporation in August) preceded Cambridge Credit's closure. While those failures prompted sharp falls in the share prices of other property developers, finance companies and banks, Cambridge Credit's failure saw public nervousness spread directly to other financial intermediaries. The following day, runs developed on building societies in NSW, Victoria, Queensland and South Australia. While the runs in NSW and Victoria were comparatively small, the runs in Queensland and South Australia were far more severe. On 2 October, the Acting Federal Treasurer announced that the Reserve Bank had told the trading banks to consider sympathetically any request for finance from financial institutions that were responsibly managed and had adequate asset backing. The Reserve Bank would stand behind any bank that provided liquidity to troubled building societies.^[62] A similar statement by the Acting Prime Minister was released the following day, and the runs in Queensland tapered off by the end of the day. The form of words contained in these two press releases was to be used on several occasions over the next two decades.

Although the Hindmarsh Building Society in South Australia was financially sound, it was subject to the most severe run.^[63] The run, based on rumours the society had lent to failed property companies, continued, little affected by the Acting Treasurer's statement. The run exhausted the society's cash reserves. The National Australia Bank lent the society cash until the National also ran low. On 3 October, the South Australian Premier, Don Dunstan, addressed customers queuing outside the Hindmarsh's offices, assuring them that their funds were safe. The run subsided the next day. Dunstan tabled, but never proceeded with, the Building Societies Temporary Assistance Bill, which would have authorised him to borrow $10 million from the Reserve Bank to lend to the building societies.

Precedents for such state government support of building societies were established in the 1930s, 1940s and 1950s when the state governments introduced guarantees over building societies as part of policies designed to encourage housing construction (Abbott and Doucouliagos 1999). Official reserve or stabilisation funds were also set up for building societies and credit unions in several states. The funds typically provided for the protection of depositors in the event of insolvency; some also provided for temporary financial assistance in the event of financial difficulties (Australian Financial System Inquiry 1981).

Accentuating the liquidity squeeze was the variable deposit scheme that required those borrowing from overseas to place one-third of the amount of their loan in a deposit paying no interest.^[64] Introduced in December 1972 to address a ballooning capital account surplus, this constrained the capacity for capital inflow to offset the tightness in domestic liquidity conditions.

The liquidity squeeze of June–September 1974 saw the banks forced to borrow from the Reserve Bank to preserve their LGS ratios. At the height of the squeeze, borrowings from the central bank peaked at $353 million (more than 3 per cent of bank deposits). In June, the Special Reserve Deposit (SRD) requirement (which was the successor to the special accounts regime) was lowered to alleviate the pressure on the banks. At the same time, the variable deposit requirement was reduced from 33⅓ per cent to 25 per cent. It was further reduced to 5 per cent in August.

In October 1974, the Reserve Bank also introduced a Special Drawing Facility that allowed banks to borrow, at a concessional rate of 0.25 per cent below the 180-day Treasury note rate, amounts equivalent to 1 per cent of their deposit liabilities.^[65] While the original term of the loans was for six months the loans were later extended and were not repaid until July 1975. The Special Drawing Facility was much more a safety valve to smooth the operation of the domestic money market rather than last-resort lending. Under the facility funds were allocated to each bank in line with its share of total deposits. All banks initially drew down their full quota.

In November, in addition to the broader liquidity provided by the Reserve Bank, a special line of credit for a further 1 per cent of a bank's deposits was made available to banks involved in support of non-bank financial institutions on a substantial scale. Unlike the Special Drawing Facility, this was regarded ‘as an exceptional and temporary arrangement’.^[66] Although the provision of funds was not specifically tied to a bank's loans to troubled financial institutions, banks applying for funds from the Reserve Bank were required to submit details of the assistance they had provided to those financial institutions. Two banks drew on this facility, the Commercial Bank of Australia (banker to Queensland Permanent Building Society) and the ANZ (banker to the Industrial Acceptance Corporation).

While the loans were not made directly to the troubled institutions, since the extension of loans to the two banks was prompted by the non-banks' demands for liquidity that would not otherwise have been met by the market, the Reserve Bank was acting as lender of last resort. This support was provided at a rate that was neither concessional nor penal, but at the same rate then applying to loans under the LGS convention. The provision of this additional finance was not publicly announced. Although a press statement was drafted, it was not released for fear that it might undermine confidence in those institutions receiving support. Instead, the Federal Treasurer made a general statement about the broad easing of monetary policy.

This marked the first occasion on which funds were lent under the Reserve Bank's policy confining the provision of last-resort loans to banks, while standing ready to support any bank that found its own liquidity strained as the result of providing assistance to an illiquid, but solvent, non-bank financial institution. This policy remained in place until the 1990s (Fraser 1990).

There were two main rationales for this policy. Firstly, banks were viewed as being central to overall system stability – an approach endorsed by the Australian Financial System Inquiry (the ‘Campbell Committee’) in 1981. In the Campbell Committee's view, banks deserved special treatment because of their role in the payments system and as a safe haven for small investors, and the impact that a banking collapse would have on the economy as a whole.

Secondly, while the Banking Act 1959 required the Reserve Bank to protect bank depositors, it was not directly responsible for the interests of depositors at other financial institutions. Moreover, since the Bank did not supervise the non-banks, this limited the scope for it to control moral hazard-driven behaviour that may have followed from the provision of direct support. The banks that dealt directly with the non-banks were better placed to assess their underlying solvency. In 1985, Reserve Bank Governor Robert A Johnston stated:

Basically, we see the Reserve Bank's role as to ensure that there are adequate liquid funds in the market place whilst leaving it to the market place to determine the allocation of funds amongst competing institutions. Our concern would be the avoidance of a loss of confidence in the financial system generally, rather than the fate of individual members.

‘Thou may not kill, but need not strive to officiously keep alive’.^[67]

The Australian Financial System Review Group (the ‘Martin Review’), in 1984, argued that the risk of loss to a building society's bank would impose useful commercial discipline, since it would be easier for a private bank to refuse assistance to induce a society to run down its own liquidity reserves before seeking aid (Australian Financial System Review Group 1984).

10.2 Queensland Permanent Building Society

While the runs in October 1974 eased quickly, weakness in Queensland building societies persisted for several years. On 13 March 1976, the Queensland Treasurer suspended the ailing Australian Permanent Building Society. On 17 March, the Treasurer placed one society under administration, while another five suspended payment. Three weeks later, the Treasurer announced that the five suspended societies would either have to sell their assets to other societies or be amalgamated into one large organisation under the aegis of the State Government Insurance Office.

On 28 September 1977, the Queensland Permanent Building Society closed its doors, after having suffered a run and finding itself unable to reconcile its own accounts. The same day, the Acting Federal Treasurer issued a press release distancing Queensland Permanent from other building societies and stating that ‘there was no need for concern on the part of investors in other building societies’. The statement added, ‘the permanent building society movement had the full support of the Government in its role as a major provider of housing finance in Australia’.^[68] The statement also mentioned the Reserve Bank's policy that banks should look sympathetically at requests for assistance from sound building societies.

In October 1977, the Acting Federal Treasurer issued a press release foreshadowing a Queensland Government scheme to ‘rescue’ Queensland Permanent and avoid denying depositors access to their funds until liquidation processes were completed. The statement also noted that the Reserve Bank stood ready to address any liquidity problems at banks that might arise from possible ‘rescue’ schemes.^[69] The trading banks, however, refused to directly support Queensland Permanent. The Queensland Government hurriedly introduced legislation giving it wide-ranging powers to buy time in the liquidation process, including the power to obtain liquidity for the society through a process of compulsory loans from other building societies. However, the government's attempts to re-open the society were unsuccessful and the society was taken over by the State Government Insurance Office. All depositors were repaid without any loss. The takeover was financed by compulsory loans from other building societies and direct payments by the Queensland Government.

Queensland Permanent's closure triggered a run on the Metropolitan Building Society (Queensland's largest building society at the time). The Reserve Bank provided a line of credit to the Commonwealth Bank, which in turn lent to Metropolitan. Like the loans provided to the Commercial Bank and ANZ in November 1974, the line of credit should be regarded as a last-resort loan. The Reserve Bank publicly announced that arrangements had been made to provide

‘ample support’ for the Metropolitan, and that it had provided a substantial line of credit to the society's bankers.^[70] The loan to the Commonwealth Bank was provided at the non-penal rate then applying to loans under the LGS convention.

10.3 St. George Permanent Building Society

In March 1979, a run on the St. George Permanent Building Society developed following the broadcast of unfounded rumours that it was in danger of imminent collapse. At the time, St. George was the second largest building society in NSW. On the evening of 2 March, the NSW Premier addressed investors stating the Government guaranteed that they would not lose their money.^[71] Despite this, the run continued. On 5 March, the Acting Federal Treasurer issued a press release that included reference to the Reserve Bank's understanding with trading banks that they consider sympathetically requests for finance received from solvent building societies. The statement added that St. George had large amounts of liquid assets available to it, and that building societies generally were sound. The run substantially eased following this second statement.

St. George contacted the Reserve Bank regarding financial assistance; however, the Bank redirected the society to its banker. The Reserve Bank reminded the bank of the arrangements for providing emergency assistance to non-bank financial institutions. The bank in question did not see a need to support St. George, which in its view had ample liquid assets to meet withdrawals. St. George's liquid assets were, in the event, sufficient for it to weather the depositor run. In April, however, St. George was forced to stop lending for a time to strengthen its liquidity. While the NSW Government considered proposals to support the society, it was ultimately able to trade out of its difficulties.

The Reserve Bank recognised that its policy could ‘sometimes appear unsatisfactory, especially because the fate of an institution might effectively be left in the hands of competitors’; however, it looked to the banks ‘to respond responsibly and sympathetically to reasonable requests for assistance’.^[72] The criticism by St. George of these arrangements led the Campbell Committee to recommend that governments examine the feasibility of an industry-based support mechanism for the non-banks. The Martin Review Group, however, rejected the proposal that the Reserve Bank stand ready to lend to such liquidity-support entities, on the grounds that this risked extending Commonwealth Government responsibility to non-banks' liabilities.

10.4 The Bank of Adelaide

During the 1960s, the Bank of Adelaide acquired the Finance Corporation of Australia (FCA), which focused on the more risky aspects of property finance, such as lending to property developers and residential second mortgages. FCA grew to become a large component of the bank's overall business. In 1978 FCA's operations accounted for just over 60 per cent of the bank's profits. Falling property prices, however, quickly eroded that profitability. In April 1979 the Reserve Bank expressed its concern about the effect of transfers of capital from the Bank of Adelaide to FCA on the bank's ability to meet its own liabilities (particularly, its obligations to depositors).

A British bank, Standard Chartered Bank, made an offer for the bank that was blocked by the Federal Government. The takeover would have breached the Government's restrictions on foreign ownership of banks and its requirement that no one shareholder may hold more than 10 per cent of a bank. The Bank of Adelaide also sought a merger with the Bank of NSW, but rejected the Bank of NSW's bid as undervaluing FCA (Sykes 1988).

Following its rejection of the offer from the Bank of NSW on 26 April, the Bank of Adelaide approached the South Australian Government for an equity injection. The bank asked the government to subscribe to $40 million worth of shares partly paid to 10 cents each. The South Australian Government was not prepared to take on such a large liability. The government offered to subscribe for $10 million worth of shares if the bank could find others to take up the remaining $30 million. After examining FCA's affairs, a group of the major trading banks decided that they were not prepared to give it direct support.

On 3 May, the Bank of Adelaide reported that the profitability of FCA had slumped dramatically, due to the crash in property prices (Sykes 1988). On 10 May, the Reserve Bank told the Bank of Adelaide that it should not give any further support to FCA and instructed the Bank of Adelaide to find a merger partner within a matter of days. Following pressure from the Reserve Bank, which sought to smooth the bank's exit from the industry, the major trading banks agreed to make a subordinated loan of $50 million to the Bank of Adelaide. At the same time, the Reserve Bank provided the bank with a $10 million specific liquidity facility as an extension of the bank's right to borrow under the LGS convention. On 14 May, the Reserve Bank issued a press release indicating that the facilities provided to the Bank of Adelaide were sufficient to ensure the Bank of Adelaide could meet fully its commitments.^[73] The Australian Bankers' Association and the Bank of Adelaide also released supporting statements. The liquidity facility and coordinated public statements were successful in preventing any run on the Bank of Adelaide. On 22 May, the ANZ takeover of the Bank of Adelaide was announced. Despite opposition from some shareholders and a proposal that the Bank of Adelaide issue new capital to cover FCA's losses, ANZ's takeover came into full effect on 1 October 1980.^[74]

Since the Bank of Adelaide was small (its share of trading bank deposits averaged around 2 per cent throughout its life (Merrett 1985)), it is difficult to argue that its failure posed a threat to the stability of the financial system. The liquidity facility provided by the Reserve Bank was a means of ensuring the orderly exit of the Bank of Adelaide – consistent with the former's depositor protection responsibilities – rather than a last-resort loan.

Footnotes

Press Statement by the Acting Treasurer, the Honourable Bill Hayden, MP, Press Release No 80, 2 October 1974. [62]

The Co-operative Building Society in South Australia suffered a less severe run. [63]

There was also an absolute embargo on foreign borrowing for maturities of two years or less. [64]

One alternative to the Special Drawing Facility discussed between the Reserve Bank and the private banks, but not pursued, was a proposal that the banks be allowed to defer settlements of foreign exchange with the Reserve Bank. [65]

Letter from the Reserve Bank to the chief executive of each major trading bank, 8 November 1974. [66]

‘Prudential Supervision of Banks’, address to the Victorian Division of the Securities Institute of Australia and the Institute of Chartered Accountants by Robert Johnston, Melbourne, 21 February 1985. Reproduced in Reserve Bank of Australia Bulletin, March 1985, pp 571–575. [67]

Press Statement by the Acting Treasurer, the Honourable Eric L Robinson, MP, Press Release No 108, 28 September 1977. [68]

Press Release by the Minister for Post and Telecommunications and Minister Assisting the Treasurer, 77/69, 5 October 1977. [69]

Reserve Bank of Australia Press Release, 13 October 1977. [70]

The Sydney Morning Herald, 3 March 1979. [71]

Fraser(1990). [72]

Reserve Bank of Australia Press Release, 14 May 1979. [73]

Opposition to ANZ's takeover from some shareholders led to an inquiry by the South Australian Full Court into what alternatives to ANZ's offer were considered by the Bank of Adelaide's management. This inquiry was set a tight deadline for fear that an extended delay would see ANZ withdraw its offer (Sykes 1988). [74]