RDP 2001-07: A History of Last-Resort Lending and Other Support for Troubled Financial Institutions in Australia 11. The Deregulated Era

In 1981, the Campbell Committee released the results of a broad-ranging review of the conduct of monetary policy and banking, which recommended lifting much of the regulation imposed on the banking system. As a result, the means for conducting monetary policy moved from direct control to open market operations.

The Campbell Report also set out detailed recommendations for the conduct of lender-of-last-resort policy.

In the newly deregulated environment, competition intensified and banks' credit standards softened. The resultant boom in commercial lending, particularly property finance, unwound in 1990. While public confidence became fragile, issuance of press statements in support of individual institutions were sufficient to stem several deposit runs. Although a large building society and two state banks failed, no liquidity assistance was required in those cases.

11.1 The Campbell Report

The Campbell Report's recommendations for lender-of-last-resort policy were very much in line with Bagehot's prescriptions. While no legislative prescription for lender-of-last-resort policy was proposed or implemented, the report endorsed ‘the well-established tenet of central banking practice that, above all else, it is the function of a central bank to ensure a sufficient availability of liquidity to preclude a financial crisis stemming from a loss of confidence in the capacity of viable financial institutions to meet their obligations’.^[75]

The report argued that provision of liquidity support facilities by the central bank, unless applied with great restraint, risked creating moral hazard problems. Last-resort lending should be only associated with ‘rare and unusual circumstances’. The Reserve Bank should also satisfy itself that a troubled institution could not meet its liquidity needs via other avenues without jeopardising market confidence in its viability. Moreover, last-resort lending should generally entail a penalty (except where the circumstances giving rise to the emergency were clearly beyond the control of an individual institution).

The Committee considered that, except where there were strong reasons for believing that the overall stability of the financial system would be impaired, non-viable financial intermediaries should be allowed to fail to preserve efficiency and competition within the financial system. The Committee also argued, however, that the manner in which a failure is handled is important. The exit of an insolvent institution should be managed in a way that did not cast doubt on the viability of others.

In 1985, the LGS convention was replaced by the Prime Asset Ratio requirement, a prudential, rather than monetary policy, requirement. This marked the end of automatic lending to the banks. Instead, any lending to banks would be at the Reserve Bank's discretion and the Bank would aim to ensure that the banking system's need for liquidity would be met without recourse to direct lending to banks.

11.2 The 1990s Recession

Deregulation in the mid 1980s intensified competition in the banking industry. Credit growth ran ahead of banks' risk assessment procedures, which, in many institutions, had not adjusted to the newly liberalised environment. In 1989, the combination of high interest rates and a softening in the commercial property market brought broadly based credit quality problems to light. The banking industry experienced its worst losses since the 1890s. The largest losses were recorded by the State Bank of Victoria and the State Bank of South Australia. The state government owners of these banks provided significant capital injections in the resolution of these problems. Westpac and ANZ (the second and third largest banks in Australia) recorded large losses for their 1991/92 financial year following revaluation of their property assets. Both banks had sufficient capital to cover their losses.^[76] Against this background, public confidence became more fragile, with runs on a number of non-bank financial institutions including building societies, friendly societies and property trusts. Although this nervousness spread to some of the smaller banks, at no time were there serious concerns about the overall system.

11.2.1 Building societies and regional banks

By early 1990, the Farrow Corporation and its building society subsidiaries (Countrywide, Federation, Geelong and Pyramid), accounting for just over half of building society assets in Victoria, but less than 1 per cent of the assets of all deposit-taking institutions in Australia, had been subject to rumours about their soundness for some time. Following adverse press reports, a run developed on 12 February 1990. Press statements were issued by Victorian Registrar for Co-operative Societies, and the State Treasurer and Attorney-General (jointly) indicating ‘depositors’ funds in Pyramid building society are secure'.^[77] The latter statement also referred to the Reserve Bank's longstanding policy of supporting banks that provided liquidity to building societies that are responsibly managed and have adequate asset backing. The statements were not successful in stemming the deposit outflow. The Farrow Group had already fully drawn on its lines of credit with several banks, and they refused to increase those credit lines without the provision of substantial security.

The group's liquidity continued to deteriorate, and the group went into liquidation in June. The Victorian Government arranged for the State Bank of Victoria to make a direct payment to unsecured Farrow depositors to cover the par value of all deposits and withdrawable share capital (Kane and Kaufman 1992). The Reserve Bank issued a press statement in July 1990 noting ‘the Bank believes that the problems of the Farrow group are not shared by other societies in Victoria (or any other State)…the banks will assist the building societies in maintaining liquidity’ and, ‘the Bank will provide any necessary liquidity support to the banks involved’.^[78]

Three aspects of the Reserve Bank's approach were criticised by the Victorian Inquiry into the failure of the Farrow Group (Habersberger 1994). The first was the Reserve Bank acquiesced to the inclusion of the references to it in the press statement issued by the Victorian Treasurer and Attorney-General that could be taken as implying Reserve Bank backing for the group. The Bank, however, sought to emphasise that this was a statement of the Bank's broad policy rather than any specific assurance of finance to the Farrow group.^[79] The Victorian Government's press releases were the eighth instance where the Reserve Bank's policy had been referred to in statements issued by the Federal Government, State Governments or the Reserve Bank (see Appendix B).^[80]

Second, it was argued that the Bank should have done more to smooth the closure of the Farrow group. As was the case with difficulties experienced by building societies in other states, however, the Victorian Registrar of Building Societies' role as supervisor saw the Victorian Government carry the responsibility for the liquidation.^[81]

The third criticism of the Reserve Bank's role was that it underestimated the systemic implications of Farrow's failure. While the failure had a severe impact on the Geelong region and caused some contagion for non-bank financial institutions in Victoria, the spillover to other financial institutions and other regions was well contained. The Farrow group was found to have fuelled its growth by adopting highly risky lending policies, misstating its accounts and deliberately breaching the regulations that applied to building societies. Therefore, if support had been provided to allow the Farrow group to continue in operation on systemic grounds, this would have entailed particularly high moral hazard costs (Kane and Kaufman 1992).

Public concerns about non-bank financial intermediaries spilled over to the Bank of Melbourne, which had converted from building society status in June 1989. On 16 July, the Governor released a statement that noted the bank was meeting all prudential requirements and that ‘the Reserve Bank would ensure that the bank has adequate liquidity’.^[82] Following the Bank's press release, the outflow of deposits slowed, but it was not until a month later that the bank's total deposits once again began to rise. Over this time, the Bank of Melbourne was able to meet all withdrawals from its own resources, without recourse to the standby facility provided by another private bank.

In Queensland, Metway Bank (which converted from building society status in July 1988) had similar problems in September and October 1990. The bank's management moved to quash suggestions of the bank's instability, pointing out that it had no exposure to any major entrepreneurial borrowers, and the bulk of its portfolio was made up of residential mortgages. This statement seemed to exacerbate the run. On 3 October, the Reserve Bank responded with a press release along the same lines as that issued in relation to the Bank of Melbourne in July. This time, the Bank's statement had an almost immediate effect, ending the run that day.

The spillover of concerns about building societies to the smaller banks mirrored earlier problems in Western Australia. In August 1987, bad loans at the West Australian Teachers' Credit Society led the Western Australian Government to legislate to allow the society to be taken over by the state-owned Rural and Industries Bank of Western Australia. The Western Australian Government funded the resulting losses borne by the Rural and Industries Bank. In October, Challenge Bank, a former building society that converted to bank status, was subject to a brief run. The trigger for the run was a malfunction in the bank's automatic teller machine network. The Governor of the Reserve Bank issued a press release, which ‘scotched rumours in the Western Australian media concerning the stability of Challenge Bank’, adding that ‘the Reserve Bank stook squarely behind’ the bank.^[83] Within a few days the run ceased.

Contagion effects were a concern in each of the instances of support for the regional banks. However, each of the banks affected was small and, like the case of the Bank of Adelaide, depositor protection responsibilities, rather than broader systemic concerns, motivated the Reserve Bank's statements of support.

11.2.2 The State Banks

As the losses made by the State Bank of Victoria and the State Bank of South Australia came to light in 1990 and 1991, the Reserve Bank discussed the possible need for liquidity support with the banks and their state government owners.

The primary source of State Bank of Victoria's problems was losses in its subsidiary, Tricontinental, which were more than 3.5 times greater than the value of State Bank of Victoria's capital. The Reserve Bank was prepared to offer short-term emergency liquidity support to the State Bank (provided the Victorian Government indemnified it against any losses) if the bank were to exhaust its stock of liquid assets. The Reserve Bank also offered to help the State Bank sell its portfolio of Commonwealth Government securities if the need arose, either by assisting the sale of those securities in the market or by buying them itself. In the event, no such arrangements were required. In August 1990, the State Bank was sold to the Commonwealth Bank.

The problems at the State Bank of South Australia were occasioned by the rapid growth of the bank (between 1985 and 1990 the bank's average annual growth in assets was almost 44 per cent), which saw it take on substantial bad loans. By 1998, the South Australian Government had provided the bank with assistance amounting to almost 3 times the bank's 1989 capital. The government assumed full control of the division managing the bank's impaired assets and sold the remainder of the bank to a private bank. The closure of the bank was conducted without recourse to Reserve Bank liquidity support.

The Rural and Industries Bank, owned by the Western Australian Government, became the subject of a brief run in January 1992. The Reserve Bank Governor issued a statement that noted deposits with the Rural and Industries Bank were guaranteed by the State Government of Western Australia, but added that the Reserve Bank would take whatever steps necessary to ensure the bank had adequate liquidity.^[84]

11.3 Current Arrangements

In July 1998, following the Financial System Inquiry (the ‘Wallis Inquiry’), the Australian Government implemented wide-ranging reforms to Australian financial regulation. One element of the reforms was the transfer of responsibility for supervision of banks from the Reserve Bank to the newly formed Australian Prudential Regulation Authority (APRA).

The Wallis Inquiry argued that the central bank's involvement in monetary policy, management of system liquidity and provision of the interbank settlement system provided it with the powers, tools and knowledge to be best placed to manage systemic risk (Financial System Inquiry 1997). Under the new arrangements, therefore, the Reserve Bank remains responsible for overall financial system stability, including lender-of-last-resort arrangements. In providing support, the Bank's preference would be to do this through its usual daily operations in the cash market, providing liquidity to the market as a whole rather than to individual institutions. Nevertheless, in principle, a lender-of-last-resort loan could be made to any institution supervised by APRA. However, the Bank has clearly stated that ‘the Reserve Bank's balance sheet is not available to prop up insolvent institutions’ (Macfarlane 1999). In sum, it remains the case that:

…in the highly unusual case in which a fundamentally sound institution was experiencing liquidity difficulties, and the potential failure of the institution to make its payments posed a threat to overall stability of the financial system, the Bank would be able to provide a lender-of-last-resort loan directly to that institution.^[85]

In April 1998, the Reserve Bank introduced new prudential guidelines concerning banks' liquidity management. Responsibility for these arrangements now lies with APRA. Rather than relying solely on minimum liquidity ratios, the new arrangements emphasise institutions' liquidity management policies, including their ability to meet a five-day ‘name’ crisis.^[86] In doing so, institutions cannot assume that the Reserve Bank would provide support (Reserve Bank of Australia 1998).

Footnotes

Australian Financial System Inquiry (1981, p 100). [75]

In Westpac's case, the losses were covered, in part, by an issue of shares that was not fully subscribed. The issue's underwriters covered the shortfall in the share issue. [76]

Text reproduced in Habersberger (1994, pp 1314–1317). [77]

Reserve Bank of Australia Press Release 90–16, 2 July 1990. [78]

Reserve Bank of Australia (1995, p 46). [79]

In fact, the Reserve Bank had not been given the opportunity to review the wording of the press statements before they were made public and so the statements were more suggestive of direct support than had been the case in previous public statements. [80]

Reserve Bank of Australia submission to the Farrow Group Inquiry. Text reproduced in Habersberger (1994, p 1630). [81]

Reserve Bank of Australia Press Release 90–18, 16 July 1990. [82]

Reserve Bank of Australia Press Release 87–27, 30 October 1987. [83]

Reserve Bank of Australia Press Release 92–02, 6 January 1992. [84]

Macfarlane (1999). [85]

A name crisis is one in which an individual institution experiences liquidity difficulties due to events specific to that institution. [86]