Australian Prudential Regulation before and after the Global Financial Crisis

This paper reviews the nature of Australian bank prudential regulation before and after the Global Financial Crisis (GFC). It begins by providing a detailed conceptual framework for understanding the functions of banks and deposit-takers, the theory of what can go wrong with the operation of these institutions, and the logic of prudential regulation. It then traces developments in Australian prudential regulation from the introduction of the formal capital-based framework in the 1980s to the implementation of the Basel III regime after the GFC. The paper concludes that the introduction of the Financial Claims Scheme was clear a change compared with pre-GFC arrangements and one to be welcomed but one that constituted a clarification and formalisation of an existing perception suggested by the depositor protection provisions of the Banking Act rather than a fundamental change. The paper also concludes that the introduction of the Basel III liquidity regime did constitute a more fundamental modification. Requiring banks to hold enough liquidity to manage net cash outflows over a thirty day period in stressed conditions, engenders confidence in deposit-takers and provides a backstop to the effectiveness of capital measures designed to reduce the likelihood of financial instability. Changes to authorised deposit-taking institution (ADI) capital regulation that lie at the core of the Basel III regime also represent positive and desirable developments in the Australian context. In particular, enhancing the quality of ADI capital to ensure that it provides a cushion of instruments genuinely available to absorb losses in the loan portfolio and related exposures, and ensuring that securitisation arrangements do not leave residual credit exposures unaccounted for in the provision of this protective cushion, enhance the safety of Australian ADIs. That these represent fundamental changes in philosophy compared to pre-GFC arrangements is less clear. Their importance is unquestionable but the paper concludes that they are better characterised as significant refinements to the risk-based calculation of capital than as fundamental changes to regulatory philosophy. The paper also argues that while Australia’s adoption of Basel III’s macroprudential apparatus appears on the surface to constitute a genuine innovation in prudential regulation, the Australian Prudential Regulation Authority (APRA) had been practising macroprudential regulation before the GFC and there is a longer tradition of thinking about such regulation in Australia dating back to the Napier Royal Commission of 1935-37. It is, however, argued that the explicit recognition of macroprudential regulation represents an important and positive development. The paper lastly argues that the importance of financial stability as a policy objective and the nature of macroprudential regulation which has the potential to address this objective, raise questions about the wisdom of having split monetary policy and prudential regulation functions in 1998 and recommends revisiting this question and reassessing the institutional structure within which prudential regulation is conducted in Australia